U.S. GOVERNMENT PUBLISHING OFFICE

30–768 PDF WASHINGTON : 2018

S. HRG. 115–280 

THE UNIVERSAL SERVICE FUND 

AND RURAL BROADBAND INVESTMENT 

HEARING 

BEFORE THE

SUBCOMMITTEE ON COMMUNICATIONS, 

TECHNOLOGY, INNOVATION, AND THE INTERNET 

OF THE

COMMITTEE ON COMMERCE, 

SCIENCE, AND TRANSPORTATION 

UNITED STATES SENATE 

ONE HUNDRED FIFTEENTH CONGRESS 

FIRST SESSION 

JUNE 20, 2017 

Printed for the use of the Committee on Commerce, Science, and Transportation 

( 

Available online: http://www.govinfo.gov 

(II) 

SENATE COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION 

ONE HUNDRED FIFTEENTH CONGRESS 

FIRST SESSION 

JOHN THUNE, South Dakota, Chairman 

ROGER F. WICKER, Mississippi 

ROY BLUNT, Missouri 

TED CRUZ, Texas 

DEB FISCHER, Nebraska 

JERRY MORAN, Kansas 

DAN SULLIVAN, Alaska 

DEAN HELLER, Nevada 

JAMES INHOFE, Oklahoma 

MIKE LEE, Utah 

RON JOHNSON, Wisconsin 

SHELLEY MOORE CAPITO, West Virginia 

CORY GARDNER, Colorado 

TODD YOUNG, Indiana 

BILL NELSON, Florida, Ranking 

MARIA CANTWELL, Washington 

AMY KLOBUCHAR, Minnesota 

RICHARD BLUMENTHAL, Connecticut 

BRIAN SCHATZ, Hawaii 

EDWARD MARKEY, Massachusetts 

CORY BOOKER, New Jersey 

TOM UDALL, New Mexico 

GARY PETERS, Michigan 

TAMMY BALDWIN, Wisconsin 

TAMMY DUCKWORTH, Illinois 

MAGGIE HASSAN, New Hampshire 

CATHERINE CORTEZ MASTO, Nevada 

NICK ROSSI, Staff Director 

ADRIAN ARNAKIS, Deputy Staff Director 

JASON VAN BEEK, General Counsel 

KIM LIPSKY, Democratic Staff Director 

CHRIS DAY, Democratic Deputy Staff Director 

RENAE BLACK, Senior Counsel 

SUBCOMMITTEE ON COMMUNICATIONS, TECHNOLOGY, INNOVATION, 

AND THE INTERNET 

ROGER F. WICKER, Mississippi, Chairman 

ROY BLUNT, Missouri 

TED CRUZ, Texas 

DEB FISCHER, Nebraska 

JERRY MORAN, Kansas 

DAN SULLIVAN, Alaska 

DEAN HELLER, Nevada 

JAMES INHOFE, Oklahoma 

MIKE LEE, Utah 

RON JOHNSON, Wisconsin 

SHELLEY CAPITO, West Virginia 

CORY GARDNER, Colorado 

TODD YOUNG, Indiana 

BRIAN SCHATZ, Hawaii, Ranking 

MARIA CANTWELL, Washington 

AMY KLOBUCHAR, Minnesota 

RICHARD BLUMENTHAL, Connecticut 

EDWARD MARKEY, Massachusetts 

CORY BOOKER, New Jersey 

TOM UDALL, New Mexico 

GARY PETERS, Michigan 

TAMMY BALDWIN, Wisconsin 

TAMMY DUCKWORTH, Illinois 

MAGGIE HASSAN, New Hampshire 

CATHERINE CORTEZ MASTO, Nevada 

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C O N T E N T S 

Page 

Hearing held on June 20, 2017 ............................................................................... 1 

Statement of Senator Wicker .................................................................................. 1 

Statement of Senator Schatz .................................................................................. 3 

Statement of Senator Nelson .................................................................................. 197 

Prepared statement .......................................................................................... 198 

Statement of Senator Klobuchar ............................................................................ 198 

Statement of Senator Peters ................................................................................... 200 

Statement of Senator Hassan ................................................................................. 202 

Statement of Senator Fischer ................................................................................. 203 

Statement of Senator Capito .................................................................................. 206 

Statement of Senator Baldwin ................................................................................ 208 

Statement of Senator Cortez Masto ....................................................................... 210 

WITNESSES

Michael J. Balhoff, CFA, Senior Partner and Cofounder, Charlesmead Advisors, LLC ............................................................................................................... 3 

Prepared statement .......................................................................................... 5 

Shirley Bloomfield, Chief Executive Officer, NTCA-The Rural Broadband Association ................................................................................................................ 172 

Prepared statement .......................................................................................... 174 

Eric B. Graham, Senior Vice President, Strategic Relations, C Spire ................ 178 

Prepared statement .......................................................................................... 180 

Karen S. Rheuban, MD, Professor of Pediatrics, Senior Associate Dean, Continuing Medical Education and External Affairs; and Director, University 

of Virginia Center for Telehealth ........................................................................ 186 

Prepared statement .......................................................................................... 188 

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THE UNIVERSAL SERVICE FUND 

AND RURAL BROADBAND INVESTMENT 

TUESDAY, JUNE 20, 2017 

U.S. SENATE, SUBCOMMITTEE ON COMMUNICATIONS, TECHNOLOGY, INNOVATION, AND THE INTERNET, COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION, Washington, DC. 

The Subcommittee met, pursuant to notice, at 9:56 a.m. in room 

SR–253, Russell Senate Office Building, Hon. Roger Wicker, Chairman of the Subcommittee, presiding. 

Present: Senators Wicker [presiding], Schatz, Blunt, Fischer, 

Heller, Capito, Gardner, Young, Klobuchar, Markey, Peters, Baldwin, Hassan, Cortez Masto, and Nelson. 

OPENING STATEMENT OF HON. ROGER F. WICKER, 

U.S. SENATOR FROM MISSISSIPPI 

The CHAIRMAN. Good morning, the Subcommittee will come to 

order. Today we will examine the Universal Service Fund and its 

impact on broadband investment in rural America. I’m glad to convene this hearing with Senator Schatz, my good friend. 

When Congress passed the Telecommunications Act in 1996, it 

made clear that all Americans should have access to quality communications services at just, reasonable, and affordable rates. 

From that time, the Universal Service Fund, established by the 

FCC, has been a primary mechanism for achieving universal communications service across the country. It has supported the deployment of communications networks to rural and remote geographic areas, and it has provided essential support to build out 

networks to health care facilities and other institutions that would 

likely go without service. 

In 2011, the FCC significantly reformed parts of the USF program in an attempt to address past shortcomings and inefficiencies, 

particularly when deploying communications services to high-cost 

rural areas. Many of these reforms stemmed from economic assumptions and other judgments about how the Commission anticipated funding needs for service in hard-to-reach areas. They also 

aimed to make support more efficient while modernizing programs 

and ensuring next generation communication technologies and 

services reach rural areas. 

Despite reforms, challenges within USF persist. These challenges 

include the program’s ability to support meaningful investments 

into the broadband deployment and conduct necessary maintenance 

on established networks. As a result, this has left a disparity in the 

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quality of communications service between urban and rural areas. 

Inadequate data collection methods are also one of USF’s challenges, leading to an inefficient distribution of funds to truly underserved and unserved areas. 

To address this issue, I recently joined Senator Manchin in introducing the Rural Wireless Access Act, which has the support of 

several of my colleagues, including Senator Schatz, Senator Fischer, Senator Klobuchar, Senator Moran, and Senator Peters. This 

bill would require the FCC to standardize its data collection methods to ensure that USF support is directed to rural communities 

in Mississippi, Hawaii, Minnesota, and in areas across the Nation 

that are actually in need. 

Reliable data is a critical step toward eliminating inefficiencies 

within the USF program and fulfilling the statutory goal of universal service. I appreciate the efforts of all the stakeholders involved to improve data collection at the FCC. As these efforts continue, it is important that this data be collected quickly so as not 

to delay the delivery of essential communications services through 

programs like Phase 2 of the Mobility Fund to communities in 

need. 

Ensuring the deployment of broadband service to rural health 

care providers is another critical component of the USF program. 

Today, Senator Schatz and I will reintroduce the Reaching Underserved Rural Areas to Lead on Telehealth Act. With this bill, several health care providers that offer service predominantly to rural 

areas would qualify for support under USF’s Rural Health Care 

Program. Mississippi is a leader in telemedicine and is driving the 

use of innovative technologies to improve the quality, accessibility, 

and affordability of care. Robust broadband connections, supported 

through USF, are vital to the adoption of this lifesaving technology. 

The importance of our efforts to deliver broadband service to 

rural areas cannot be understated. Job creation, economic development, and access to digital innovation, such as telemedicine, fully 

self-driving cars, and smart communities have become increasingly 

reliant on the presence of high-quality, high-capacity broadband 

networks. It is imperative for all Americans to have access to the 

communications services promised by USF programs. 

I look forward to hearing from our witnesses today about the 

state of broadband investment in rural America and how the USF 

program is affecting the market. I also hope the witnesses will offer 

recommendations on how the Commission can address inefficiencies within USF to ensure that the economic and digital opportunities afforded by broadband reach our rural communities. 

Our witnesses today are Mr. Michael Balhoff, Senior Partner, 

Charlesmead Advisors; Ms. Shirley Bloomfield, Chief Executive Officer, NTCA-The Rural Broadband Association; Mr. Eric Graham, 

Senior Vice President, Strategic Relations, of C Spire; and Dr. 

Karen Rheuban, MD, Director, University of Virginia Center for 

Telehealth. 

I am delighted to have all of these witnesses here today. I now 

recognize Senator Schatz, my teammate on this subcommittee, for 

whatever opening statement he chooses to make. 

3 

STATEMENT OF HON. BRIAN SCHATZ, 

U.S. SENATOR FROM HAWAII 

Senator SCHATZ. Thank you, Mr. Chairman, for convening this 

important hearing on USF. USF, as you all know, was created to 

make sure that all Americans have the security and the opportunities that come with being connected to essential communications 

networks. 

But today it’s not enough to have access to voice services; access 

to broadband is a necessity for people to be able to participate in 

society. Tasks like applying for a job, accessing government services, or doing homework are now nearly impossible without 

broadband. And yet too many Americans don’t have access to 

broadband, particularly those living in rural and isolated areas. 

In fact, the FCC’s yearly broadband report indicates that millions 

of Americans lack access to high-quality—excuse me—high-speed 

broadband services. We can’t close that divide without USF, which 

is why the FCC has done a lot of work since 2011 to update USF 

and refocus it on deploying broadband. 

So what’s next? First, we have to remain vigilant against waste, 

fraud, and abuse. The FCC should continue to examine reforms 

that stress transparency, accountability, and enforcement. 

Second, distribution mechanisms within the USF must ensure 

that support goes where it is needed the most. USF’s E-rate and 

Lifeline programs are critical to bridging the digital gaps that exist 

for people living in rural and tribal areas as well as those from underserved communities. The programs fund broadband access in libraries and schools, and provide low-income Americans access to 

opportunities that can lead to a better life. 

Another key component of USF is its Rural Health Care Program, which provides support to qualified health providers so they 

have the broadband service necessary to provide telehealth services. These are crucial services for people who live miles from the 

closest health care facility and may lack access to specialists. 

Finally, as the FCC thinks about the best allocation and use of 

USF funds, it must take into account the unique circumstances of 

certain localities. In Hawaii, there are unique geographical and 

topographical challenges that make delivering broadband very difficult and very costly. For USF to deliver on its promise to connect 

all people, it has to account for such challenges. 

I thank today’s witnesses for joining us at this hearing. I thank 

the Chairman for convening, and I look forward to discussing these 

important topics. 

The CHAIRMAN. Well, thank you very much, Ranking Member 

Schatz. 

Thank you to our distinguished panel for joining us today. 

We will begin with Mr. Balhoff. Can you give us about 5 minutes 

of opening testimony? We’ll take your full statement into the 

record. 

STATEMENT OF MICHAEL J. BALHOFF, CFA, SENIOR PARTNER 

AND COFOUNDER, CHARLESMEAD ADVISORS, LLC 

Mr. BALHOFF. Thank you very much, Chairman Wicker, Ranking 

Member Schatz, and distinguished members of the Subcommittee. 

I very much appreciate the opportunity to speak to you today reVerDate Nov 24 2008 09:27 Jul 24, 2018 Jkt 075679 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 S:\GPO\DOCS\30768.TXT JACKIE
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garding ‘‘The Universal Service Fund and Rural Broadband Investment.’’ I’ve done a tremendous amount of work over the years, 

nearly 30 years, focused on this industry as a financial analyst. 

I was 16 years at Legg Mason, which is an investment firm 

based in Baltimore, but we provided published advice across the 

country and actually internationally. I headed the Equity Research 

Group there that focused on telecom and technology, and it was 

widely recognized during that period that we had the foremost 

practice in rural telephony in the United States. So we were pretty 

significantly in demand to provide our advice on strategic issues. 

I’m now an investment banker at my own firm providing merger 

and acquisition services again to rural carriers. So our specialized 

interest is rural telephony. 

I have four summary remarks. 

First, as you are aware, Universal Service Funding is critically 

important in assuring a robust and capable telecom network supporting voice and broadband, as you’ve already mentioned, in rural 

and high-cost regions. USF or the Connect America Fund, as it is 

now known, is not a subsidy program, nor is it a tax arising from 

appropriations; rather, it is a payment system to compensate for 

real network costs that benefit all users of the domestic network, 

whether those users are in New York City; or in Vacherie, Louisiana; in Los Angeles; or in Fremont, Idaho. Payment of investment and operating costs across the country, and notably in highcost rural areas, are dependent, as Congress previously found, on 

rates paid by all Americans who rely on that universal network. 

Second, the level of universal service funding has a direct effect 

on network investment. I know, and I am not guessing, that carriers in rural regions have sharply curtailed network investment in 

the wake of the 2011 FCC Transformation Order. Among other 

things, it’s reflected in the loans from the lenders to this industry. 

So specifically illustrating this, the Rural Utility Service at the 

Department of Agriculture has been able to place its entire loan allowance each year—that’s $906 million—every year through 2011. 

In the wake of the 2011 transformation order, however, the following year they were able to only place 11.6 percent, where previously they had placed the entirety. And it has not yet risen above 

37 percent since that time. This year, it’s running around 20 percent. Last year, it was 28 percent. 

Illustrating what is happening at many companies, and there are 

many examples, a board of a large cooperative just told me days 

ago that it had stopped a $26 million fiber build, affecting 970 

miles of fiber, and 6,976 customers, purely and simply, according 

to the Board, because of the FCC’s budget control mechanism. I 

cannot state strongly enough, the carrier investment in all of my 

experience, and I know that this is the reality, is driven by available funds, and it’s disproportionately harmed by the uncertainty 

in funding levels. 

Third, as I quantify in my written testimony, which is much 

longer, the FCC has acknowledged that the USF funds available 

for small rate-of-return carriers for the upcoming year is short by 

12.4 percent. I actually state in my written testimony, I believe 

that understates the shortfall which, under the previous rate-of-reVerDate Nov 24 2008 09:27 Jul 24, 2018 Jkt 075679 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 S:\GPO\DOCS\30768.TXT JACKIE
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turn allowance, would have been 16 percent, and I believe that the 

number is actually higher, which I describe. 

My belief is that it’s difficult to square this with Section 254 of 

the Telecom Act, which legislates that universal service should be 

sufficient. By definition, it appears to be insufficient. 

Fourth, and finally, my testimony also points to what I believe 

is the greatest USF problem, which Senator Schatz pointed to, in 

underinvested areas. That is, the largest carriers have strategic 

commitments to nonrural businesses and are underinvesting in a 

way that affects the largest number of rural customers across the 

country. 

Based on my nearly 30 years analyzing this industry, I’m here 

to testify as strongly as I possibly can that the most widespread financial problem in rural America is found in the areas and customers served by the largest carriers. I believe that those large carriers actually are doing something that is responsible, which is that 

they’re deploying their capital in a way that is productive for them. 

I believe those large carriers, however, are not properly incented to 

invest in those areas, and as a result, that we need to incent sales 

of those properties by the large carriers to other carriers. 

I’m happy to address any questions that this subcommittee may 

have. And I thank you for your time. 

[The prepared statement of Mr. Balhoff follows:] 

PREPARED STATEMENT OF MICHAEL J. BALHOFF, CFA, SENIOR PARTNER AND

COFOUNDER, CHARLESMEAD ADVISORS, LLC 

Chairman Wicker, Ranking Member Schatz, and distinguished Members of the 

Commerce Committee. Thank you for inviting me to testify today regarding the 

‘‘Universal Service Fund and Rural Broadband Investment.’’ 

My name is Michael J. Balhoff. I am a senior partner at Charlesmead Advisors, 

LLC, which is a Baltimore-based investment banking firm that I co-founded with 

two partners in June 2011. We provide merger-and-acquisition as well as valuationrelated services to companies in the telecommunications industry, notably the rural 

telecommunications industry. I have provided independent financial analysis and 

advice in the telecommunications industry for nearly 30 years. My education and 

business background are found in Appendix 1, attached to this testimony. 

I would like to address two questions in this hearing. 

• The first concerns whether the universal service fund (USF)—more recently 

known as the ‘‘Connect America Fund’’ (CAF)—is sufficient to support networks 

and services required in rural regions. 

• The second question concerns how to improve the targeting of USF/CAF monies 

to better achieve the policy goals associated with those programs. 

I. IS USF/CAF SUFFICIENT TO SUPPORT NETWORKS AND SERVICES IN 

RURAL REGIONS? 

The simple answer is ‘‘no.’’ Setting aside the shortfall for larger price-cap carriers 

for the moment, I believe that small rate-of-return (RoR) carriers are insufficiently 

funded, possibly by $260 million annually. I have two comments in support of my 

response. 

A. THE FCC ITSELF ACKNOWLEDGES THAT THE FUND, AS CURRENTLY 

CONSTITUTED TO SUPPORT SMALLER CARRIERS, DOES NOT HAVE 

SUFFICIENT FUNDING 

The FCC authorizes the actual payments of universal service funding through the 

Universal Service Administrative Company (USAC). Pursuant to the FCC’s March 

2016 Rate of Return Reform Order, USAC recently released its calculation of a budget-driven reduction in payments to small RoR carriers for Fiscal Year mid-2017 to 

mid-2018. I summarize the calculation in a table below. The calculation preserves 

payments to Alaska carriers, to carriers that have chosen to receive Alternative 

Connect America Cost Model (ACAM) funding (albeit at levels lower than the origiVerDate Nov 24 2008 09:27 Jul 24, 2018 Jkt 075679 PO 00000 Frm 00009 Fmt 6633 Sfmt 6621 S:\GPO\DOCS\30768.TXT JACKIE
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1The FCC reported on December 16, 2016 that 216 rate-of-return carriers submitted letters 

electing 274 separate offers of ACAM support in 43 states. 

nal offer as I will explain below), and to carriers that are eligible for certain intercarrier support. 

Because of a cap of $2 billion on annual support for small RoR carriers—a cap 

set in the 2011 Transformation Order—funding for RoR carriers that continue to receive support through rate-of-return mechanisms will be adjusted lower by the full 

amount of the shortfall. 

The $2 billion cap was determined based on 2011 levels of support approved for 

RoR carriers. To the best of my knowledge, no analysis was performed to determine 

that $2 billion was sufficient in 2011 or that the funding would be sufficient in future years. I emphasize this important point because the Telecommunications Act 

of 1996 presents several fundamental principles for the Act, including at Section 

254(b)(5) where the law stated that ‘‘[t]here should be specific, predictable and sufficient Federal and State mechanisms to preserve and advance universal service.’’ 

(Emphasis added.) 

Because the statute mandates that USF should be sufficient, a question has been 

posed about whether there is a fundamental inconsistency if ‘‘sufficiency’’ was not, 

and is not, assessed? 

As noted above, the shortfall in payments is borne, in this calculation, by the 

small RoR carriers (those that did not elect the ACAM). Parenthetically, I note that 

small carriers with specified broadband buildouts to at least 90 percent of their 

service region could not accept the ACAM model and were compelled—due to their 

successful deployments—to remain under the rate-of-return regime. 

The calculated shortfall in available funding for mid-year 2017 to mid-year 2018 

results in a $173 million, or a 12.4 percent, RoR reduction in ‘‘allowed support’’ in 

the upcoming Fiscal Year—2017 to 2018. The shortfall appears to be prima facie 

evidence that the funding level—once assumed appropriate for 2011—is now insufficient for the smaller carriers. This upcoming adjustment follows on the reduction 

for smaller carriers in the first half of calendar year 2017 when the FCC cut CAF 

Broadband Loop Support (BLS) by $80 million, again to remain within the 2011- 

based budget. 

The FCC is not simply reducing funding for carriers that remain under rate of 

return. The FCC-determined ‘‘budget’’ is also affecting ACAM carriers. Even the carriers that accepted the ACAM are not receiving the support offered in the initial 

proposal last year. The reason is that the ACAM was oversubscribed.1 As a result, 

in December 2016, the FCC chose to address the oversubscription by reducing the 

per-line offer of support by 27 percent, from the $200 per line to $146.10. 

I suggest that the FCC itself is effectively stipulating that the 2011-based budget 

is insufficient and the Transformation Order has prompted the Commission to override the Telecom Act’s legislative principle regarding the ‘‘sufficiency’’ of funding. 

The rural trade organizations have been advocating what appears to be a reasonable solution, which is that the FCC should fully-fund rate-of-return service territories, both ACAM and CAF BLS. Their estimate is that fully funding ACAM and 

RoR carriers would require an annual increase of approximately $200–$260 million, 

which is not a dramatic increase, in my opinion, in light of growing broadband responsibilities. 

7 

2See Appendix 3, which includes the Balhoff Rebuttal Testimony, California Public Utilities 

Commission, A. 15–09–005, filed March 11, 2016, notably at pages 63–80. 

B. MY PROFESSIONAL OPINION IS THAT THE FCC WAS MISTAKEN IN REDUCING THE ALLOWED RATE OF RETURN 

I will be brief in my second point, in part because I suspect that Congress wants 

to defer to the FCC in determining the allowed rate of return. 

I believe that the FCC was mistaken when it ordered a reduction in the allowed 

rate of return in March 2016, in great part relying on a report generated by the 

FCC Staff in May 2013. The allowed rate of return was reduced from 11.25 percent 

in a transition that is gradually implemented annually through a 25-basis point reduction until the rate settles at 9.75 percent on July 1, 2021. The effect, obviously, 

is to reduce the potential funding available to small carriers. 

I provided a long and carefully-sourced analysis of the Commission Staff’s report 

on which the FCC based its decision.2 That analysis was filed before the California 

Public Utilities Commission, in a proceeding in which I represented ten small California carriers. I have attached that long testimony as Appendices 2 (September 

2015 prefiled direct testimony) and 3 (March 2016 rebuttal testimony), in the event 

the Subcommittee wishes to review the issue. 

Because I assume the Subcommittee is not interested in technical cost-of-capital 

theory or capital asset pricing models, I will make a simpler comment about the 

trends in rural costs of capital, based on my real-world investment banking experience. 

Valuations of rural telephone companies have demonstrably collapsed from ten 

years ago when rural-carrier sales were valued at approximately eight times each 

dollar of operating cash flow. Since then, the valuations have settled generally between 4.5 and 5.5 times operating cash flow, which means that investors perceive 

new risks that have caused a startling contraction of 30 percent–-40 percent in 

value. Certain fundamentals of the rural business have not changed significantly in 

that period as voice lines continue to contract and broadband continues to expand, 

but other risks have increased including competitive and regulatory developments. 

The effect is a valuation contraction that is unlikely to reverse in the foreseeable 

future. 

The financial principle is straightforward. When values contract and expected future cash flows are not appreciably changed, the explanation is that the cost of capital—the discount rate applied to those cash flows—is rising. 


620BALHO1.eps
8 

3See Appendix 2, which is the prefiled testimony, September 1, 2015, notably at pages 49– 

71. An analysis of the implied cost of equity arising from transactional data is included from 

pages 62 to 71. 

I note that this analysis is similar to valuing a home in an area where there are 

demographic changes. You may believe your house should attract a higher value because you are aware of historical values and you can tabulate your actual investment; but, if the neighborhood has changed and other economic factors have created 

negative pressures, the best indicator of value is the price agreed to by a willing 

buyer and willing seller. Whatever the FCC may argue from a theoretical point of 

view—and I disagree with specific elements of those arguments as spelled out in the 

Appendices—the willing buyers and willing sellers are telling you that the cost of 

capital for rural carriers is up sharply as reflected in the deeply depressed prices. 

Respectfully, I represent that the FCC is not correct and is therefore assigning returns on capital that are well below those indicated by the capital markets. 

Quite simply, rural carriers are no longer protected, monopoly utilities with governmental oversight and ready access to capital. It is nonsense to suggest that a 

rural carrier’s cost of capital which was 11.25 percent in 1990 (the last time the rate 

was adjusted before 2011) or in 2001 when the 11.25 percent was reaffirmed, should 

now be lower when competition, technology and regulatory risks have dramatically 

increased. 

If I am correct, then the shortfall outlined by USAC is not 12.4 percent, but well 

higher, as is supported in my California testimony.3 For further perspective, if the 

FCC had maintained an allowed rate of return at 11.25 percent—and again I believe 

it has gone higher still—the shortfall for the RoR carriers in the upcoming year 

would be approximately 16.2 percent, by my calculation. If the rate should be 12.00 

percent, then this coming year’s shortfall is 21.5 percent. 

I state again that I believe that RoR carriers are insufficiently funded. 

II. MIGHT THERE BE IMPROVED TARGETING OF THE USF/CAF MONIES 

TO BETTER ACHIEVE THE POLICY GOALS ASSOCIATED WITH 

THOSE PROGRAMS? 

Yes. I respond again in two parts, one regarding small carriers and the second 

regarding larger, price-cap carriers. 

A. ROR CARRIERS ARE INSUFFICIENTLY FUNDED BUT THE TARGETING 

APPEARS GENERALLY REASONABLE 

The FCC and USAC have generally done a good job in determining how the funding is allocated for small RoR carriers—based on investment and operating costs 

that are carefully tracked. And the FCC models indicate, with some degree of accuracy, that funding levels are too low. I believe that the reason for the shortfall, in 

part, is the accelerating pace of required upgrades to meet customer needs in a rapidly evolving broadband world, but the systems appear to me at this time to be generally reasonable. 

B. MOST RURAL AREAS OF LARGE CARRIERS, PRICE–CAP CARRIERS ARE 

OFTEN WHERE THE PROBLEMS EXIST 

In the 2011 Transformation Order, the FCC stated at paragraph 21 that ‘‘[m]ore 

than 83 percent of the approximately 18 million Americans that lack access to residential fixed broadband at or above the Commission’s broadband speed benchmark 

live in areas served by price cap carriers—Bell Operating Companies and other 

large and mid-sized carriers.’’ 

This paragraph is stunning in making two important points. First, the FCC is 

stating that 15 million Americans lack residential broadband access in larger-carrier 

regions. For perspective, the large price-cap carriers served a total of approximately 

60 million lines at that time; it can be inferred that the vast majority of large-carrier rural lines are underinvested, assuming that the large-carrier broadband-capable lines are concentrated in non-rural regions. Second, at most, 17 percent of the 

underinvested lines are in regions served by smaller carriers, which suggests that 

the former USF system was working with laudable effectiveness. This second insight of course raises the question about why the new system should further limit 

support to companies that have been investing successfully to achieve policy goals. 

Since the time of the Transformation Order, the FCC has attempted to address 

this underinvestment problem, notably in large-carrier, price-cap regions. The Commission authorized initiatives such as the Connect America Fund II to offer incremental funding to build out to specified high-cost service locations. 

Still, my experience is that very little widespread investment is occurring in rural 

regions of the large carriers. And the reason, in my opinion, is that many of those 

9 

4 USAC at https://usac.org/hc/rules-and-orders/rate-of-return-reform-order.aspx. See, also, 

https://apps.fcc.gov/edocs_public/attachmatch/DA-15-509A1_Rcd.pdf and https://apps.fcc.gov/ 

edocs_public/attachmatch/DA-16-929A1_Rcd.pdf. Note that the column for large, price-cap carriers includes only FCC-designated high-cost or extremely high-cost locations, not the total number of lines served by the large carriers in the states. The rural local exchange carrier (RLEC) 

column provides the total number of lines served by RLEC, that is, RoR carriers, in the state. 

carriers are focused on more urban, more wireless, more enterprise, and more international opportunities that provide superior opportunity for growth. The failure to 

invest in rural areas, therefore, may not explained by insufficient capital or insufficient universal service funding in most cases, but by the strategic focus of those 

larger carriers which is dedicated to other ‘‘more productive’’ businesses. 

This is the major ‘‘targeting’’ problem, in my opinion. Large carriers own substantial swaths of rural America, but are not likely to make significant financial commitments in those areas. The largest carriers have major other responsibilities, which 

are not in rural regions in any state. To illustrate, the table nearby indicates that 

the large carriers in Mississippi have the greatest number of high-cost rural properties—150,000 in the state—compared with small carriers that serve a total of 

67,000 lines in the state.4 The table summarizes state-by-state how that illustration 

is the rule rather than the exception as the high-cost locations and extremely highcost locations where large, price-cap carriers are the providers of service are generally larger than the number of lines served by small carriers (rural local exchange 

carriers). Again, I contend those smaller carriers are investing in rural America at 

approximately appropriate levels. If the FCC is right that large carriers are underinvesting—and I think it is correct—then the problem of targeting is not a capitalallocation issue. It is a problem that is explained by the fact that the wrong carriers 

own those properties. 

I believe that there are promising solutions that involve creating appropriate incentives for large carriers to divest underinvested and non-strategic properties to 

smaller carriers in the state or in nearby states. Further, I believe it is possible to 

craft solutions that require buyers to invest at levels that assure broadband services 

at levels that are comparable to those in urban areas. One solution involves forgiving sale-related taxes imposed on the sellers so that the sale prices can contract 

to acceptable levels—not to reward the seller, but to assure that the buyer can acquire the properties at deep discounts to current market prices and with sufficient 

financial headroom for greater subsequent investments. Those solutions are under 

discussion at the present. 

10 

For the purposes of this hearing, I propose that it is critically important to understand the nature of the problem before taking constructive steps toward broadband 

solutions. It is my testimony today that the major broadband challenge is centered 

in regions where the carrier-owner has no strategic intent to improve those regions. 

The solution, therefore, must involve assessing how to incent sales by underinvesting carriers to dedicated operators that have the obligation to upgrade in 

those regions. 

III. CONCLUDING REMARKS 

I am happy to discuss the shortfall in funding or the reasons that large carriers 

are generally ill-suited to provide service in rural regions. 

Thank you and I look forward to answering your questions. 

APPENDIX 1—BIO OF MICHAEL J. BALHOFF, CFA 

Michael Balhoff is a Senior Partner and co-founder of Charlesmead Advisors, 

LLC, and is Managing Partner at Balhoff & Williams, LLC, a professional services 

firm that provides financial-regulatory consulting and advisory services to companies, investors and policymakers in the communications and energy industries. 

Before founding Charlesmead Advisors and the predecessor firm to Balhoff & Williams, Mike headed the Technology and Telecommunications Equity Research Group 

at Legg Mason and, in the final seven of his sixteen years as a senior analyst at 

Legg Mason, he covered equities in the incumbent local exchange carrier industry. 

Prior to joining Legg Mason in 1989, Mike taught as a graduate and undergraduate teacher. Mike has a doctorate in Canon Law and four master’s degrees, 

including an MBA—concentration finance—from the University of Maryland. He is 

a CFA charterholder and is a member of the Baltimore Security Analysts Society. 

Mike has been named in six annual awards as a Wall Street Journal All-Star Analyst for his recommendations on the Telecommunications industry. His coverage of 

telecommunications, and especially rural telecommunications, was named by InstiVerDate Nov 24 2008 09:27 Jul 24, 2018 Jkt 075679 PO 00000 Frm 00014 Fmt 6633 Sfmt 6621 S:\GPO\DOCS\30768.TXT JACKIE

620BALHO2.eps
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tutional Investor magazine as the top telecommunications boutique in the country 

in 2003. 

Mike is a Registered Representative of and Securities Products are offered 

through BA Securities, LLC Member FINRA SIPC. Any testimonial or endorsement 

may not be representative of the experience of other customers and is no guarantee 

of future performance or success. 

APPENDIX 2—CALIFORNIA PREFILED TESTIMONY OF MICHAEL J. BALOFF, CFA 


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I. lnu·oduclion and Purnost 

Q. Ple;,se state your n:une ;111d position ror che record. 

A. My name is Michael J. Balhoff. I am ManagjngPannerofBalhotT& Williams, LLC 

("B&W"). and my business address is 5850 Waterloo Road. Suite 140, Columbia, 

Maryland 2 1045 I am niSQ Senior Partner ofChorfcsmcnd Advisors, LLC 

f'Charlcsmead"), and Charlesmcad has the same business address as B&W. 

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\Vhat services do 6&\V and Chnrlesmead l)rovide? 

B&W provides advisory services, including financial and regulatory consulling, Our 

clients are various telecommunications, cable television. and energy companies. 

B&W previously was known as Balhoff & Rowe, LLC, and then Balhoff, Rowe & 

Williams. LLC. The finn changed ils name 10 reOeerrhe active panners. bUithe 

services of the fim1 have remained consistent since the company was established in 

2004, With two other panners, I also co-founded Charlesmead in June 2010 10 

prO\~ de investment banking services to telecommunications companies. My services 

in this procoeding are provided thr0<1gh B&W. 

Pleasr des cribe your t•elevant educational and professional background. 

J have a docronue a11d fO\tr masters degrees. including an M B.A .. wi1h a concemra1ion 

in finance. from the Uni versity of Maryland. l am a Chanered Financial Analyst and 

am a member of !he Baltimore Security Analysts Society. During a period of 16 years. 

I was a senior equity analyst and Managing Director with responsibility for leading the 

ce1ccommunications and technology sell·sidecquity research group at Legg Mason 

Wood Walker. Inc .. which was the wholly-owned capital markers di,;sion of Legg 

Mason. Inc. ("Legg Mason"), headquartered in Baltimore, Maryland. In 1ha1 role, I 
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staffed and supervised a team of sell··side equity analysts providing research coverage 

of technology and telecommunications companies. With respect to regulated 

companies. I supervised and provided research coverage of incumbent local exchange 

carriers ("LLECs"), long..distance providers, and competitive local exchange carriers. 

Ovt:J th~ l~.st ~..:vcu yca1s of my time at Leg~ Masun, l wa!!l ahu the •. n iunuy aualyst 

providing research coverage of local exchange telephone companies. including the 

regional l)ell operating companies and publicly-traded rural telephone companies My 

practice at Legg Mason was recognized notably for detailed coverage of rural 

relcphony and the specific questions that arise related to the financial eOCcts of 

regulation on equity securities in that sector. My more extensive resume. including 

publications. presentations, and testimonies, is included as Exhibit MJB - I. 

On whose behalf are you offcring te-stimony in this llrocceding? 

I am oflering testimony on behalf often small. rural California IL.ECs in this 

proceeding. The rural ILECs are Calaveras Telephone Company, California-Oregon 

Telephone Co., Ducor Telephone Company. Foresthill Telephone Co., Kemtan 

Telephone Company, Pinnacles Telephone Co .. The Ponderosa Telephone Co .• Sierra 

Telephone Company, Inc., The Siskiyou Telephone Company, and Volcano Telephone 

Company. I understand that the companies generally refer to themselves as the 

"Independent Small LECs." 

\Vhal is your relationship with tht rompanies? 

I have no current relationship with any of these companies except that they have asked 

me to analyze the appropriate cost ofcapiral for them. Prior to chis work, I have not 

had any relationship \\~th these companies. 
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Q. Have you appeared berore the Calirornia Public Utilities Commission 

(•'Commission"') in any other proceedings? 

A. No. I have not. However, I have provided regulatory testimony conceming 

telecommunications mailers before the Regulatory Commission of Alaska, the Iowa 

Utili tie:. Boa1..J, the:: Pulllit: Utility Ct.muuis!<iiuu oCTc:::ns . . the. Vc::•u•out Pulllit: Sc::avit:c:: 

Board. the New Hampshire Public Utilities Commission, and the Maine Public 

Utilities Commissiot~. 

Ll. PURI•OSE ANO SUMMARY OF TESTIMONY 

Q. \Vhn1 is the puq>ose or your testimony in this proceeding? 

A. I have been asked to provide testimony addressing cost of capital related to the 

Independent Small LECs in connection with an application to be submiued on 

September I, 2015 to this Commission In 1).15-06-048, the Commission ordered the 

Independent Small LECs to initiate a consolidated proceeding where the issue or Cost 

of Capital ("COC') would be examined for each carrier.' J understand that the results 

oftlte COC proceeding are to be applied in the next cycle of General Rate Cases 

("GRCs") to take place generally from 2015 d>rot~gh 2019 My testimony is focused 

on estimating an appropriate cost of capital for application in these rate cases. I will 

provide recommendations regarding an appropriate cost of equily capical and related 

cost of capital metrics to aid the CPUC in determining an appropriate Weighted Cost 

of Capital ("WACC") for each of the companies. 

I S.c Decision 15.()6-048 June 25. 201$ ru 20. 

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Q. \Vhat are your specific qualifications for evaluating cost of capital for rural 

telephone com pan itS? 

A. As I explained above. at Legg Mason, I developed a financial speciali1.ation in the 

equities of rural telephone companies in addition to my broader telecommunications 

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ooveHtgc.. I have .giv~n nuust:wu.s pJ~en atjuus tv the National A:ssot.:i~ iuu uf 

Regulatory Utility Commissioners ("NARUC") and appeared before Congressional 

and federal agency groups. Most recently. after the Federal Communications 

Commission's ('·fCC'') sweeping 2011 refonns of universal service and intercarrier 

compensation, I was invited to brief the Depanment of Agricul1'ure's Rural Utiliries 

Service ("RUS"). the White House. the Secretary of Agriculture, and the FCC 

conecn>ing the financial cfleets of those policy changes. On the basis of covcra¥c of 

rural companies. my Legg Mason pracrice was named by lnsrittnional Investor 

magazine as the top telecommunications financial a1lalysis boutique in rhe country in 

2003. I was also honored 10 be named as a Wall Street Journal All-Star Analyst in six 

annual awards for lhe performance of my C(JUity recommendations. 

Plensr sununarizr your prores.sion:d carter nrte•·leaving Legg Mason. 

In 2004. I had ~~e opponunity 10 co-found a company with Robcn Rowe, who was 

chairman of the Montana Public Service Commission as well as former pre-sident of 

NARUC and fom1erchairman ofNARUC's telecommunications committee. 1l1e 

professional focus at Balhoff. Rowe & Williams and at Charlesmead has been on rural 

relccommunicarions caniers and services. Our primary work today is investment 

banking-related as we represent buyers and sellers in the lLEC industry. advising in 

transactions involving the sales or purchases of entire companies. or advising 
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regarding transactions involving segments of businesses such as wirc.less assets, 

cowers. fiber transport. cable television operations and data centers. Our setviees 

require us to value celecornmunications assets and advise managements and boards of 

directors regarding strategic opportunities. 

Q. \Vhnt information did you review related to this testimony? 

A. I evaluated. amon~ other sources, the procedural record in Commission Rulemakin,g 

11-ll-007. prior cases involving cost of capilal brought before the Commission. 

United Stares Supreme Court docisions related 10 cost of capital, orders of the FCC 

CQnceming rare-of-return matters. cosl·of-capital resources related to telephone 

companies as compiled by lhbotson/Momingstar2 and DutT & Phelps.3 as well as 

transactional data that we maintain at our firm. Charlcsmead Advisors. I have also 

studied the financial reports of each of the lndependem Small LECs. reviewing their 

capital stntcture and debt costs. with a focus on the last six years from 2009 through 

20 14. 

2 Jn M:lf'C.h 2006. Mon1ingstar. Inc. compleuxl its previously lnnounccd acquisition of lbborson Associares. :t 

leading pro' idcr of assct nllocation rcscnrch and services. IbbotsOn 1\ssociatcs "as founded by Professor Roger Ibbotson in 1977. and expanded over cimc 10 compile and publish annual \'aluation data widely used by 

the fin:tncial community. As of20 14. Momingst:tr no Jong.cr publishes the Ibbotson valuation ma1crials. 

" hich, os of 2015, me included 111 the Duff & Phelps l>ttblications. lbborson/Monungstar still pubhshes us Clcuslc Yearbook \\tth impon:uu financial infomlation in suppon of,aluation profcsston.als. All the Ibbotson 

and Duff & Phelps cited ~1gCS and tables arc included in e ... hibil MJ B - 2 

3 Duff & Phelps is n rtS))Cctcd glolxtl \'::tluation nnd corpo~tc lin:tnce odvisor focused on scn.·ices including complex valuation, dtsputc consultmg, M&i\ :md n..--struc.turing. ·lllc company publishes :U'lnual st.uisucal 

valuation resources that arc\\ de !~ used by the financial community All the lbbolson and Duff & Phelps cited p3gcs :lnd 1ablcs arc iJ1Cludcd in E.xhibll MJB .. 2. 

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Q. Please summarize your testimony. 

A. I recommend a cost of capital for the Independent Small I,ECs to be utilized for 

ratemaking purposes in the rate case cycle to take place from 2015 through 2019. My 

testimony is generally divided into the following sections: 

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Approaches tn calculating cost or capital. Theinhial section oftJ1is 

testimony outlines the theoretical framework for estinlating the cost or capilal. 

detailing the standard approaches for calculating a corporate cost of C3J)ital, 

including capital structure. cost of debt and cost of equity. I e.'Oplain that the 

use of several cost·of .. capit.al assessment methods in a proceeding such as this 

one aJiows the regulator or analyst to arrive at improved confidence that the 

conclusions are reaso•1able. Conclusions based on just one methodology or 

data source are less reliable. I emphasize that de1erminations of1he cost of 

capital are not slavish applications of one formula or even several formulae, 

but are judgments arising from testing multiple inputs and thoughtful 

considerations ofindusuy data Accordingly, I begin with traditional valuation 

approaches. using the Buildup Melhod, which is a varia1ion of the Capital 

Asset Pricing Model ("CAPM .. ), with a modification (using an average I .06 

beta based on five rLECs) to make the industry·specific factor beuer match the 

Independent Small LECs' industry. I then use several time periods and 

approaches 10 assess any variations irl the resuhs. Then I test those resuhs 

based on transactional data to ensure their validity. 

lnduslry chnnges thnl affecl the cor·porate cost of capital for n~:11l ILECs. 

The second section emphasizes that the Commission should assess industry 
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forces to understand how those factors affect the companies and the degree to 

which those forces impose new and greater financial pressures. An analys1 

uses historical statistics with the assumption that the future may be like lite 

pas~ but I explain that assumption should be tested because U1e future may be 

ai~kieJ u1 s~fc:t tlnsu the •nast. tlej)t:m.liug on tlu! OOIIt:-111 m teasuuallly 

anticipated risk drivers in a given industry. Valuation and detcnninations of 

costs of capital always involve judgment I provide data and arguments in 

suppon of the fact tltat the industry risks are not less- but demonstrably 

greater- than they were nearly rwo decades ago when the Commission seuled 

on a presumptive 100/o WACC for the ten Independent Small LECs. I also 

supply data from real-world mergers and acquisitions ("M&A·"). which show 

that valuations have contracted sharply since the early 2000s, notably over the 

last five or six ycao·s. signaling that the rural lLEC cost of equity has been 

raised to a significant extent. almost cenainly because of adverse changes in an 

indus-try undergoing a fundamental transfonnation from monopoly to 

competition and from a focus on voice telephony 10 a focus 0 11 broadband 

services. These data provide the rationale and a compelling confim1ation of 

increased costs of equity over recem years. To be clear. while interest costs 

have declined recendy. there is little question in reviewing the data that the net 

cost of equity has risen steeply in U1e last decade. 

Calculation of :111 appropriate range li nd estimale for equity costs. To 

calculate a cost or cqui•y. I begin with the well-tested Buildup Method. which 

is conceptually the same in implementation as the CAPM. both of which are 
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~rad itional valuation approaches. Using those methods, and by making 

appropriate adjustments for equity risk. industry-specific risk. and size risk. I 

identify an appropriate range for the Independent Small LECs' equity costs, 

On the basis of the historicaJ data. I estimate that a realistic range for the 

lm.h!pt::nth:.ut S111all LEe~· t:o~t ofct)Uity i!it I'JO/o tu 2.2%, i:utLIIrc~uuucuc.l 

18.5%. which I \\~I I show to be a conservative calculation. I a.lso testify that an 

assessment of industry risks provides the Commission with a high degree of 

confidence that the cost of equity for ~te Independent Small LECs is 

substamially higher than ir was eighteen years ago when 1he Commission set 

the I 0'/o target WACC. Given the relatively low costs of equity that are often 

applied in public utility sectors, I recognize that some may initially be skeptical 

about a 18.5% equity cost estimate, but I am confident that it is reasonable for 

these companies and appropriate for adoption in this proceeding. If anything, 

the cost of equity I recommend may be lower than will be required to anract 

capita] for investments in rural telecommunications infrastruclure. As I explain 

above. I rely on multiple methodologies to test and ne-tcst my findings. and 

then I check the results against M&A data in an approach that is rigorous. 

intellectually honest. and convincing ln 1his section. I also provide a Stlllllnary 

of other premia that I have chosen not to add to my estimate. including premia 

for li<Juidity and marketability risk>, in spite of the fact that there is significant 

authority for including those incremental adjustments. The data and the 

methodologies demonstrate that my proposed cos• of equity in this procecdi11S 

is both responsible and conservative. 
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Debt costs. There is evidence lhatthe lndependem Small LECs will have 

lesser access to debt capital in the future and that debt costs are likely to rise in 

the future. The average and median costs of debt in 2014 for the seven 

Independent Small LECs with debt on their balance sheets were 4.5% and 

4.8%, respectively. If the Commission wishes to use a target cost of debt to 

calculate a target W ACC. I recommend the use of 5.5% as the cost for 

forward-looking debt The interest rate is in line with Sierra Telephone's 

current cost of debl and Jess than the 5.6% average for the AAA corporate 

monthly rate from January 1997 to June 2015. I will provide a full explanation 

for this recommendation below. 

Cnpitnl strucwre. I present the actual capital s1ructures for each of the 

Independent Small LECs. and repon that the 2014 equity ratios averaged 

70,1%. The capi1al SlnJCt\lre ratios have remained relatively stable over recent 

years (e.g .. there was a 68% average equity ratio five years ago in 2010). I also 

ofTcr my opinion abO\It how a hypothetical capital structure might be 

formulated, if a he Commission were to use such an approach I tesrify d1a1 it is 

my judgment thatlhe approp1iacc cap hal structure is coward the high end of the 

Commission's I 997 equity ratio ·•zone of reasonableness." which was 

previously defined as 600/o to 80%. It is my opinion thai an imputed capital 

stniCt\lte mig)n reasonably incorponue equity percemages between 70% and 

SO%, particularly as lenders and other investors have become more cautious 

abooa the industry If the Commission chooses to use a target for the 

companies· cost of capital, I recommend 1hat the Commission use the equity 
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and debt costs that are presented in this testimony as reasonable In the event 

that the Commission seeks to set an overall rate of return for all companies. I 

have calculated a standardized WACC tha. assumes a 700/o equity ratio (at the 

low end of the range I believe is reasonable for such a hypothetical figure), a 

t;OSI ufc<.1uity of 18.5% anti a IAISI oftlt:bt ufS.S%, lt:.!iuhiug in a \VACC of 

14.6%. I test that W ACC. using the underlying data and actual transactional 

prices over the last several years, 10 provide convi ncing suppon for the costs of 

equity and the proposed \V ACC that I present in this testimony I demonstrate 

that M&A data are the most reliable test of .. reasonableness .. for valuations and 

hence for costs of equity. and those data confirm the conservative nature of the 

estimates that I calculate using the CAPM-related methodologies. The data 

from these variO\IS analyses are compelling and suppon my conclusions. 

13 Ill. LEGAL BACKGROUND. 

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Please briefly SUilHUar•ize the legal precedents regarding equily COS I or fnpital. 

As a preliminary matter. I wane to clarify 1ha1 I am not an auomey. However. as a 

financial expert, I am aware of and familiar with ~tc legal precedents that define the 

legal constraints on state con1rnissions ir1 setting appropriate rates ofrc-lum for 

regulated utilities. The Supreme Court oft he United States has confi rmed wellestablished legal precedents for defining the allowed fair rate of return in nuemaking 

proceedings. In Bluefield Wo/cr Work.< & lmpro•Tmeut Co. v. Public Sen•ice 

Commission ofiVeSI Vu·gimtl. 262 U.S. 679 (1923) (''Bluefield'), the Supreme C0<1rt 

concluded that: 
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A public utility is entitled to such rates as will pem1it it to cam a 

return on the value of the propeny which it employs for the 

convenience of the public equal to that generally being made at the 

same lime and in the general part ofche coun1ry on investments in 

other business undenakings which are auended by the corresponding 

risks and uncertainties. . . The return should be reasonable. 

sufficient to assure confidence in the financial soundness of the 

utility, and should be adequate, under efficient and economical 

IIUI.IIH.~CIIICII , lO llli:ti lllHin ami SUJ.Ij)Ull it.s \:HXIit amJ CJU11Jie itiU ai~e 

money ne<:essary for the proper discharge of iiS public duties. 

In Fcd<rt•l Power C<immission "·Hope N(ltum/G(IsComfXIII)'. 320 U.S. 391 ( 1944) 

("Hop(• "),which expanded on Rluefic!d and emphasized that a utility's revenues must 

also cover "capilal cosls.'' 1hc Supreme Coun fun her found 1ha1. 

From the investor or company point of view ic is imponant that there 

be enough revenue not only for operating expenses but also for the 

capital costs of the business. These include service on the debt and 

dividends on the stock.. . By that standard lhe re1uru1o lite equ11y 

Qwner should be commensurate with returns ou im.·eslmt:IIIS in o1her 

t•merprises hm·ing corre.,Jxmding risks. That return, moreover, 

should be sufficiemlo assure confidence in 1he financial inlegrity or 

the enterprise. so as to maintain its credil and auract capital 

(Emphasis added ) 

In Duquesue L•ght Compauyct al. v./xn•idM. Bamsch eta/., 488 U.S. 299 { 1989), 

1hc Supreme Coun rei1ermed 1hc s1andard of I/ ope and Bluefield and then added 

imponant new guidelines, including "regulatory risk:' which is a distincl risk to be 

re<:ognizcd by regula!Ors in defoning a fair rate of•·e1um: 

Admittedly. the impact of cenain rates can only be evaluated in the 

context of the system under which they are imposed. One ofche 

elements always relevant to setting the rate under HOp't! is the return 

inveslors expe<:l gjvenlhe risk of the enterprise. lei.. a1603, 64 S.Ci., 

at 288 ("(R)eiUmlo 1he equity owner should be commcnsura1e with 

returns on invesunents in other enterprises having corresponding 

risks .. ). Bluefield W(t/U Works & /mpron.mu:m Co. v, Public Service 

Comm'n of West Virgimo. 262 U.S. 679.692-693.43 S.CI. 675, 679, 

67 L-.Ed 1176 { 1923) ("A public utility is entiiled 10 such rates as 

will permit it to earn a return . . equal to that generally bei•lg made 

at the same time and in the same general pan of the country on 

inves1ments in other business undertakings which are attended by 
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corresponding risks and uncertainties•). The risks a utility faces are 

in large part defined by the rate methodology .. . Co11sequently, a 

State's decision to arbitrarily switch back and forth between 

methodologies in a way which required investors 10 bear the risk of 

bad investmems at some limes while denying 1hem the benefit of 

good investments at others would raise serious constitutional 

questions 

1"hc three standards offaimc$$ rdatcd to returns arc financial integrity, capital 

attraction~ and comparable camings, which were reiterated in the Pcnnian Basin Area 

Rate Cases' 

In short, an equity owner in a rate-regulated utility should be allowed the opponunity 

to earn rerums that are comparable with those derived from invesunems in other 

businesses that have equivaJent risks., with appropriate adjustments for other risks such 

as regt1latory risk. The issue to be determined by the Commission. therefore. is what 

rate of return is necessary to allow the Independent Small LECs 10 eam on their 

investments a retum that is c:omnlensurate with Lhe risk-adjusted, market-based rate 

available for other similar investmen1s. My professional opinion is that the current 

I 0"/o overall rate of return applied in ratemaking for Independent Small LECs should 

be signilicantly misedto rcllect the increased risks since 1997. The ren1aindcr of this 

testimony will develop and suppon thai opinion, relying on relevant data and 

authoritative sources. 

\Vhy should a commission be concerned about ensuring that a ut ility is itssig ned a 

reasonable return ou C.:lpit:d? 

-' /'(•rmlan /Jasm Art"tr Rilftt Cases. 390 U.S. 747 ( 1968). St.•t• also Fedeml /'owu Commi.,·~·Jun v. Memphis 

Ught. Gas & Wmu Divisimt. 411 U.S. 458 ( 1973). 

rase 13 of 79 
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A. A commission should be concerned about what is ·'fair" to confom1 with the law a~ 

defined by I he U.S. Supreme Coun (C.I/ .. financial imegri1y, capilal anrac1ion. and 

comparable earnings). That is, the inves1ors who have dedicated capi1al to the ulility 

have a righ110 a reiUm 1ltat is legally juslitied Bu~ even sening aside the legal 

stambuU. a ~,;u mi ssiu u that is fUI,;UM!ll vn ~u:slvlllt:~ wdfau:: will abu ~g. ia: that a 

utility without a n appropriate equity return will be aHisk in attractinJ! future capital 

because no rational investor will commit capital investmem if the equity or other 

returns are insufficient. The rational investor will seek altemative and superior returns 

in investments other than rhe utility if expected returns at the utilily fall shon of 

market·based rates. To be clear, if the Commission were to assign a retum on 

invcs1ment that does not reward an investor for the industry's risk, the outcome is 

predictable~ An insufficiem return on invesunent is likely to result in a redirection of 

capital away from the utility. not because the inveswr is a "bad acto1·." but because lite 

investor should not be e.xpected to act irrationally by committing capital where risk is 

not properly rewarded. 

Federal and Califomia regula10rs have iden1ifled a ";de range ofbroadband 

deploymen1 goals and continued network investment is needed to meet those goals. s 

However, an improperly low cost of capital could thwan achievement of these 

objectives. Moreover. an insunicient rate of retum cou.ld disince.nt investments 

necessary to e nsure service quality and network reliability in rural areas. In short, if 

the cost of capital is too low, it will hun rural consumers and rural communities. 

S S.·r!•CC 1015 fli'O(KI/xmd Report orKI Norlet•o(Jnqulry. FCC 15·10 (rei. Fcbruory 4, 20 15). Pub. Uul Code * 215.6. Pose 14of79 
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IV. BEGINNING THE CALCULATION Of THE COST Of CAPITAL, USING 

STATISTICAL SOURCES. 

A. /)ETERMININ(; TN£ CAP/Till. STRUCTURE. 

Q. \VIntl is involnd in cah:uhtting Ill ltiJproprhttc \-VACC''.' 

A. Valuation (including estimation of cost of capital) is both an art and a science. Most 

fundamentally. the process requires judgment, and it must employ data that create a 

discipline to the process. Estimation of an appropriate rate of return begins with the 

com)l<llation of a WACC that sums the costs of debt and equity. each weighted by irs 

proportion in the real or tlte hypothetical capital struciUre of the subject companies. 

There can be disputes regarding whether 10 use the market value of debt and make 

adjustments for the tax effects, but it is more typical to use embedded costs which are 

1he "aciUal imerest obligations. inch.1ding amoniuuion of discoum premium. and 

e.<pense of the utility's embedded debt O<Jtstanding . ··• Using this Iauer approach. 

for e:umple. if the cost of debt is 6.00/o, the dividend on outstanding preferred equity is 

7.0%. and the cost of common equity is estimated 10 be 12.0%, while the capital 

structure includes 5% preferred equjty and 70% common equity, the caJculated 

WACC would be as illustNucd in Table I below. 

6 Roger A. Mon1t Nc'H Ur: t~law,, Finane(•, Pubhe Utilities Rcpons, June I , 2006 (hcreaner .. Morin .. ). p. 26: 

sec E.,hibit MJB. 2 DufT & Phelps und Ibbotson source pagrs cited in the testimony including 

O&P 2015 A-2 :tnd IJ.-2 

Exhibit MJB - 3. 

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J"uhle 1: lllltSirulitm o[t.·osl o(t.•apitul based tm t.·upilal S/Tild ,.re 

t of Ptrct•nt.-:.t·of 

CUIIihd ('lll)illll AIIMftttd cosE 

Dcbl 6.006/.:. 25.00% I.SOO!. 

Ftn::(em.'d cqutty 1 0<>-lo 5.()011/o 0.33% 

Common ~ul ' 12.00% 70.00"'/o SAOO/o 

WACC 10.23•4 

Q. Please comment on capital structure as it pertains to thi.s proceeding. 

A. Evaluating the capital structure of a company involves detennining the total capital 

available to the company and the individual capital components, which may include 

6 several kinds of debt or several kinds of equity. The regulator or financial analyst 

detem1ines the current or average percentage of each component in the tolal capital 

structure of the company. h is also possible to use the actual capital structure or a 

9 hypothetical capital structure in detem1ining the WACC. However. in regulatory 

10 proceedings, I believe that hypothetical structures arc often used to bener match 

II industry-wide capital s1rucnarcs or 10 simplify regulatory regimes afleccing many 

12 utilities or to assure the buildup of equity. A commission may detennine that a .. fair" 

13 price for capital renects an industry·bascd average capital structure, even if the equity 

14 ratio for a company is relatively low The rationales for using a hypothetical capital 

15 smacture rather than the aclual s1ructure can be conuovcJ'sial as such a process requires 

16 subjec1ive judgment. It is my understanding that the Commission has attempted in the 

17 past to arrive at a more generic cosl of capital that is forward-looking, and therefore 

18 the WACC may not be based stricLiy on any single company's actual capital structure. 

19 l support this goal of determining a cost of capital that is forward-looking, and I 

20 believe that it would be unreasonable to use a company's acnaal structure if SliCh a 

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structure is inconsistent with forward·looking e.'<pectations regarding the appropriate 

mix of capital sources. 

Q. Are you f:uniliar with the Commission's historical aJ)J>ro:tch with respec1 co 

t.RJ>ital sCn,cture? 

A. I understand that the Commission sought in the past to establish a 1arge1 \VACC that 

allowed for differing capital strucmres at small telephone companies.' In the cases 

that were decided in 1997, for example, the Commission determined a WACC of 10"/o. 

which was deemed to be a reasonable target, and then it tested that WACC by using 

the actual cost of debt for Califomia I LECs and by evaluating the residual retums (an 

implied cost of equity) for the Independent Small LECs. The Commission's 

conclusion at that time was that a WACC of 100/o .-esulted i11 retums on che 

Independent Small LECs' acrua.l debt and equity that were \\;thin acceptable ranges.s 

The adoption of this overaJI rate of return allowed companies to manage their own 

capital resources, while maintaining a reasonable overall cost of capital for ratcmaking 

purposes. See. e.g. 0 .97-04-036, at p. 12 ("[c]onsistent with our treatment of cost of 

capital for large and mid·size 1eJecommunications companies. and as an incentive for 

applicant to manage its capital structure, we decline to adopt a specific capital 

structure."). 

7 My undco.;tnndmg is ~tat the CPUC rcsol\'cd cos ~f-<::ljll tnl pro<ecdings in 1997 for c>ch of the Independent Small LECs. See .97~4-{136 (Califomia.Oregon Telephone Co.): 97-0-1~34 (Calaveras Telephone 

Company): 97 04~35 (OucorTelcphonc Company): 0 .97-04-032 (Sicm Telephone Compony. Inc.):"" 

aL<() Res. T-16003 (Kenn:tn): Res. T-16004 (Pinn:tcles): Res. T·l6005 (Ponderosa): Res. T·f6006 (Siski,ou): Res. T-1 6007 (Volcano) · 

8 .'i<!e, e.g .. 97-0-1~36 (Califomia.()n:gon Telephone Co.). p. 9: .97~ -034 (Colavcras Telephone 

Company), p. 9: .97-0-1 ~35 (OucorTclephone Compony). p. 9. 0.97-0-1·032 (Sierra Telephone Company, Inc.). p. 9. 

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IL ESTIMATING THE COST OF DEBT. 

Q. Is the cost of debt difficult to determine? 

A. for regulatory purposes. the cost of debt is usually the ac1ual cost as specified in the 

lending documents.o l~owever. it is possible to use a diiTerent cost of debt. for 

e.:<ample, to generalize for an indusuy or to nonnalize in a tin1e period \\11en deb1 costs 

are assumed to be unsustainably high or low, as I will explain below. In all cases, the 

regulator or analyst should assess a realistic set of debt costs that are forward-looking. 

As is well known. the current prices for debt are today at historic low levels. due 

significantly to the Federal Reserve's (--Fed .. ) bond-buying program: and there is an 

e.'pectation d1atthose rntcs will rise as the Fed alters its monetary policy. I will also 

explain below t11at debt resources appear to be increasingly u11a1·ailahlc to smaller 

ILECs because the primary lenders to the industry have grown increasingly cautious.10 

For rural U...ECs, the etlCcts of greater industry·wide risk combined with lesser 

availability of debt can shin the capital structure toward a higher percentage of more 

costly equity or even toward having virtually no debt at aJI.II 

Q. Cm1 we simply use the debt costs as renected in the m:u·ket today in :tssessing the 

debt comporrerH to cost or cnpital? 

A. No. Again. the Commission must look for .. reasonable .. calculations for forward· 

looking costs, including debt costs. The Fed has engaged in a policy that has driven 

9Morin. p. 26 

10 The challenges including contraccing numbers ofS\\ itchc.:d access lines. increasing required c.api1al 

eonunitmcrus necessary 10 meet growing d:tl3 dc-m:tnd. :tnd n:gul:tiOr)' unren:tinties including shrinking 

rc' cnucs from access charges and uni\'crsal scni c.c suppor1 mechanisms .. 

I I The ten Independent Small LECs ::t))pC:tr to be mainroinins relnri\'cly Slablc capitnl stnrclui'I!;S 0\'Cr 1he lost 

fa\'c cars. Tile equity r:uios were 70%, on 3\emgc. in 2014 :md gc1lcrally t:1.11 "ithin the mngc ofthe zone or 

n::::asonablcncss referenced rn the Commission's 1997rnlecose dceisions(60% to 80% cquity). 

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Q. 

interest rates to extraordinarily low levels in recent years. with a goal of stimulating 

growth and investment. f'lowevcr. the f ed's activities are widely regarded as 

.. unsus1ainable .. as retlected in Duff & Phelps' discussion in i1s 2015 Handbook: 

The yields of U.S. government bonds in cenain periods during and 

oftcr the [finnnciol crisis of2008] mny hnve been <trlijiciltlly 

repressed. and therefore [are] likely unsustainable. Many market 

panicipants will agree that nominal U.S. government bond yields 

in recen1 periods have been ar1ificially low. Even members o1'1he 

Federal Open Markel Com mince (FOMC) have recenJiy discussed 

1hc need 10 ·nonnalize' in1eres1 ra1es:' (Emphasis in original.) 12 

AI a meeting occurring on December 16-17,2014, Jlte Federal Open Market 

Comminee( .. FOMC .. ), which is a comminee of the Federal Reserve 8ank, issued a 

statement, signaling the need to "normalize" federal policy in the future: 

Based on i1s curren1 assessmen1. 1hc [FOMC] judges Jltal i1 can be 

pmh·m m begmuiug tu uorm(.t/i:e tiN stanC(! of numemry pulley. 

The [FOMC] sees 1his guidance as consistent wi1h i1s previous 

statement thai it likely will be appropriate 10 maintain the 0 to 1

.4 

pcrccna aarge1 range for 1hc federal 1\mds ra1e for a t'OIISid<r(lh/e 

time following tl ~ end of its assec purchase program in October . .. 

(Emphasis added by Dun· & Phelps.)" 

In shon.. it would be unreasonable to use today"s unsustainable debt rates as a proxy 

for rulure debl costs. 

C ESTIMATIN(i Tf/E COST OF EQUin 

\Vhy is lhe proct.ss of :usessing the appropriate return on equily more 

c.hnllengil1g lhnrl de1erminir1g the cost of debt? 

12 2015 Duff & Phelps Va.lu::.tion Handbook: Guide to Cost otC::.pital. Market Rcsuhs through 2014. 

(Hoboken. NJ: John Wiley &Sons. Inc .. 2015) (hcrcoftcr .. Duff & Phelps 2015 Valuation Handbook Guide 10 

CoSt of Capiaal'). p 3-3: sec E.'hibi1 MJD - 2, 

l3ftL 

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A. Debt has clear legal documentation and interest obligations, and debt can be traded in 

the pllblic markets. making it possible to achieve a better detennination of ma,·ketbased costs. By contrast, common equity costs cannot be observed directly for 

privately·held companies.14 Common equity for the vast majority of rural telephone 

companic;s has no docunu:mation or defined obligation that would allow its stxcific; 

costs to be easily computed Common equity can be traded publicly. but the 

Independent Small LECs, like most rurai iLECs in the United States. do not have 

publicly-traded common equity. 

Q. I-f ow are tht costs of preferred t((uily estimated? 

If a company's preferred equity has no defined retllm. then that security would present 

•he same valuation problem as common equity. I r there is a defined retun1, the cost of 

preferred equity can be estimated using the dividCltd on the security. Four of the 

Independent SmalllECs- l'innacles, Ponderosa, Siskiyou. and Volcano-have 

preferred equity 1hat is, on average. approximately 2 percem of total capital. and those 

companies have been paying preferred dividends a1 a consistent ra1e, as will be 

detlliled below. I have estimated the cost of ~tose preferred equity securities using the 

companies' preferred dividend yields. that are 50%,6 0%. 5.5% and 7 0%. 

respectively. 

Q. llow does a financial upert typic.ally t"stimate common equity costs? 

A. Most financial expens with whom I have been associated seek to estimate common 

equity costs usingmu/up/e valuation methodologies The goal of the financial 

I-I J usc the wnn ··commor' cqui[y'" to distinguish from preferred equal) rutd I include capit.al coutributioaa a11d 

retained camings as common cqmty. 

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professional or the regulator in valuing common equity should be to chook and re· 

check che reasonableness of his or her estimaces 10 ensure chacchey are accura1e and 

sensible. When I analyzed scocks and published while a1 Legg Mason, I always 

employed multiple approaches chal included company·specilic discounled cash flow 

("DCF") u1odt:b, valu ation~ aehtti ve to the value of otht:l ~;um l .. nmie~. a uti luJ it.:al 

data and trends. At Charlesme-.ad. we do the same when we advise companies in our 

M&A business in conncc1ion with sales or acquisilive transactions. In the M&A 

business. financial advisors vinuaJiy always test valuations by studying comparable 

publi cly-craded equicies as well as OCFs chat assess probableoperaoing performance 

for each year over the projected five to ten years of the model. Additionally, financial 

professionals use comparable M&A cransaccional daoa 10 observe valuacions and 

trending in the markets over 1ime. The most responsible approach is to analyze 

valuation from nltlltiple viewpoints to provide confinnation of the reasonableness of 

che resuhs generaced by ohe mechods chosen .. 

D. USE OF THE COMft'/ON METHODOUJ(i/ES-DCF AND CAPM. 

\Vhat are the most commonly·used merhodologies to compute equity costs in 

re.gul:tlory prottedings? 

The mos1 common approaches used in regulatory proceedings coday rely on DCF 

models and on tl1c CAPM, the Iauer of which is also ohe basis for the Buildup or Risk 

Premium Method. The federal allowed rate of return for imerstme services, which was 

lase reduced 10 I I .25% li'om 12% in 1990. was derived using a conscanc-growoh DCF 

model to com puce equioy coscs, using daca from che Regional Bell Opera ling 
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Companies. also known as Regional Holding Companies ("RHCs").IS In the 1990 

reprcscription order, the FCC clarified at paragraph 35 that the formula for that DCF 

is: 

K. = D/P + G 

Wlu:n:, 

Ke Cost of equity 

D = Annual dividend on a sl1are of common stock 

P = Price of a share of common stock 

DIP = Dividend yield on a share of common stock 

G • Annual dividend growth rate 

The DCF tnodel. as traditionally used by the FCC or state commissions. is based on an 

aSSitmption of predictable dividends in a stable industry with a predictable growth 

trend. The fonnula was assumed 10 be reliable in 1990 (note that tl10se assumptions 

are no longer applicable today because the industry is no longer a predictable 

monopoly with higlt assurances of receiving returns. Rather. local 

telecommunications dividends--essentially paymc11ts for equity costs- can no longer 

be assumed 10 expand at a constant rate nor can they be assumed to be perpetual. 

Penincnt to this proceeding. I note that the DCF model relics on two other imponant 

assumptions. ne lirst is that the price of the equity can be known, \\1tich is of course 

not tnte for privately-held contpanies such as the Independent Small LECs, whose 

equity market value cannot be observed or veri tied Tlte second assumption is 1har 

there are reliable publicly-traded proxies (the RHCs were assumed to be sufiiciently 

similar to other lLECs in 1990): in that regard. as I explain below. the large dividend · 

IS FCC, /n the Matter of Repn:w;ribing the Auth<1ri;ed Rate of RetrtmjiJr lnu.•rfttm: Services of /.I)C(I/ 

lixd"mg< Ctrrricrs. 68 R>d. R<'!J. 2d (P&F) 771 (F.C.C), 5 FCC Red. 7507 1990 WL 60-l t05, FCC 90·3 t5. 

:::kt•. e.g., Exh•brt MJS a -4, pp. 8·9; the Exhtbll makes clear that lhc 1990 estimarcs of equity costs were der•vcd 

from data related to ''cry large companies with multi-state opcrntions scni ng rural and urban arc::~s . As I 

c.xp1ain below, rbcse companies h:ld - :lnd 001ltinue 10 have - lower risk profiles th:ln rul'31 telephOilC 

companies like the Independent Small LECs. 

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paying ILECs- the ones that were the basis for the 1990 DCF- are no longer suitably 

similar to the Independent Small LECs.t6 The simple constant-growth DCF fonnula, 

in my opinion, cannoc be used for this testimony. and I am unaware of any commission 

that is using such a formula today 

Q. r-\rt there \':lrituus of lht OCF' model used by finanr:i:ll analysts? 

A. As I noted above. financial investors and investment bankers use company·specitic 

DCF models that rely on estimating the individual contpany's cash flows for each 

modeled year based on highly-detailed revenue, cost and capital expenditure inputs 

over a period of time. such as tive to ten years These models involve discounting to 

the present the estimated future cash flows plus a final·year "tenninal value." The 

FCC and regulatory commissions have used the simpler, constant·growth DCF. and 

not the detailed discou111 cash flow model that I describe above. 

Q. Whal is the CAPM? 

A. The CAPM is a computation of the expected return on a security. based on concepts 

derived from the work of Harry Markowitz and the subsequent study of William 

Sharpe in 1960 The premise underlying tltis method is that the CJ<pected recurn of a 

security, or of a po,,folio. equals the rate on a 1isk-frcc security (generally assumed to 

be the long-tenn U.S. Treasury Bond for which the risk of principal loss or failure-topay is very low) plus cenain other risk-premia to adjust for systematic (market) risk. 

This approach reflects the overnll market risk (the broad market rising or faUing), plus 

adjustments for individual·company risk captured by a "beta," plus adjustments for 

size (generally called a "size premium"). "Beta" is a f.1ctor that is multiplied by the 

16 Jd The differences will be •dcntt6cd in the testimony below. 

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Q. 

A. 

e.'<pected market return to adjust for a public company's risk that is dctennined to be 

higher or lower (more or less volatile) than the overall markel risk.l1 Tite size 

premium is founde<l on the well-established premise that smaller flnns present higher 

risks than larger ones. and i1 is possible to add other premia as will be discussed 

below. The: CAPM Conuula ddi ~ a theo•c:ticallim;cu •dation:ship bc:twc:tm c:xp.:ctc:d 

return on equity (cost of equity) and risk as:tS 

K, = Rr+( ll x RP.,) + RP, 

Where: 

K, Expected return (cost) on equity 

Rr = Risk-free rate 

ll • Beta of the security (statistical volatility v. the market) 

RPr11 • Equity Risk Premiu1n 

RP!J = Size premium 

If the expected return on the security does not meet or e.'<ceed the required return, then 

the model suggests that the rational investor will not purchase the equity security in 

question. She or he will choose to invest money in other investments where the risk· 

retunt relationship is more favorable 

\Vhnt is the Buildup Mtthod~ 

The Buildup Method is an additive Risk Premium approach that relies on CAI'M 

concepts in computing the cost of equity. In reaJiry, it is the CAPM. with the beta 

calculation divided into two pans: one for the overall market risk (the equity risk 

premium) and the second for a proxy premium rei aced lO 1he indus1ry (an industry-risk 

premium). 11te Buildup Method begins with the risk-free rate and then adds a 

l7 A beta of 1_0 equals the marl<ct risk. and a beta under 1.0 OOjusts the equity risk premium tbr companies 

'' i1h n \'Oiatility in retums that suggests Jowc.r-than-mnrkct-risk. while. con,erscly a beta nbo\'c 1.0 adjustS for 

\OI:Hility that sugscsls highcNh:t•1 .. m3Jkcl·risk. 

IS DuO'& Phelps 201S Valuation Hondbook Guide to Cost of Capitol. p. 2-8: sec Exhibit MJB - 2. 

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premium for the estimated overall equity risk in the stock market, plus another 

adjustment for the relative industry-specific risk. and a further adjustment for a firm 

size premium Ibbotson Associates ("Ibbotson") first began publishing buildup 

industry risk premia in its S1ocks. /J01Kis. Bill. tuKI lnjlafion lolnllfion £tlifiun2000 

Yt•arbuulc.. Huwt.!Vt:-1 ~ sin~t.! 2015. OuiT & Phdp~ l1tls inlt.!g alclllllu~h oCtile wsl uf 

capital analyses from Ibbotson and Morningstar (which purehascd the Ibbotson 

business) into DuiT & Phelps' annual ~olua1ion Hatulbt>Ok. IbbOtson/Morningstar also 

published additionaJ statistics. including industry risk premia. categorized by three- or 

four--digit Standard Industry Classification ("SIC") codes. which DuO' & Phelps now 

includes in a separate volume. entitled 2015 l{lfuafion Handbook: Judu:ury Cos/ of 

CapitaJ.I9 The incumbent local telecommunications industry is designated as 

"Telecommunications. except RadioTelephone" with an SIC code of 4813. The 

fomlUia for the Buildup model is the following:20 

Kc e Rr+ RPm + RP. + RP" 

Where: 

K. 

Rr 

RPm= 

RP, 

RP, = 

Expected return (cost) on equity 

Risk-free rate 

Equity risk premium 

Industry risk premium 

Size premium 

Duff & Phelps also provides a fomlUia ~tat is an alternative to the Buildup Model 

presented above. In that ahemative. a size adjustment that includes the market 

premium can be added to che risk-free rate. That is. only two variables are added. and 

those are the risk-free rate and the combination of the size and market premium. I will 

19 Duff & Phelps 20 15 Volu31iOn l·b ndbook: lndus1ry Cost of Copital. (Uobokcn. NJ. John Wiley & Sons, Inc., 2015). 

ll1 Duff & Phelps 2015 Voluation Uondbook Guide to Cost ofCapilal. p. 2-8: sec Exhibit MJB - 2. 

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provide that estimate, which further conlim1s l1H! results of my analysis. although the 

calculalion is rcla•ivcly crude. 

E. USE OF TRANSACTIONAl. l)ATA TO CONFIRM CAPM ESTIMATES. 

proceedings? 

A. ln my experience. the CAPM. Buildup and OCF models are the most commonly-used 

cost-of-capital estimation tools in regulatol)' proceedings.2t Before the mid-1960s. the 

Comparable Eamings approach was used almost exclusively in regulatory valuation 

exercises. but it was replaced by the OCF after thattime.22 In the investment banking 

industry. including at our tim1, Charlesmead, value (with calculations that rely on cost 

of equity estimates) is assessed using the CAPM, wilh adjustments for size or 

company·specific ditrerences from the industry. and delailed (not the constant growth) 

DCFs As I explained earlier, we also rely on two other methodologies that are not 

typically used in regulatOI)' proceedings. but which help to confirm the validity of our 

conclusions. Specifically, we assess multiples (ratios) of enterprise value ("EV"), 

which is defined as equity value !>Ius net debt (total debtless cash and equivalents), 

divided by cash flows, mos1 often u.s.ing operating cash now (earnings before interest, 

taxes. depreciation and amottization or"EBITDA''). We compile those EV/EBITDA 

multiples and other ratios from actual transactions. so we can understand the market 

2l There arc v:t.ri:nions oflhc CAPM. including the EmpiriC31 Capitnl Asset Pricing Model ("'ECAPM"). the: 

Arbitr:lgC Pricing Model ("APM .. ). and the F3m:t-Frc-nch Throc-F::~ctol' Model. These models rely on s:imil:'tr 

concepts rclntcd to proxy groups and market risk estimations. As I will explain. I bclie"c that the larger 

'prox~ ·· com~nics do 001 suffieicmly c:~pc rc regulatory Md sm.:lll-business risks. and thatahcmative CAPM- b3.Sed models do not refine an csamt:ltion of those risks. 

n Morin. JX!Se I 8. 

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perception of value and the trends over rime.23 The resultant ratios pemtit us to 

'' normalize .. our comparisons of one transaction with other transactions. \Ve are 

convinced that the most infonna1ive valuation approaches are based on real-world 

transactions between a knowledgeable buyer and seller. As such, 1hese data provide 

iusights into e-fficiclll ;:md rcal-time asst:Ssnu:nts ur valuc anU lisks, 

Q. How do you ur-il ize actualu·:msacfionnl data in your analysis? 

A. Especially instructive are the insights derived from transactions when companies are 

bought or sold in their entirety. Transactions provide direct data related to private and 

public companies. large (llid small ellterprises. \\~1h01.n any control discount. Like all 

professional financial advisors. Charlesmead tracks M&A data over time to understand 

tl>c trends a•>d provide appropriate advice to buyers and sellers. Those insights are 

even more valuable when an industry is undergoing dramatic change. as is happening 

with companies such as the Independent Small LECs. Or Roger Morin, Professor of 

Finance and author of the oft-cited rex~ New Regulatory Finauce. notes the problem 

with historical models when the future is IIOIIikc the past. 

[S)hills in growth prospects take some time before they are fully 

reflected in the historical growth rates. Hence. backward·looking 

gro"1h and statistical analysis may fail to fully reflect the fact that 

the risks and growth prospects of utilities have escalated, and may 

only provide limited evidence that the risk and I he COSl of capital to 

these utilities have increased.l" 

11 is clear to me that we are in such a period for telecommunications carriers, both 

large and small ILECs, as these markets are driven by rapidly-sl>ifting eusto•ner 

23 The o.pproach is analogous to rco.l ~st:.uc mctncs such as price per squo.rc foot or grocery store labels with 

price per unit, In the C3SCOf JLEC trn.ns:u;tio-ns. we assess ho'' much 3 bu)Cr is \\illing 10 pay for one dollar of 

opcr:111ng eosh flo" (EBITOA). 

"" Morin. p. 436. 

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demand for voice, video, broadband, as well as the ongoing overhauls of regulatory 

suppon mechanisms, more limited access to capital, and evolving competitive threats. 

It is my opinion that the transactional valuations are most instructive and specific as 

they capture risk that is not fully explained in the CAPM or the Buildup Methods 

believe that 1he historicaJ data are drawn from a less turbulent time for the industry, 

which means that the CAPM-based data are inclined to wtdcr.wate the cost of an 

ILEC's equity today. The transac.tional approach provides a corrective as it is more 

current information and is based on the concept of"fair value" which involves an 

arms· length transaction between a "willing buyer and willing seller ··2; Using M&A 

data, we track rising value(declining risk) over time, stable value (unchanged risk) or 

deteriorating value (increasing risk). While we rely on thcsedaca in our transactional 

work, I will only use the M&A data in this proceeding to COitjirm lhefiudmf[s derived 

from the CAPM-based approaches, and ll()t Jo estahlisha baseline cost ojequi(Y. 

Q. Are you able to provide data to ''erify all the rransnctions in I he marketplace? 

A. Some, but not all. transactional data are available. Exhibit MJB- 5 provides the 

publicly-available data related co small ILEC transactions from 200 I 10 the present. 

Some ofchc transactions listed in the Exhibit a1>pear to have higher valuations in 

recent periods but the ILEC valuations that rely primarily on LEC services-sales of 

ZS Jbbotson SBB12013 Valuation Ycartlook. Markee Results for Scoch. ll<>nds. Bills. and Inflation 1926-2012 

(Chicago, IL: Monungst>r,lne., 2013) (hereafter '"IbbotSOn 2013 Valu:uoon YC3tbook'"): sec lbbotsOn2015 

Clossic Vcortlook Markee Results forStocks.ll<>nds. Bills and lnnatio<~ 1926-2014. (Chicago.IL: MomingsL". lnc .• 2015). ercan~r "l'bbolSOn 2015 Classic Yearbook''), p. II: ··Fair markl!l \rtlue is defined by IRS 

Revenue Ruling 59--60 lscc. 2.02)ns · . the price ::u "hich the propeny would change hands bcl\\CCO a 

"illing buyer and a willing seller when the fom1cr is not under any compulsion to buy :u1d the l:utcris not 

under any compulsioi1IO sell. bolh parties h.wi118, reasonable knowledge of relevant f.1.cts ... (Emph:tSis in 

original): sec Esloibit MJB- 2. 

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ILECs without cable TV. wireless, significant fiber transport. or tax benefits- are 

valued consistcmly lower over the last several years, in a range today of 4.5 to 5.5 

times lasHwelve-month EBITDA. I frequently repon on the generalized trends and I 

regularly explain 1hose trends at industry conferences.26 

Q. Can a valid cost of t:AI)ili\1 nnnlysi$ use the cost orequit'y f•·om the stotks oft he 

flublicly-traded I L£Cs to estimate the capital costs for small I LECs? 

A. The analysis can l>eJ:In with data derived from guideline or proxy ILECs. as has been 

done for many years. However, small ILECs have characteristics that make their risks 

considerably diO"erem fl·omthe risks at larger companies. and the difi"erences appear to 

gro\\;ng. Accordingly, we cannot rely exclusively on ~t ose data Indeed, the 

ditrerenccs between diversifoed publicly-traded carriers and small private carriers are 

much larger than when the FCC set the interstate rate ofretum in 1990. 

Q. Pl('ase t~ J)I!linth e differences btlwtt:n largt and smniiiLEC$ as it r'ertnins 10 

their invtstment and marker risk. 

First. and probably most significan~y . ~1e regulatory factors afi'cctingsmall rural 

carriers are fundamental co the business of tl1ose companies, which have a high 

proponion or their opcl"atio•lS in regions that are uneconomic or less economic than 

those served by largeeaJTiers Large eaJTiers rely on relatively little or no regulatory 

suppon revenues because their businesses are concentrated in denser areas and those 

carriers provide lesser-regulated or non-regulated produCis such as \\~reless, enterprise. 

and extensive video products. In light of the rural carriers' relative dependence on 

26 .. We. t•.g .• Mich;IICI J. Balhoff. Slide Prcscnlnt•on: F:lnttrgmg Strarcgic: Value· Crt•allon, June 201-&, pn:scnted 

ltthe Georgi:\ Tclcoommunicnuons Associarjon Coc,fcrcncc. Orl::u,do, Ftoridn (hcn::aflcr ·'Georgia 

l)rcsc•Hntion"). slide 7. Sec E-xhibit MJB- 6. 

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universaJ service support and intercarrier compensation revenues. regulatory threats to 

these revenue sources dispropootionately increase the risk profiles for these smaller 

carriers compared with those of larger carriers. Second, the larger carriers are all 

engaging in significant acquisition activities, based on their tinancial capacity to 

ellicicncies (syneogics). which oflen reduce the taogct companies' cash operating costs 

by 20%-30"/o, and allow for crilical diversification of operations. II is imponantto 

note that e~-ery large ILEC is or has been engaged in sweeping acquisitions in 

cransfomting che carrier's businesses. made possible by significant size and access to 

capital.27 The large ILECs' capacity ro mitigate today's operating risks through major 

acquisitions is a strategic advantage Lhat is not being employed to a meaningful extent 

by smaller ILECs and is likely not available to smaller ILECs.l8 Finally. large carriers 

generally have extensive access to publicly~ ra ed equity capital and cost .. effectivc 

debt capital. The Independent Small LECs do not have public C(Juity and have limited 

access to cosHffoctive debt, as will be e<plaincd below. 

27 AT&T Inc .. SEC Fonn 10-K Annual Rcpon 2014 Retric'cd from SEC EOOAR "cbsitc 

http/A\\\ \\ we uO\/cdgar ~html. Seq 4. AT&T Inc. 20 14 Annual Report. ''Other Business Maners," p. 2 1. 

Verizon Communic:.ttiOilS. Inc .. SEC Fom1 ~K A•wual Rcpon 2014. Retrieved from SEC EDGAR \\Cbsltc 

hug·/1\\\\ \\ sec soy/edgar !ihtm!, Seq 4. Eshibit 13, .. Acquisitions and Divcstitun:s." p. 34. ncu~ Link. Inc .. 

SEC Fonn 10-K Annual Report 20 14. Rccrie'ed from SEC EDGAR website hupl/\\\\ \\ ssrc.go,/cde:u sh11T'II, 

.. Acquosiuons," p. 13. Frontier Communications Corpomtoon (2014). Fonn 10-K Annual Report 2014. 

RctriC\Cd from SEC EDGAR \\Cbsilc hnp:/1\\W\\ sec govkdgar shunl . .. J\cquisations." p. F~l . \Vindstl\.---am 

(2014), Fonn 10-K Annual Report 2014. Rctric'''" from SEC EDGAR website 

hun·!/\' \\ \\ see go\' cd~\lr !tlnml , ''Srr.:ttc_gic Acquisitions.·· p . .S. Consolidated Co munic uio-n s Holdings. 

Inc .. SEC Fom1 10-K Annual Report 2014. Retrie,·cd from SEC EOOAR website hnn·/1\\\\ \\ sec yoy/cdgar sluml, "R<."«nt Business Ot.:\·clopmcnt$:· p, F-7. 

28 for a sunu a~ graphical prescmatton on the u·an.sfonnation of large JLECs. et~ Georgia Prescruation, 

E.<hibit MJB - 6. slides 10- 14. 

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Q. Oo valuation professionals typically make adjuslme.nts for size of the companies? 

A. Yes. Most professionals rely on the data and resources provided by companies such as 

Morningstar, Inc. (Ibbotson Stocks, Hon<l<. Hill<. and lnjlation ("SBBI")) and Dutr & 

Phelps. LLC.29 B01h Ibbotson/Morningstar and Duff & Phelps are clear that 

cJjuslmc:nts should be m(tde for !lize cO"ects and othc1 risk f~cto• :s. 'For c:x~mple, Ouff 

& Phelps in irs 2013 Ri:•;k Premium ReJXN'I wrires: 

Research tells us that the CAPM often mispriees risk for cenain 

investments. Spocitically, researchers have observed that commonly 

used methods of measuring risk used in the CAI'M (spocitica.lly, 

beta) ofien understate the risk (and thus understate the required 

return) for small company stocks. ExaminaLiOI1 of market evidc11ce 

shows that within the context of CAPM. beta does not fully explain 

the difference between small company returns and large company 

returns. In other words. the historical (observed) excess return of 

ponfolios comprised of smaller companies is greater than the excess 

return predicted by the CAPM for these ponfolios. This 'premium 

over CAJ>M' is commonly known as a o;bela·adjusted size premium" 

or simply "size premium".JO 

To be clear. investors require a return for smaller companies that exceeds that 

predicted in the CAPM for larger companies. as proven in the historical studies. Til is 

investor behavior cannot be ignored in valuation. Moreover, Dull' & Phelps is clear in 

its l'alualiou Htuulbuak. ciled ab0\1C, that research verifies the existence of a size 

premium. This premium is appropriately added to the equity return to reflect marketbased risk that is greater for smaller companies compared with larger companies. 

lbbOison/Morningstar also provides statistics to demonstrate the effoct of size on 

l'l lbbotson 2015 Class1c Yearuook: Ibbotson 2014 Clnssie Yearuook. Market Results for Stocks. Bonds. B1lls. 

011d lnflotion 1926·2013 (Chicogo. ll..: Momin.gSI>r, lnc .• 2014)(hcrcoftcr ··Ibbotson 2014 Classic Yearbook"): 

Duff & Phelps. 2014 Valu:lliOn I land book. Guide 10 Cost of Co1>iul (Chicogo. IL: Duff & Phelps. LLC, 201~)( crcaftcr "Duff & Phelps 2014 Guide 10 Cost of Capital") 

30 Duff& Phelps. Risk Prt!millm Rt.•JKirt 10/J (Chic:-ago.ll ... : Duff & Phelps. L..LC. 2013), p. 60. avai :~b1c:: 31 

http://\\"'' .duff:lndphelos.eom/SiteCollccttonOoeun\cntsfRcoortsi<EXCERmo/ol020 13%20DuffU/o20PhcJps 

1)?2QR,sk%20Prcm,,•m%20Rcoort odf. 

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Q. 

A. 

returns. and summarizes this relationship wilh the comment that "[i]f sma.ll companies 

did not provide higher long-term returns, investors would be more inclined to invest in 

the less risky stocks oflargc companies.''l t 

F. OTHER REASONABLE PREMIA . 

Wf/ICN ARE NOT US£1) IN TIJIS ANAI.YSIS 

Are thtre sources justifying adjustments that must be made in calculating lhe 

cost of equity other I han the size premium cited abo,·e? 

Yes. I will not use any other adjustments in this testimony. but it is important to 

recognize that there is ample evidence that fun her adjustments can and possibly 

should be made. The Internal Revenue Service(" IRS") has issued guidance on 

valuation over the years. including in its Revenue Ruling 59-60. vvhich provides a 

framework for valuation or the stock of closely-held corporations or the stock of 

corporations whe.re marke1 quotations are e-ither lacking or too scarce to be recognized. 

Morningstar. Inc, in its 2013 Ibbotson/Morningstar SBB/1 'aluation Yearbl)()k. states 

that Ruling 59-60 "changed the way businesses are valued and is the comerstone of 

the valuation process.32 111at Ruling begins with the catanselahat an appraiser should· 

. . maintain a reasonable auirude in recognition of the fact that 

valuation is noa an exact science. A sound valuation will be based 

upon all the relevant facts. but the elements of common sense, 

Jl Ibbotson 2014 Classic Ycorbook. p 109: sec E.'hibit MJB- 2. 

l2 11Jbotson 2013 Valuation Y=book. p. 12: sec Exhobu MJB • 2. S.e also. Ibbotson 2014 Cl:o.ssoc Yearbook, 

pp 123-127 in ''hich liquid •~ -related in\'csting issues an; explained, as they require an adjusuncnt because the 

·-premium is the cxtt'3 rctun1 :u' i•hestor \\OUld dcm:1nd in order to hold a sccurir~ th~ cannot costlcssly be 

trndcd" (p. 124): sec Exhibit MJ B · 2. 

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infom1ed judgment and reasonableness must enter into the process of 

weighing those facts and detennining their aggregate significance.JJ 

IRS Revenue Ruling 77-287 recognizes that there arc imponant valuation differences 

and considerations for small and closely-held eompanies.34 Fun her, various United 

States Ta.x Coun and Coun of Federal Claims cases support the appli cation of 

discountS or premia arising from illiquidity. lack of marketability, lack of control, and 

industry risk. 3S In panicular. there is substantive suppon that the cost of equity should 

include additional premia for illiquid and less~marke ab e securities 

~~ IRS RC\'Cnue Ruling 59~60. soc. 3.0 I, :w:ul:lblc <U Jmp'li'\" \\ 3ucg oom/l)ocumems(RC\ellue/Rc, Ru!eW~ 

li.2.Jlllf. Sec E..tlibit MJ B - 7. 

l-IIRS RC\'Cnuc Ruling 77-287. av3il::sblc at hun /Ann\ at1cs com/l?ocumcnts!RcH;nu!!IRc-..Rulc71-2:;t7.ndf, 

Sec E.xl>ibit MJB - 7. This ruhng pertai•>s to discounts that :uc used for securities that cannot be n:sold 

inunedi:ttcl~· beClluse they 3re restncted from rcs.1lc pursu~t to Fcder31 sccunues 13\\S At Sec. 4.02, the 

Ruling notes: 

Pursuant to Congressional dirce1ion, the SEC undertook :.m 3Jt3lysas of the purchascs. sales. and 

holding ofsc."<;uritics by fin::mcinl institutions. in order to det.;nninc the: effect of institutional activity 

upo11 the securities m:Jrket. The study tcpon w:.s pubhshcd i11 cis,ht \'Oiumcs i11 M:Jtc:h 1971. The fifth 

\Oiumc pro\ ides an rutalysis of restricted se-curities 3lld deals" ith such atcms as Lhc chmnc1criscics of 

the resrriered securities purc.h:lSCrs :1nd issucl"$, the s1ze ofuans:ICtiOnS (dollars rutd sh:'lteS). the 

marketability dtscounts on diffcrciH tradmg markets. and 1hc resale JHOvisions. 'lltis research projec1 

provides SOniC guidat\CC ror measuring tbc diSCOUJU in th:lt it conuins infonU:ltion. b3scd 01\ the 3ctual 

espcriencc of the marketplac.:;. showing thor. during the period surveyed (January I. 1966. throug:h 

June 30, 1%9), the :tmomu of discount aiiO\\cd for restricted securities from the c~ding price of1he 

unrestricted securities was generally related to the foliO\\ ing four factors learnings. sales. tr.lding 

markel. and rcS31c ~rcemc t provisions). 111e sm3llcr the s.1.les. according to lhc SEC study and the IRS Re\'COue Rulmg, the gte3tcr lhc disoount. 

JS See, f!.g .• A1tmtlellxmm v, romtmssioner. T.C. Memo 1995-255 (June 12. 1995): Huherv. Commis:liouer. 

T.C. Memo 2006-96: 1006 T:>.' Ct. Memo LEX IS 97 (Moy 9, 2006); Hs1t11<• "/Frazier .lclke Ill v. 

Comnusslt»ll!r, T.C. Mcn>o 1005-131 (M>y 31.1005): listnte of Webster li. Kelle)lv. CommiSSIOII<!r. T.C. 

Memo 2005·235 (Ocl II, 2005). See the Amcncan lnStJtutc of Pubhc Acroununrs. Stattmt.>nt on S'rtmllards 

for Vttlumion Stn·ices. pa~ 40. :1\'nilablc at 

(http://,,"\\' .:tiCp3.org/lntcrcStAre:t.sfFonmsicAndVaJu:ttion/Do'' nl03d:tbleOocumcntsiSSVS _Full_ Vcrsion.pdf 

)' --ounnglhe course of a valuation engagement. the \'31u:nion 3J:13Iyst should consider " helhcr valuauon 

adjustmcms (disoounts or premiums) should be made to 3 pre-odjtl.ffln;mt value. Examples of\'aJuation 

:ldjustmcms for valu:uion of 3 business. business O\\llCrship imcrest. or security include 3 discount for lock of 

markcltthihty (Jr hqmdity llJtd 3 discount for lock ofcomrof." (Emphasis in the origin31.) 

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Q. Can you expand on your comments about adjusting for illiquidity or lack of 

m:.trkt'tnbility? 

A. I will not make any specific adjustments in this testimony for illiquidity or lack of 

marketability, but I note that the omission of such a premium is a funher signal of the 

Wll!'iCI\'i.1lblll of the C!!>t imat~ in thi!!> aualy.sis. imm~ia l v•u lt!.:»iu nals have Ucvdupct.l 

a consensus view that cost of capital should be adjusted based on size eft'ccts. as 

explained above l·lowever, in a,h/itiou, chere is a convincing case that 1here should be 

another premium related to liquidity/marke.tability. Because the size effect premium is 

premised on larger or smaller stocks that are martetable and liquid, a premium to 

account for insufficient marketability and liquidity can, and likely should. also be 

applied. In 2009. the LRS provided a 115-page "Diseo<mt for Lack of Marketability: 

lob Aid for IRS Valuation Professionals" in which the IRS authors. clarifying that the 

document was not the official position of the IRS. set out the study's purpose " to 

identify issues around [the discount for lack of marketability or ·DLOM'] and to 

present techniques to assist valuators in the field [with information] . of value not 

only to our own personnel but also to our valuation customcrs ... 36 The gujdc docs not 

recommend a specific approach or premium but concludes that the DLOM in the 

marketplace may be 20% to 25% based on Securities and Exchange ("SEC") studies, 

approximately the same amount based on tax eoun rulings.l? Thus. there is evidence 

3<> IRS Enginccring/Valuatio<l Program OLOM Team, Discount for L.1ck of Markctobiloty: Job Aid for IRS 

Valu~tion rofession:~ Is.. Xpl'cmlx:r 25. 2009. a\'ailablc at bup·u,, '' '" '!'S gm/pubfirn-ut!fdlom pdf I hereafter 

"IRS DLOM .. I. p. I. 

37 JRS DLOM. p. 77: .. Greatest "cightinsofiSEC-studyl t..rrulsactionsoccurrcd "ithin the '1 5%' and '25%' 

implied discount g roupings. 11us suggests a ost~ mon discount for lack 

ofm:ukct.abili · of20% .. : p. 80. ·'the v~du:uor " ill tc\ icw the resultsofscvcml c:&.scs such :lS McCord. Uppo 

and Pcracchio and then base the c:ho•cc of discount on the discounts accepted by the court in the rC\"iC\\Cd 

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!hat an adjustment should be made related to both size and lack of marketability. II 

has been my experience 1hat marketability is reduced further in environments where 

investors find that regulatory obligations are greater than in other j urisdictions and 

4 where sales are perceived to be accompanied by more challenging regulatory 

oomJitiuu>. \Vhile I <1m '-AJHvim.a::tlthat such a t.li>~Hl fot lavk uf111~ukt:htUility l ikdy 

6 should be included. the omis.wou of such (I discoum ma~·es the inclusion of a sl;e 

premium ewm more critical iutltl! calcu/(llion of the cost of equily to a .. ~ .. wre au 

appropriale return on eq i~y. 

9 v. INDUSTRY CIIANGtS ·niAT AfFECT THE CORPORATE COST OF CAPITAL 

10 FOR SMALL ILECS. 

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Q. l)lenst summarize the m:1jor <'hanges in the lLEC induscry that have affecltd the. 

cost of rquily for lht Independent Small LECs. 

A Over the las1 15-20 years. changes have occurred that have dramarically increased risk 

for ILECs in general and notably for the small, rurai iLEC industry, including the 

carriers involved in this proceeding,. The changes can be explained as sequential 

forces Technology changes accelerated, increasing 1he number of compe1i1ors. New 

eompelitors have forced changes in regulatory systems. And the changed regulations, 

paniculariy for I"LECs focused on less economic service regions, have created a 

significant uncertainty among debt and equity investors. 

c:.scs. For' cx.'lmple, the t:lngc of coun d•seou•ns might h:1vc boen from 20% to 15% so the v:.lu:uor chooses 22.5% with the rmion:llc thai his \'aluation subject 

is simil3r 10 the subjects under consider:ltion in the ca;;es ciuxl Judges arc sometimes found 10 ldOJU1his 

opproach as "ell The j udge w11l look ru McCord wnh us 20% discount ruld 3dd 3 factor of say 3% b3scd. on 

his ::malysis of the special factors of his case to ::~rrivc at a chosen OLOM lc\-cl of23%."p. 80; .. ,Vruck found a 

discouol for lac.k of :ukcra.bili ' of 17.6%., Hcrt.zcl & Smnh found a discoUIH of I 3.5% for bck ofliquidi · or lhat Bajnj ct al dctcnniocd that the discounl for lack of marketability should be 7.23%." 

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Q. Bow have t« hnology changes ilfTected the telecommunications marketplace? 

A.2 The pancrn is cle<~r that competitors arc using new tccl>nologies - notably using LP-bascd and 

wireless platfonns- to target wstomers in highly-profitable markets and then subsequently adding 

customers in relatively less profitable markets. As digitaJ technologies developed and wireless has 

Ut..-"(.:0 11~ IIIUit: P~IV<'I~ively JcliaUit:, \.:OII ~I tU S aV~ Ut:~n abl~ lu a lhi:t\.011101 Ullly busillt:SS \.:U.) OII =>, 

6 but also residential customers. Figure I and 

9 

10 l'ig11re 1, below, depict cunent nationwide data from USTelecom. the major ILEC trade 

II organization, which tracks access line loss and competitive market share .J.S Notably, 

12 the competitive losses of voice seiVices have remained significant over time and the 

13 ··voice" losses are pri marily driven by the migration toward wireless SeiVice. 

14 Fi;:urc 1: Amuwl Switt:ltt41 Access tine Loss 

15 

2006 1007 1001 2009 1010 1011 2011 201J 2014P 201$P 

_,,. 

.. ,. . .,. 

38 P:unck Orog."Ul, Voict· CompetitiOn Has H1ded 1/J c Dum/nom·,·. (W:lShington. DC: US Tclcron'l. April 

20 14). a,·ailablc at http://www ustc ccom orglb ogl"oicc-compclition-lms-cndcd-ilcc-dominancc~. 

Page 36 of79 

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Page 37 of79 

1().1'11012 

St)Jt~: US 1't-hocom .• lpnl 10f.l. 

Figure 1: ,\'hare t{Natitllt11'ide U.S. 1/(mseho/d't 

tOOl 1004 100$ 1(101 1007 1001 1009 1010 101 1 lOU 101l'l014Pl015P 

Sm 'C'~: US 1'~/t'CONt •• lpri/ 20f.l. 

Is increased competition a positive developmenl as coml)t tilors and ILECs offer 

produclS more efficiently? 

Yes. as a general matter, competition is a constructive force that., in the bis, piccure. 

benefi ts custo1ners. The competitive 1hrust into rural America is also positive from a 

bo·oad policy perspective. but it is notable that coonpctitive gains appear to be 

concentrated in clustered populated regions or along major roadways where customers 

can be served economically. It is also notable that competition is significant, even 

when the markets have n01 been des-ignated as ·•competitive .. by regulators. because 

wireless is the primary threat to landline residential voice service, even where it is not 
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a complete functional substitute.YJ lntem1odal competitive threats have meant that 

rurai iLECs arc left with an increasingly higher proportion of high-cost and often 

uneconomic propenies along with a Carrier of Last Reson ("COLR") responsibility 

that requires them to fulfill any reasonable request within their defined seiVice 

tt:nitoric:s. Rt:eent PCC polic..-y has amplifi00 :~ t:n'I!Ct by n .. -x1uirin,g 1\m l~.:alrie. S 10 

fulfill all reasonable requests for broadband access at specified download and upload 

speeds. 40 The result is approximately rhe same fixed ne1work costs and investments 

but fewer cus10mers over which 10 spread those costs 

I generated a study related to this problem, relying on e,,tensive data in Texas.•• The 

Texas study evaluated 350.000 access lines. using conlidential financial data Among 

ocher conclusions, the study highlighted that without universal service funding. 77% of 

the rural wire centers genernted on average a negative 9.7% return on investment. And 

13% of1he wire centers generated an average positive retum of2.9%. which was 

insufficient to justify investml'!nl. Finally. I 0% of the wire centers generated a 1 00/o 

tetunl or higher. The CO•lclusion was that, without universal sei'Vi<:e suppon furlding 

("USF''), 90"/o of the wire centers are candidates to lose service entirely. From a 

financial perspective, then. the 1'0St majonty of rural wire cemers ar~ um•cmNJmic -

"' E\'co where'' ire less service may not be ubiquitously fi.mctional. 35 I undcrst."tnd i.s the case in m~y 

Independent Smnll LEC an.:ns.. some customer$ choose ''in:lcss services as n substitute for \\ircline SCf\ icc. 

lllis phcnometlon makes wireless sen ices 3 serious thre:u to the financial st.:lbility of a rur.tl telephone 

company in spite of the fuel that the \\irclcss scn1cc rna}' be less reliable or not ubiquitously available for 

customers . 

.1<) See F('(' f'mmect An,.ri<'O FmMI £'/'('Order, FCC 1~-190 (rei. Dec. 18. 201~) (cstoblishing the 10 Mbps 

download / I MbJJS uplond stand:trd ns n re<Juin:ment for receipt offcdcr:\1 high<:ost suppon) . 

.at M1eh3el J. BalhofT, Robcn C. Rowe. and Brndley P. Withams. Um1-v:rso/ .')(:rwce l·im<lm~: H.t:aliues of 

.')nvmg 7i:lecom Cu.\'tOmcrs in Hlgh·Cost Regions. (Columbia. MO: Balhoff & RO\\C. 2007). available al 

hnp:fb, \\ \\ .b.:alhoffrowc.con\/OO(/USP,·o20Funduu;%20Rcil1tues%10of'%20Sen. tng.%20TcJeeomo/o20Custotncr 

s%20Jn %20 •gh ~0Cos %29 c.c ons%207 . 

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and would not be seJVed- absent high-cost support. The data in that 2007 report 

asSt•med that the ILEC w<X•Id continue to have intcrcarrier compensation revenues and 

margins. This study also relied on the assumption that the universal service system 

would continue in substantially the same fom1 as it had for the decade preceding 2007. 

Hvwt:ver, tltt: 111u,.t u:~eut FCC 1c:fot n 1 in Nuvt"lllbc:t 201 1 has unmllatc:t.l the 

elimination of terminating access charges by 2020 and implemented a sweeping and 

evolvins set of rcfonns of the federal universal service system.

42 The impon of the 

20 I I refom1s is that the financial outlook for small carriers is today more dire than the 

cases I studied in 2007. where the situation was already challenging. 

Q. Does the rate--of·•·erurn reg ulatory platform or the Independent Small LECs' 

:access to C~llifornia lJigh Cost Fund A e'CUCf·A'') shirld the lndependt.ut Small 

LECs from the clfecls which )'Ou describe? 

A. The Independent Small LECs are no1 shielded if there is a failure to de1ennine and set 

appropriate rates of return While the rate·of·rcturn regulatory struclure shoold result 

in a fair opponunity for companies to cam a reasonable rate of return. that opportunity 

only e.xists to the extent that the rate structure is set, based on reasonable assumptions. 

Rate-of·rctum regulation provides no guarantee that a company \\~II achieve any 

panicular revenue level, and I believe thai CHCF-A support is not retroactively 

incre.ased 10 remedy revenue shonfalls that carriers may have incurred. Moreover. I 

·U Comu·ct Amcrit'll Fund. WC Docket No. 10·90, A Nmiona/Bnxulhlmd Pltmfi'r Our 1-irwrc. GN 

Docket No. 09·51, l.::stablisltiug .Ju.w t.md Reasonable Rt1tts for/..J)<:al Exchtm~e Carriers, we Docket No. 

07-135. H1gh-Co:if Uulw:rsal !)(:n·lc.'l: Support. we Docket No. 05-337, Dc•·clvplng tm Unified 

httercan·ier Compr.msation Re}!ime. CC Doc·kel No. 0 1·92. Fedem/-State ./omt /Joord on Unh-ersal 

Sc11·ice. CC Docket No. 96-45. Ufclincoml Unk-Up, WC Docket No. 03-109, Unii'Crso/ Scn·ice 

Mobilil)' Fml(/, Wl" Oockc1 No. 10-208, Repon and Order and funhcr No1iee of l>roposed Rulemaking, 

26 FCC Red 17663 (20 11 )("USFICCTrtm.ifonnotion Order··). 

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believe that the Commission has incroduccd certain high-cost fund reductions from the 

federal system and applied them to CHCF-A calculations. including the imposition of 

a "corporate cap'' that is designed to disallow companies' corporate e.'=penses .. '\t•e 

0 .14-12-084, at p. 101 (0.1' 3). Further, theCHCF·A program remains under review 

iu R. ll·l l·007. and the s(;ope of that p1~cdiug could Culllle-1 tlue-ateu ludcvcw.lc::ut 

Small LEC revenue streams. See 0 .14·12-084, at p. J243 Re£,'Uiatory changes and 

risks must be taken as a whole in assessing the financial stability of carriers whose 

service is targeted 10 cus101ners in a high proponion of less-economic regions 

43 Notttbly. this decision defines Ph:ase 2 tO include a n::c:::ons dc~ ion of" hethcr mte of return regukuion "ill 

cont1nuc and other major potcnual ch::mgcs 10 the rcgul:nory structure under wluch the lndcpcndc1\l ,~ull 

LECs opc r:~t . I offer no opinion as to the likelihood of any of these adjustments being m~dc. but their 

continued considct:llion underscores the profou1ld lulccnaimy and associ:ued risk that lndcpc1ldcnt nre 

experiencing. 

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Q. Is support for wireline neh'I'Orks les..~ important given the rise of wireless services'! 

A. No. it would not be correct to say thai wireless is the future of all telecommunications. 

I make this point because the Commission might ask whether it is appropriate to 

maintain a utility. and hence its cost of capitaJ. if the industry is dying. 1 do not 

l.ldievc. thc. wi1c.l iuc. industay i~ Uyiug,l.lut nttllc.J I IJdic.vc. that it is evolving towau.J a 

new core service. I note that customers are today increasingly reliant on broadband. 

which is now an imponan1 service. l1•e FCC's 2011 refonns ofUSF and i01ercarrier 

compensation e·ICC .. ) outlined this migration in its USF ICC Tramformalion Order 

ci1ed above. AI paragraph 10 of1he USF {('(' TramifomwlifJII Order, 1he FCC s1a1ed 

that it was "modernizing USF and ICC from supponingjust voice service to 

supponing voice and broadband. bo1h fixed and mobile, 1hr0<1!lh IJ' networks is 

required by statute." 

Broadband is likely 10 remain primarily a wired service. l'he FCC reponed in 2009 

that the average monthly consumption of wired data services was 9 gigabytes ("'GB") 

and 1he agency e.xpec1ed the average to rise to 15 GB by ~te end of20 I 0.-"' The FCC 

now repons 1ha1 the average fiber user and average DSL user consumes each momh 32 

GB and 22GB of da1a, respectively.•s The growth in volume is up over a year ago by 

42% and 79"/o, respeclivcly. Funher "proving" the value of lite wired broadband 

nc1work. the two dominant U.S. wireless carriers- Verizon and AT&T. h1c. 

CAT &"r')-have invested, respectively, over $20 billion in FiOS and over $14 billion 

4-1 FCC. Bmndband Performan«. OB/1"echmcnl PafX'' No .J. ~wailablc at bnp-/J rnn~jtjo fcc goy!oanonalbn>adbjlnd-plpn!bm.:K(ba.nd-pcrform;mcc-p;mcr pdf. p 6. 

-'S FCC, A Report on C'tHuunu·r Win.' lim· Hroodband Puformanet: In tht! U.S .• Ch3t1S 19 and 20, :lV::tilablc ;U 

http://w\\ w.fcc.gov/mcasunng-broadb:uld-amcrica/20 13/Fcbruruy. 

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in U·verse.-16 The reason fOr tl1at huge capital commitmen1 is that tl1e average home or 

business uses too much bandwidth to be cost·effectively served by n commercial 

wireless provider at codayts rates. Funhem1ore, a consumer. using today's average 

\'o~re.li ne volumes. would be required to pay over $200 monthly for commercial 

wire/~:.~ ... bu.>adOaml Crom Vt:ri~on Wilc;:;h::ss or A1'&T Wiu:h;:ss. Couwu:n.:htl ir~l e:s:s 

is not today a substitute. and. in my opinion, is not likely to be a price·effective 

subs1itu1e in 1he foreseeable fu1ure in ligh1 of 1he growing demand for broadband 

bandwidlh 

In shoo. \\~reless and wireline platfomls provide complementary services. Consumers 

currently rely on data·centric communications services that are growing at a rapid rate, 

requiring carriers to continue to invest in wirelinc plant that is not likely to be replaced 

by commercial wireless services. The federal policy is clear 1ha1 bo1h wireless and 

'vi reline services will be needed and should be supponed in rural and low-densi1y 

regions, as ubiquitous. high-quali1y wired service will continue to be important., and 

''~II likely remain a major policy goal for the foreseeable future.47 

Q. \Vhnt do you mt.an by 1he st:Uemrnt that invt.stors nrt more uncertain about lht 

wirtline industry than they hnvt been in tht past? 

-16 Whdc Vcrizon and AT&T ha .. c slo,,oo or stopped lugh lc\ciS ofimcsuncnt 111 recent years. the reason 

n:hucs to the faclthat they ha\C complctt:d their buildout in higher density regions. and those companies have 

opparcnlly de1em1incd that certain O\\Cr~cns-ity regions are tOO expensive or that there arc altem:uive 

businesses m whtcll to am·cst c:q>itnJ to cam superior rctums (compared with the low-densny regions.) 

.&J Sec US/•' /C("1'rtmsformtlll01'1 Ordt . l>a.l":'k. 10: "U11der these CJrcuJl\SiilliCC$, rnodcnuzmg USF and ICC 

from supponmgjust \Oicc service co supponing \'Oicc and broadband. both f'i.\:cd and mobile. through lP 

networks is required by st.atulc. The Communica1ion.s Ac1 dire<:IS 1hc Commission tO preserve ond :td\'ance unwcrsal service: ·Access to 3d\'3nccd tclccommumc.at•ons :u,d inronn:uion services should be provided mall 

regions of the Nation." It is the Commission's st:ttutory ob ig~tion to maintain the USF' consistent with that mandate and to conunuc to suppon lhc nation ·s lclecommur\icatiOI\S illfr:tS~ructure ir\ rumJ, insular. and 

high-cost areas." 

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A. lm•estors are now assigning lower valuations (higher required return on equity) to 

IJ..ECs and becoming even more cautious in light of the regulatory uncenainty and the 

changing competitive marketplace. The equity prices of the ILEC-cemric carriers. that 

is, those without major wireless operations, have lagged, as is illustrated in Figure 3. 

Tin: ntp i~ vtoviU~ an imlexccl vi~w U~ginn iug in2000 fot the ~tlX.:k ptiu~ of 

CenturyLink (ticker symbol CTL). Frontier (FTR) and Windstream (WIN). and 

tracking their perfomtance relative to the S&l' 500. which is widely used as an index 

for the overall market.•s The three carriers are the largest of the publicly-traded lLECs 

\\1ith no wholly-<lwned wireless business and with extensive service in rural areas. 

Figure 3 illustrates that. from the low point in the market collapse in 2008, the S&P 

500 has sharply outperformed the three ILEC companies. which I believe arc 

approximately representative of investor sentiment about ILECs prior to considering 

any "size effects' or rural carrier regulatory risks. The stocks ofCcnturylink and 

Wirldstream have outperfomled Frontier's stock. in pare because those two car·riers 

have diversified within the last five years into business and data services where 

investors may be expecting higher growth. Windstrcam's stock weakened at the end 

of April2015. as the company spun-<lffits operating assets to a real estate investment 

trust ("REIT") in a sales-leaseback. and investors appear to be uncenain about 

valuations for the surviving operating company and the REIT, Frontier has the largest 

percentage of ILEC-only operations and has at least recently slipped below the 

perfomlance of the other two carriers and that of the S&P 500. It is my conviction that 

the market has a negative view of the LLEC businesses. and this graphic is illustrative 

-18 St:md:ud & Poor's 500. is 3. \\ idcty .. uscd stoek m:lrket illdex based Oil the m3..tkct c:spil3Jiz:uions or 500 large 

companies ha' ing common stock listed on the 1\frYSE or NASDAQ. 

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of the growing investor caution. The underlying data for the figure are provided in 

Exhibit MJB - S. 

Figure J: lmlexed equity nu~r eu;: larger rur11l ca"ie.r ''· S&P j00 

... 

Sourc~: J'aJm Flnrmc~. 

Q. Does the transa ctional market r e.Oect the same ca ution abo ut the ILEC indusr·ry? 

A. Yes The prices paid-<!xpresscd as multiples on cash now (e.g .. EV/EBITDA)-to 

acquire or bid on pure·play49 lLECs have fallen since 2001 and most notably since 

2007.50 Investors use multiples on cash How to make ir easier to compare one 

I? A .. purc-play .. ILEC is best defined ;t.S an I"LEC without signif1C3nt ocher non·ll.EC scn~ccs such as major 

c:.ble or" ire less or cxlensivc fiber tn'u1spon: 1h.:tt is, lhc ILEC"s business is JOSCd J>rimarily of voiee 3.nd 

broodb:.md services to residenu31 and busmess customers. 

5fl Multiples nre used 10 provide a better .. :lJ>J>Ics-t04 lpples.., oornp:uison from one ll':'lnS:\ction lO the 11ext. 

Muluplcs allow the financial :.d,,isor to focus on rntios that indicate ho\\ much a buyer is\\ illing to pay. for 

example, for S I of revenues or more lypically Sl of opcr.1.1ing cash no" · reg~rd ess of the size of the 

unns:.cuon So, 8.0:..: (8timcs) the as~ year's camings before mtcrc.s:Lta.'<CS. depreciation :Uld nmoniz.-'kUOn 

( .. EBITDA '')means th:Jt M investor is willing to pay $8 for S I of opcrn1ing cash flo" generated over the lase 

m el\'e m<>Ltths, bcc:1usc he or she 3Ssumcs it" ill be possible to realize a risk<tdJuSlcd sufficicm re1un1 on 

111\'Cstmcnt O\'Cf fu1urc periods. 

Page 44 of 79 

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lransaction or one valuation. wi1h another. 51 In 2001. as detailed in Exhibit MJ B • S. 

there were three rural llEC transactions at an average price that was 10.2 times las:t· 

twelve-month trailing EBITDA.l2 Figure 4 illustrates more recent, large and medium· 

sized ILEC u-ansactions since the beginning of2006, depicting how the pricing trend, 

based on muhiples of EV m EB TDA~ has wcakcned.SJ In the period since 1he end of 

2008. 1he average purchase price of the seven annoonced 1rans.actions was 5.4 times 

EBITDA}·1 Because smaiiiLECs do noa typically announce sale prices, most of the 

data remain confidential and we are not able to discuss specific pricing fbrcenain 

uansactions on which we have worked. However. my panners and I have been 

reponing in our presentations at conferences that the "going rate' for a pure-play ILEC 

appears to have collapsed to approximately 4,5 to 5.5 times trailing (last full year) 

EBITDA, which means that the value today is about half the value reflected in the 

EBITDA multiples realized in 2001 and about 56% to 69% (based on 4.5x and S.5x 

51 Multiples ~I'C saand3tdiutions. Jn the fin:uH::i~J "orfd. rnul1iples :..re :malog.ous 10 housin~ priC\..~ per squ:Jre 

foot. or, for lin..-s. pounds per square inch. Big homes can be oonlpared \\ ith small homes. and inOation in I:Jrgc 

tires with mfl:Jiion in all i~s . 

52Jn 2001. Country Road acquired Saco Rwcr (8 .. h: trailing EBITDA). TDS a.equarod MCf, lnc. (9.6x). and 

D&E ocquirod Conestoga ( 12.5x). 

SJ Again. the dat3 arc included i1t Exh1btt MJll · 5. The :.tbbtc.\'i:uions include CNSL (Consohd:ucd 

Communic.1tions). CfCO (Conun w~hh Telephone). CTL (CcnturyTcl whif;:h became CcnturyLink). 

CZN!FrR (CitJzens Communu::.atJons "hich bec:uue Fronltc~). O&E (D&EConununieations). SNET 

(Southern Ne-w England Telephone'' hich ilfC the Connecticut opcr.uions of AT&T). WIN (Windstream). and 

VZ (Vcrizon). The grccn bubbles (FairPoint·Vcri:wn. CcnturyTci-Emb.1.rq. Fronticr--Vcri1.()n, Md 

Ccnturylink..Q\\CSt) in the gr.tphic ''ere ta".OO':uua.gcd tmJlsac.tions (RcH:rsc Monis Trusts or stock·for~ 

stock). \\ hich means thai the sales prices would likc ~ ha,·c been some,, hat highi:r if there had been no lax 

benefits, In 1hc case ofsc"ernl rcccnl lr:lns:tclicms. I he prices \\Cre higher 1h:m the~· might othcmisc h:avc been 

bcc:~.usc they mcluded non-ILEC opemtions thnl :ldded inc.remen1ol \'aluc (Windst.rcam·lowa Telecom. 

Blackfoot·fairPoim. and Consolid:ucd·SurcWcst. ConsoJid:ucd·Envcntis). "hich also suggests that the pure 

ILEC ''aluc is lo"crchan t.hc bubble depicts. For example, the Iowa Telecom sale included $130 million in nel 

opem1in.g losses. which means th:uthe EVIEBrTDA calculation should bt! adjusted lo"er. 

S:l Charlesmc-ad h3S trnckcd 71 tmns.'tCtJons in the penod announced fi'OJn the bcg.uming of 2008 to tho present. 

and has provided services n.:latcd to nine announced lLEC trnnsactions in thai period. The publici~ ,1.\railablc 

d:ua :.tre unfonun:ucly sca.rce, but our 1>ublic discussions at cotlf'crcnccs O\rCr the last sevcmJ yeats pro' ides 

corroboration of this testimony 

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EBITDA) of the 8.0 times EBITDA value realized on average between 200 I and the 

end of2007.SS To be clear, investors appear to be signaling that there is significantly 

greater risk today compared ''1th ten years ago or even live years ago. as will be. 

discussed funher below. 

SS The most recent unnsactions are Consolidated Communications' purchase of En\ cntis "hich included 

substJ.Iltial fiber tr:u\Sport (4.200 miles) and busincss-f:Cntric scn·iccs (business and broodtxlnd account for 

more th:'ln 50% of revenues). providins the rc:.son for the relatively high v~Ju :uio . and Frontier 

Communications· proposed purchase ofVcrizon 's operations 1n thn::c states. 1ncludmg Califomia., "here the 

\'3lu:ttion of5.9x EV/EBITDA is likely ower~ Frontier rcpons that it is p.'lying 3.7 times EBITDA aAer 

excluding 3\'0idcd (un3IIOC3tcd) cosrs on 03y I of the 3Cquisiti01\, The st3tistics 3boi'C usc 3~' I Ell Ill) A 

c.1lcul:nions fol' Lhe Fromicr-AT&T troo$lccion (:\M OlU)C:Cd 0:\y I EV/EBITDA of4.8x, Frontiers Fin~ i:~ l 

Analyst prcscntalion 12/17/13. slide 3)and for the proposed Fronticr~Vcrizon tmnsaction (frontier's fm~lcial 

An:'tlyst presen :~.~ ion, 215/15, slide 6): and Envcntis is excluded bce::suse ic is nOI:lJ)I)ropriatc tO compnrc 3 

fibcNransport and busmess-ocnmc comp~l Y to ILEC.·only opcr::tuons. Illustrating the prcscm.auons \\C h:lVe 

made. I ha\'C attached a slide deck projcccod and distributed June 16, 20l4 as part of my keynote for tile 

Goorsia Telecom Associ:uion. I cited at slide 7 that the appropn:uc value for lLEC ::ssscts was S.Ox tt:tlling 

EBITDA: se<: Exhibit MJ B- 6. 

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Figure J: RcJNJrfetl ft"!ultlp/c; 011 Ell/1'/)A for 1/.ECA<.•ttui:oltiom: 

Q. r\re there cautiont1ry signs in the debt markets for sm:1H I_LECs? 

A. 

Page 47 of79 

1().1'11012 

Yes. Lenders have become more cautious in lending to smalliLECs, if the banks are 

v.i lling to lend at all to the carriers. For example, CoBank (S95 billion in assets}. 

which has been a large lender to rural wireline companies. repons that it is making few 

loans. almost none of which are principally for infrastructure improvements. CoBank 

sem a letter to the FCC in 2012that elucidates its concerns about the current 

regulatory environment for the Gnancial viability ofruraiiLECs 

CoBank is concerned about the negative impact the USF/ICC 

Transfonnation Order (the Order) Unfonunately, we view 

many of the provisions of the Order . as antithetical to that goal. 

A ITordable broadband for all Americans cannot be achieved 

without increasing the funding spent to S<tppon broadband 

deployment. The rate-of-return regulated Rural Local E.xchange 

Carrier has historically done the lion's share of the work in 

deploying U\tly robust broadband in n~tal America. Instead of 

trying to find ways co cut and cunail suppo11 tO these carriers. we 

continue to believe the Commission's goals would be bener served 

in finding ways to help these carriers continue to succeed in their 
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decades-long mission of bringing modem telecommunications 

services to their subscribers. S6 

Similarly. the RUS. which is pan of the Dcpanmcnt of Agriculture. has $4.7 billion in 

principal outstanding for telecom infrastructure loans and the Fann Bill Broadband 

Loan Program. The RUS has been able to place its full loan ponfolio every year that I 

have been able to track- 1111/i/20 12 (immediately after the FCC's November 201 1 

Transformation Order) when borrowers were lent only 11.6% of the $690 million that 

was available 111is means thm the RUS and/or the borrowers have be<:ome more 

cautious in light of regulatory instability in the industry. Further. of another $736 

million available for RUS broadband loans. only 9.4% ($68.9 million) was placed with 

carriers in 2012.57 As presented in Table 2. the percentage of available funding placed 

in 2013 and 2014 improved to 28% and 31%. respectively. but it is sri II profoundly 

troublesome that total dollars loaned declined by more than two-thirds from the pre2012 levels even in the most recent period. Our conversations with companies and 

with the RUS indicate that the low investment is a combination of caution at the RUS 

and uncertainty among the companies. Ln either case. the financial impon is similar. 

l6 Lctrcr of Robcn f . West to FCC. Marlene H. Donch. May 18. 2012. a1•ailablc at 

hups://prodttct.\\ w'' neca.org/publ ic~uioosdocs/w\\ pdl705 L L cob:l.llk.pdf. 

S1 The Unitod St~ucs Dcpanmcnt of Agriculture I Rural Development '1'he TeJcoommumcauons Progr.un." 

presentation by RUS D¢J>Uty AdmmtSir.ltor Jessica Zufolo to the Nation;1l Associ:uion of Regulatory Uuluy 

Commissioners. W3Shington. DC, Fcbru:U')' 2. 20 13~ sec Exhibit MJB • 9, slide 5. See. also. "ViiSlck, RUS 

Mc:et With Gcn::~cho"ski To Discuss 'The Need For More Changes ln lmplcment:uion Of USF-ICC 

Tmnsfonn:uion Order: Wnm Of Umntcndcd Consequences And Need For USF-ICC Support To Be Sufficient 

and ~n:dictablc." lndcpcndcnl Telecom Rcpon. Volume 12.1ssuc 3 (february 18, 2013). pp. 3·5): " In the 

meeting 1" ith FCC Chainnan Julius Gcnachowski :md his SUtff). (Socn:tary Vilsa.c,k :tndl USDA oAlcinls noted 

1h~t dcm~nds for RUS loons dropped drnm~tic~ ll y in 2012. RUS n:poncd "demand" for only 37 pcn:cnt of the 

fUnds lJ1 tu "e,rc actt.allr appropti:ucd by Congress. USDA cttcd 1hc reductions m USF and ICC tl\3t wtll result 

from the implcmcntru:ion of the fCC's Tr:tnsformation Otdcr as the rc:lSOn for the decline in loan applications.. 

Ru~J carrier :td\ Oc:lt~ s h:l\'c noted th:a! lhc reduced lo:m t'lc!ivity reflects the t'ldvcrse iml)..'tCI of1he FCC OnJcr 

on anfrnstructurc IO\estmcnt and rurnl commun•r,.• econom1c de\'elopmcnt.'' ·rnc figures \\Cre also n::ponod 10 

an ex pane filed at the FCC on Febmary IS. 2013 . The reconciliation is thai the ··demand·· for loans \\35 

reported :lS 37%3ccol'ding to SecrCUU)' Vii sack, but d'c RUS ac1u:tlly .. obligaled" thc :l.lnOuJUS reponed by Ms. 

Zufolo. 

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T'abft•1: RU"t' Joan ttL"fbr;l)' ttJ trud;tionu/tt!letonllmmh-clliOIIS 

Fisul Lonns Amount Available •;., or 

UJ)I)I"OVCd ($000) funding availablt: year jSOOOl funding 

2011 41 6~9.999 690.000 100.0% 

2012 7 79,765 690,000 11.6% 

2013 13 196,159 690,000 28.4% 

2014 14 213.993 690.000 31.0% 

2015 13 203 783 690000 295% 

Toea I 88 1.383.699 3,450,000 -101~ 

•.Jppt'(l:tinl(tU:Mr1etrdofj/scol.l'i!'OI', Juu~ JOJ5. 

SQu,~·: RurtJI l 'tdltic:.s Scrncc 

As imponant or possibly more imponant than the overall trend. it appears cha1 1he 

lower costs of debt are gene-rally unavailable to the small I.LECs. based on the 

comments from CoBank cired above and rhe sraristics of the RUS. 

6 

9 Vl. CALCUL;\TION Of AN APPROPRIATE RANGE AND ESTIMATE FOR EQUITY 

10 COSTS. 

II Q. How dots the changing ILEC marketplace :lffect the Independent Small LECs' 

12 cost of cqui1y? 

13 A. The federal rare ofrelurn was adop!ed as I I 25% in 1990 and reilera!ed in !he FCC's 

14 Mul!i-Associarion GrO<ap Order of2001 II is dinicul! 10 believe or argue rhar the 

15 appropriate return on equity is lower today. ~' fac~ industry risks arc demonstrably 

16 greater than ten or twenty or twenty-five years ago. as described in the previous 

17 soction ofrhis testimony In 1990. rhe ILEC indusrry had monopoly characrerisrics: 

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there was ongoing growth in switched minutes of use and in access lines; the caniers 

had virtually 100% mali<et share across which to manage internal cost-shifiing and the 

high fixed-cost nature of the business~ and there wa.s a regulatory safety net that was 

predictable and well understood 

There is only one change since 1990 that mighr reduce the appropriate rerum on 

equity, and that is the lower cost of debt in the last several years. butt his factor is far 

outweighed by the profound countervailing risks ofche currem environntent. Funher, 

"1th respect to today's debt levels. I note that most observers believe the Fed has been 

committed to an .. unsustainable .. approach in manipulating interest rates to low levels. 

which means that the forward-looking rates are likely to be significantly higher an 

today's rates.ss I provide data related to ~te change in debt costs in a later section of 

tltis testimony. ~lowever, low interest rates can only be pan of a cost of capital 

calculus if they are real!y tn<1ilable in the future. The evidence for noral carriers pOints 

toward increased risks. lesser availability of debt, and the probability of higher interest 

rates going forward for the general market and for the ILECs. assuming debt capital 

can even be obtained given the uncertainties arrcccing the ruraJ telecommunications 

industry 

Q. IJow do )'Ou derive tht specific iiiJluCs appropriatt for use or cht CAPM nud the 

Buildup C..'llcul:ttiO•lS co be dtveloped io this J)roceeding? 

A. The inputs most commonly used for the CAPM or Buildup Models are drawn from 

data compiled in annual publications from lbbotson.ft..1omingstar and from Duff & 

Phelps. The publications provide statistical illformation about annual risk-rree rates, 

53 Duff & Phelps 2015 Valuatioll H:ondbook Guide co Cost of Capitol. p. 3-3: sec Exhibit MJB- 2. 

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annual returns on equily for the markcl as a whole. and returns for specific industries 

rei alive 10 1he overall market lbbo1son/Mon>i11gs1ar has cominucd 10 publish i1s 

Cla.<SIC Yearbook. but it ceased publishing its Va/ua1ion Handbook after 2013, l'he 

Ibbotson valuation da1a and analyses are now consolidated into the publications 

Jnuvith::U IJy Dun~ & Ph~ v~. as of201.S. ( lllake lt:ft:tt:uce iu this lt:slimony to Uuth 

sources. which are the principal authoritative resources. 

Oo you ust. cost of equity in JHits from differe n1 periods? 

Yes. I provide input from several difTerent periods. The approach is consis1e111 wilh 

my professional view that multiple me-thodologies help to test assessments of the costs 

of equity. The expectations for returns on the "risk·free rate; ' returns on the equity 

markel and rewms on specific industries vary from one period to the next Inflation 

may be high or low: the s1ock market may be depressed or infla1cd: and the global 

markets may be aO'ected by wotulence (higher risk) or more peaceful growth (lower 

risk). We are using inputs from longer periods to reduce the eft'ects of cyclical 

conditions ahat may show up in the data. And we assess different periods to compare 

retums to co•ltinn our findings with respect to a "normalized" e;<pectalion of equity 

retun>s (costs). 

Is it aJ)prOI>riace to use lower risk-free r:ues from one 1>eriod and lower market 

equity returns from another period to ere al e a lowe.r estimate for costs of equity? 
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A. No. The statistical data compiled by Ibbotson and Duff & Phelps provide infonnation 

about the equity returns in a period relluwe to the risk·free rate in that same period.S9 

The markets expect certain retums in total. which include that period's risk-free rate 

aud that period's equity premium. 11 is not appropriate to use a market equity risk 

p11:mhun derivto:c.l from on~ iOO with a rbk-free rat~ from anutlu:r vc;riod. Agcain, I 

provide infom1ation for several periods so the Commission can confirm that the 

estimates arc reasonable. 

Q. What periods nre most appropriate to use in computing the cost of equity ror the 

Independent Small LECs? 

A. I begin with the longest period available, which is the Ibbotson data from 1926to 

2014. I also usc readily available infonnation in the most recent Duff & Phelps 2015 

l'aluari<m Handbook. which details inputs for the period from 1%3 to 2014. Finally. I 

use the Ibbotson years 1995 to 2014. which are absorl>ed into and reported in the Duff 

& Phelps 2015 l'a/ualion Htmdbook. I provide specific citations to each of these 

S0t1rees in my subsequent testimony. The CAPM/Buildup data arc included in Table 3 

below I also present the Duff & Phelps Risk Premium data in the final column for 

1963 to 2014 As I "111 explain below. the DulT & Phelps' Risk Premium approach 

uses a different size premium, which is more general because it does not include an 

industry·specific or company·specific adjustment. 

59 Duff& Phelps 20 15 Valu:uion HMdbook Guide co Cost ofC.::tpitll. p. 3-1: '1ltc risk-free rnte tmd the ERP 

Jcquny risk premium( :11\) intctrcl:tted concepts. All ERP cstjm:ues arc, by dcflnation. del-elOped In relmlon to 

the risk-free rntc." (Emphasis in original): soc Exhibit MJB- 2. 

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T'ablt· 3: Cosr of Ettuin· biiSed on CAPM/Ihlililu,J Metll()t/ 

lbbub011 l)._~p lbi:IOI.Wn l)._~p Rb-k 

Y"1 ~ Ynu!" Yt'IU'l' um 

IS!''~III:Ii 12!N::l;f!l~ 122:S:ZQI:Ii 12AJ:'SII:A Rl:s.,.frecnlle so,.. 6.61'• 4.W. 661'• 

O..'U 106 10<> 106 

f!qllll) llt\"nhtlm tcd tcd b\ CAI1M 6.67"'. 

bUill~' II~ Qtr!JIUI Il 21'11,.. t; i'~·~ 611; '~; 

R!!"t 0!''"8!"' roulh' rns• n(rfn'sal !101V· !If,&% II';(,•,) !3121'4 

l'ld ll>i~·.djwc~ ....... I'IU.l'-'t O..al"'. CU("• 0..11'• 

ils:! t!b:llli!Ull 10: C~2M U26~-.,(IJ ' ~ 1S!s t; 28'1 7~s &li' l 

ItUIII r:~ illlllal a&~l sa[s:Utlill I!I:IZ'"" 12 z:t•a 122~·-i l i :U'" 

Q. \Vby do you refer to the eombined CAPMJBuildt•P rather tban10 two distinet 

methods? 

6 A. l refer 10 1he medtods colle<:lively because the Buildup Melltod is derived from lhe 

CAPM, bolh conccprually and in tenns of the fundamen1al in puis. ln bolh methods. 

chere is a risk-free rate. an addition for the necessary market retul'n, and a size 

9 premium The Buildup Method employs beta·like inputs that are included as two 

10 buildup figures: a specific marke1 equity risk premium plus an industry·specilic risk 

11 premium. By comras1, in the CAPM. the use of a beta is a contpany·specific factor 

12 thai includes b01h the markc1 and company-specifoc premium as a single input Tite 

13 Buildup Melltod 1ypically adds t>rcmia for 1he risk-free ra1e plus 1he general marke1 

14 equity risk prcmiunt plus 1he industry·specitic premium plus the size premium to 

15 arrive at approximate-ly the same resuh as the CAPM. I \\~II explain below that the 

16 industry-specific premium for the ILEC industry should not be used in our Buildup 

17 Method, so, as Duff & Phelps SuS£estS, I included an indusuy-adjusled premium 

18 relying on an average of betas from similar companies. We do not have a beta for t11e 

19 lndependenl Small LECs. bul l use an adjusled premium of 1.06 (average bela of 5 

20 ILECs). lf 1ha1 bela of l .06 were included in a 1ypical CAPM, 1he resuh wa<.~ld have 

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been precisely the same as that presented in the table above. Jam referring in the table 

to CAPM/Buildup as one and the same in this case because the computations. using 

1he proxy beta. generate the same resuhs. 

Q. Please tXJ)Iaio the sources for and variations i_n the ri.sk-free rate. 

A. The risk-free rate is based on the yield of the 20-year U.S. treasury bond, which is 

assumed to be the best credit available over a twenty-year period (expectation that 

there will be no loss ofprincipal and guaranteed dividend payments). This horizon is 

appropriate because we arc seeking a rate tor companies that c.•pcctto be in business 

indefinitely. The risk-fre.e rates used tor the 1963-2014 period (6,61%) and 1995-2014 

period (4.92%) are drawn from DutY & Phelps' 2015 V<liuaticmllamlbook and the 

Ibbotson/Morningstar 2015 Classic Yearbook, respcctivcly.60 

Q. Are there differences of opinion nboul which risk·free rate should be used? 

A. Yes. h might be argued-with strong authority- that the appropriate rate is higher 

than the yield alone. According to this school of tho gh~ the risk-free rate is not 

simply the yield for t11e 20-year treasury bon ~ bul also includes inflation as well as 

maturiay risk.61 In cenain years, the underlying bond value is up or down, depending 

on fluctuations in market-based interest rates, which anect the price for the bonds. So. 

60 Duff & Phelps 2015 Valu:ujon U:~Jld book Guide to Cost of Cnt>it:tJ, p. 7~ 0 to 7-1 1 repOrtS 1h:u from J%3-

20 14. lhc ·tustoricnr a'crngc Mnual long•tcnn cquit~ risk premiurn1s 5.05% The nvcrngc annual risk-free 

10tc is 6.61%.'' Sec also Ibbotson, 2015 Classic Yearbook. L.ong-Tcmo Government Bond Yields. A-9. E'hibit 

MJ B · 2: 4.92% is the moruhly :wcragc for the period. 

61 Sh~nn n Pron and Roger Gr:tbowski. Cost of Capit:tl: Applieotions and Ex:uuples. "lllird Ed. (Hoboken. NJ: 

John IV1 Ic~ & Sons, Inc., 2008) ("Cos< of C:lj)oul'), p. 71 . " The so<:>llcd nsk-free r:uc rence<s 1hree 

components: I l?.ema/ rou•. A real rctum for lending, fu11ds O\Cf the im·cstment period. thus forgoing 

consump1ion for which the funds orhc1wisc could be used. 2./nj/atUm. 1l1e expected rate of in nation 0\'Cr the 

tcnn of the risk-free m\'CSU11cnL 3.A1murlly rlskormwsumml rate risk. . the nsk th::u the pnnc1pal's 

m~utet value ''ill rise or fall during the period to maturity~ a function of changes inll1e gcncr.aJ level of 

mtcrcst l':llCS ... lllis text cxpl:tins ho'' the 20·)'C:lf ll'C3Sury bot\d can be significantly ncgati\'c or very hig.h i1\ a 

gh·cn year. as the underlying bond apprcciatcsordcpl\.-ciatcs in the period. Sec E.xhibit MJB- II. 

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while the ex peeled dividend has been paid in a given period. the market.-driven price 

of the bond fell or appreciated in the year in question compared with the prior year. 

For example. in 2014. the total rewm on the 20-year treasury was up 24.5% afler 

being down 11.4% in '2013. primarily due to the movement ofmarket·based interest 

r'att:~ during tho~~ yt:(l.r~.«~ If l hitll us~ the; tvtitl n:turn for 1hc:: d~k f1~ "'~· Tab ~ 3 

above would have been replaced by the following table: 

bbol~m D& P lbbuboun l)&P Ri!t.k 

y,. • ..,. l "f'IU' \',. .... J•rn••lmn 

l'tl6: I:I 126S·lllbl l't.l:o;. :I ~l lC!bl 

Ri.;t,.f,e< ml¢ (lOIS lbOOt'-'fl T•bl¢ C-'t S70"• 7 -10'· ~60'· , ..... , .... , ... 106 106 

Eqtlil\ pKmlunt rtlldlelcd b} CAPM 66?•. 

F Ql~)' n:;-~· Cla:ll1111 01 l~a tl&l" 

tho;,: 11r •arhc• cquiu· nr;t o'nph•l 1?70"4 11:1(.% ' 3.J.4"4 IJ.0]"4 

ludll'ill')•odjUSI\."\Jj'I«O'I.i.lltl 042"• 0.30"'. O·n•. Sire"'""""'" '" CAPM {1963-201-1) S78'• S.78•• S.78'• 7.36·· 

S!l::£ $!0.:1DIJIID li!bl~.: D:l~ C= III"C: 

J',ll'al c:~tianaral 01~1 u(Qinill 18~~. I&~J ~ Zl tt.J:•Ia 211.1".&. 

1/tm•e not used 1/tis allertKIIil'e iumy calculalions, but point ou1 that this approach is 

supported by significant authorities A comparison of this 1able with the previous 

table reveals that this altctnative computation. which is included immediately above in 

Table 4. generates higher estimated eo5ts of equity for the first three columns and the 

same cost of equiry for the last column, My choice to avoid using this formulalior1 

again highlights 1he conservative nature of the approach in this testimony. 

Q. How did you generate tht bet~l to be used in your calculations? 

62 Jbl>otson 2015 Cl:t$$ic Yc;utook. Tobie C-4. pp. 2. 4: ' ''" Exhibit MJB- 2. Sec also Tom COJ>Ciand ctnl . 

McKi tse~ & Company. Valuario•L Mcasuri11gand M::Ul:18ing the V31ucofComJXUlics (NC\\' York JohJ1 Wiley &Sons. 1990). p. 192. Sec Exhibit MJB- 12. 

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A. Duff & Phelps provides industry-specific adjustments that can be used in d1e 

calculation of the Buildup analysis. which is a useful approach when no companyspecific beta is available, and such is the case with the lndependem Small LISCs. The 

industry·specific adjustment relics on data compiled for SIC codes., which, in this case, 

i~ SIC cod~: 4813 (ide:phone Cvnnnuni~;ations. ~'<ccpt Radiote:lt:phom:).6J 11t~; 201 S 

adjustment for SIC 4813 is recommended to be ·1.44%. which would offset the long· 

term historical equity premium (dropping it lower by I .44%) because the industry 

companies in 48 13 are perceived, according to the data in Oufl' & Phelps, as having 

less risk compared with the overall market However, Dull' & !'helps explains that an 

analysr can review the companies included in the industry·specific group todetennine 

whether they are truly comparable, and then Dull' & Phelps provides a formula for 

adjusting the industry-specific risk if a .. custom .. beta is used.M The companies 

included in SIC code4813, upon review. are very different from 1he Independent 

Small L.ECs. as reveaJed in a quick glance at the entire list in the fOotnote be1ow.6S 

The companies include Ce111uryLink, multi-national Cogent which is an Interne• 

Service Provider, and General Communications Inc., which is primarily a cable and 

6.l Dull'&. Phelps 20 t5 Val notion Hondbook Gu•dc to Cost of Capital. pp 5·1 2 to :1-22 Ibbotson 2015 Class•c Ycatbool.. Appendix C-4, p. 6. &.'C Exhibit MJB • 2. 

64 DuO'& Phelps 2015 Voluation Handbook Guide to Cost ofC.pital. pp. 5·14 to 5·15, and the adjustment is 

.. (PccrGroupBeta x RPm) - RPm·': sec Exhibit MJB- 2. In the CAPM table. the adjustment is (1 .06 .x the 

cquit~ nsk prcnuum) - cquit~ nsk prcmmm. ,,Juch l.S sllO\\D as lhc "tndustry..adjustcd industry risk premium 

Windstn:am \\OUid ha,·c been included in our calculation of the industry beta. but the com)Xl.ny rcccnt ~ 

divested itsassc1s. ::and Vnlue Line now repons Wind$1rel.ln·s bela as "NMF". 

6S The COIII pM~ ist for SIC ~813 C311 be downloaded fron1 Ouff & Phcii>S 01 hup://"" " duff:'tndphefps_eom/SttcCo11cciiOnD«-umcnts!Sen ces/Yttlu:lfl01\/Cos t%20of%20C:l!)IW ~f~rth% 

2020 1 ~ IBP%20Comoom 0 j.201ast 'FINAl o/4{)(! I:'\ I:'\ ndf. 11tc companies are Alask3 Communications 

S}S .• c,~. AT&T Inc .• Cablcvision S}'$ Corp .• Ccnnll'~ ink Inc., Cincinnati Bell Inc., Cogent 

Commumc.at•ons Holdtngs. Consol1d.llCd Commun1c:uions Holdmgs Inc., Elephrult Talk Commun•catio•ts Inc., 

Empire District Electric Co .. Frontier Communications. Corp .• General Communications. Hawaiian Tel com 

Holdco lnc .• Hc2 HoJdjng.s Lnc. JOT Corp. L¢,•cJ 3 ComtnU1ticat10ns lite., LICf Corp. New Ulm Telecom lne .• 

Otclc:o Inc .. Sprint Corp .. Vcnzon Communications Inc .. Windstrcam Holdings Inc. 

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wireless company. The listed companies serve muhiplc states andfor non·U.S. 

regions. with a variety of businesses including enterpl'ise services. wireless and cable 

television products. These companies bear no reasonable resemblance to very small. 

locali ze ~ \vi reline carriers with between 300 and approximately 20,000 customers, 

SU\;11 as t1n: lltlt:pt:I Jtl~l ll S111all LEC:!!>. Bt:(;.aU!Itt: uf lilt: fumhtlllt:ltlcd dilTt:.lt:ll\;t:~ lJt:;twt:t:ll 

the SIC Code 4813 proxy gr0t1p and the Independent Small LECs. I then reviewed 

rcpons from Value Line Funds to compile betas for companies that might be relatively 

more comparable in tem1s of concentrated ILEC services and relatively smaller size. 

The comt>anies that are more comparable. in 1ny estimation, are FairPoint 

Communications. Inc. (Value Line beta of 1.4). Telephone & Data Systems, Inc 

(Value Line beta 1.2). NTELOS Holding Corp. (Value Line beta l.O), Frontier 

Communica1ions (Value Lilte beta 0,95) and Consolida1ed Communications (Value 

Line beta 0. 75).66 On the basis of the five companies, I used the average beta of 1.06. 

but believe that the figure is still low for the Independent Small LECs. again because 

the comparison companies are larger and more diversified, thereby likely resulting in 

an understated (too low) beta. This underscores the critical nc.!d for a size premium, 

which I will discuss later. 

Q. \\'hnt is the tquily risk f)remium iU1d how do )'OU tStirnAit that pl'emium? 

A. The equity risk premium is the difference between what a risk-free investmentgenerally using the long·tenn Treasury Bond as a proxy- would generate and what 

stocks in the market over the same pcl'iod wet1ld produce. Generating a market equity 

66 Sec Exh1bit MJB- 13. 

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risk premium is a simple e.xercise in subtraction, taking the total market return or 

c.xpcc1a1ion, based on his1orieal dala, for cqui1ies and subtracting the risk-free ra1e. 

The appropriate market premium data are abu a~ed in studies such as DufT & Phelps 

2015 Vtrluation HtuKibook which builds on the data previously published by 

UtJubu lirv ulll iug~hu. In E.xl1ilJit 3.10 uf tht:: un~ & Plldp~ Valuuliun Hwtdbuuk 

Gmde '" Cos1 ojCc>prml. the Handbook repons that the long-horizon equity risk 

premium is 7.0%. which is the observed premium from 192610 the present For the 

period from 1963-2014, the equity risk premium is 5.05% as reponed by DufT & 

f'helps. For the period from t995 10 2014, the premium is 6.S4% as also reponed by 

DufT & l'he.lps.67 

Q. \Vhat size premium should be applied? 

A. As Ibbotson/Morningstar did in the past. DuO' & Phelps pro,; des two approaches to 

size premia based on its longer-term observations of data. The size effectS ean be 

captured by adding them to CAPM resuhs or to the risk-free rate. using one of two 

difi'"erent size premia, each appropriate to the diflCrent respeclive starting points for the 

analysis. I used the former because the Iauer approach is less precise, but I also repott 

the Iauer result below. The data, based on statistics from 1963 to the prescn~ are 

compiled in the DufT & Phelps 2015 Value>! ion Htrm/bOQk Guide 10 Cosr <>JCtrpilttl in 

the Appendices. with Exhibit B-2 providing size premia above the CAPM and with 

E:~h it Ae2 providing size premia over the riskefree rate. I provide the pages from the 

relevant Appendices in Exhibit MJB • 2. The pages in question divide companies into 

groupings (portfolios) ranked by size from I to 25, wi~t 25 being the smallest. 

67 Duff & Phelps 20 IS Valuation Hondbook Guide to Cost of Capitol. pp. 7-11 ond 3-23. Sec Exh1bit MJ B - 2. 

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Ponfolio 25 in Appendix Exhibit B-2 and in Exhibit A·2 includes companies with an 

average book value of$65 million, which is larger than any of the b>dependent Small 

LECs. I have used the smoothed premium of 5.78% over the CAI'M for l'onfolio 25 

drawn from Duff & Phelps E.xhibit 7.3 rather than I Oz premium of 11.98% (smallest 

g.~uup in the t~nth tlooilc:) 0 1 the 8.94% (aveaagc uftllt: twu smallest gwups in the tcutl1 

decile). funher underscoring thar my estimate is conservative.GS 

Q, \\'hy did you not use the stze premium O\'Cr the ri.sk~fl' e rate as provided in 

Ap(K'IIdix Exhibit B-2? 

A. For J>onfolio 25, the indicated smoothed size premium is 12.49%, '"''hich is combilled 

with 6.61% risk-free rate since 196.3, resulting in a cost of equity of 19. 1%.69 The 

estimate is in the middle of the other estimates generated in Table 3, but, in my 

cSlimation. is so general and approximate that it is not necessarily helpful in this 

discussion 

Q. \Vhnt is the Duff & Phelps Risk Premium? 

A. Duff & Phelps provides an analysis ofl>ortfolio 25 stocks. indicating tha~ since 1995, 

this group of stocks has generated a rota! return of 21.43%. This percentage is 

comprised of the 6.61% risk-free rate and the 6.67% excess return predicled by the 

CAPM in addition to the size din'Crence. which was 8.15%.

10 As I e:"plained above, 

tl1is forn>ulation does not make any adjustments for indusuy-spec.ilic risks or 

company-specific risks, so the inputs and results arc more general. The results rcOect 

what actually oc.curred. providing insight into what might have been expecccd. The 

68 Duff & Phelps 2015 Vahunion li.'Uldbook Guide to Cost ofCapll31. p. 7·10. see E.'<hobit MJB • 2. 

(f) Dull' & Phelps 2015 Voluation Handbook Guide 10 Cost of Olpilal. sec Exhibil MJB - 2. 

'" Duff & Phelps 2015 Valuation Handbook Guide to Cost ofCapilal. p. 7- 11: sec Esbibu MJB - 2. 

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size premium in this case is higher than in the first three scenarios in Table 3, but it is 

Slill below !he lbbOISOn!Momingslnr nnding 1ha1 lhC smaiiCSI gro<ap should be 

assigned an 11.98% premium.71 

Q. Are you concerned :tbout the magnitude or these pl't'rnia? 

A. No. Size premia are standard modifications in CAPM calculations, and 1hey are 

clearly appropria1e for application here.72 lbbo1son/Momings1ar and DutT & !>helps 

have compiled extensive data to show that very small companies. such as the 

lndepcnden1 Small LECs. should have a size premium that is substantially higher !han 

1he 5.78% premium thai I use above. The 1emh dedle(grouping of 1he smalles1 

companies) is subdivided in DuiT & Phelps E.xhibi1 7.3 imo fourca1egories. lOw, lOx, 

lOy, and I Oz. wilh respective size premia of3.18%. 5.54%, 7.51%, and 11.98%. The 

IbbOtSon/Morningstar 2015 Yearbook provides da1a in TablcC-1.73 Ibbotson/ 

Momings1.ar explains that 1he smallest sub--category of ... IOz'• includes companies with 

a market capitalization of up to $96.16 million.74 At the same time. I have chosen to 

be conservative and use a prernium of 5. 78% rather than 11.98%. and have applied this 

figure to each of the periods being analyzed. 

Q. Can you l)rovide rhe debt and equity inrormation for the lnd~p~ndent Srunll 

LECs? 

71 Duff & Phelps 20 15 Valuation H:uadbook Guide 10 Cos! of Capll31. p. 7· 1 0: sec E.,hibit MJB • 2. 

12 See. e.g .• l)u(f & Phelps 2015 Valuation H:u>dbook Guide to Cost ofCapiUll, pp. 4·1 to 4·24: sec Exhabil 

MJB- 2. 

73 Dull' & Phelps 20 15 Voluation l·l:u>dbook Guide 10 Cos1 ofC3pi1al. p. 7-1 0. Exhibia 7-3 lbboiSon 20 13 

V31u:ation YC3rbook Table C·l. Sec Exhibll MJO • 2. 

14 Ibbotson 201 3 V3luataon YC3rbook. p. 216. Table C· l. Sec Exlubil MJB · 2. 

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A. Yes. Table 5 summarizes the debt and equity for each of the Independent Small LECs 

from 2010 to 2014 based on infom•ation that I received from the companies. lllc 

book value of all the ten Califomia ILECs is very small, and the largest book value is 

reported by Siskiyou Telephone, which has $60 million in 2014 book equity, while the 

Pasc61 of79 

10-1710l-l 

avc:.ta!;t: anti mruiau value:. fot all tht: lndt:pt:m..lt:.ltt Stu<tll LEC:. a1e $20.2. million cuu.J 

Sl4.3 million. respectively: thus, it is apparent that the ten Califomia ILECs fall in the 

lower half of the ·· 1 Ot" group, for which the indicated size premium is 11.98%. 
72 


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J"uhlt· 5: .\imt/1 LEC.~wtul debt aud Cfl.uirr 1010-201-1 (Sl 

2010 20 11 2012 2013 2014 

Com1non [quil) 

Qlbn:ras s.•1u1s 9.10-1.2 16 s.R•l.007 8.513.358 8.SI3.J58 

Cnl-0"' 13,8S1,635 l.l,517,3 1"' 5.GH.~6 16,552.928 17,560.657 

Ducor 4.999.962 5.251.S71 4.706.568 3.560.678 3.061.029 

ForcsthiD 5.878.103 6.7 ... 103 7.320. 103 7.666.103 8.06U19 

Ktmlilll 9.953.000 10.835.000 IO.SOZ.O<lO 10.802.000 10.967.000 

Pinnacles 3.512.216 2,819,75 1 1.623 5~ 2,705,·U3 2,911,15() 

Ponclc:I'OSil 26.7"'9.3$3 26.508.056 31,127.582 JG.J23.3U• 38.068.157 

Siski_\ou 50.805.747 58.305.399 59.897.477 59.91 •. 38• 59.602.160 

Sa:rm 38, 172. 169 37, 133.193 33,01),8S7 39,619,212 .OSS,20~ 

Volctmo 16.551 2S3 l l 560 425 19 28*) ; .... 20955 729 12 085.190 

"' tr. ~t 17.897.926 19,277.903 19.326,997 l0.671.Jil 20.192.223 

t-!i:slia!l IJ912 RUC U676 l:'i7 l~U:!~U 12 627 lli ~~ l~~·9 

Pn:•rt IT\~('(Juil~ 

Pinn:Kics 7<1,000 70,000 70.000 70,000 70,000 

Ponderosn 792.720 792.720 792.720 792.720 792.720 

Siski)ou 418.000 418.000 418.000 418.000 418.000 

Vo~U!2 I 295 25<l I 295 250 1 295 250 I 295251> I 295250 

A''tl".tJt<': 6-43.993 643.993 643.993 6-43.993 6.3.993 

i\1cdian M~ 360 (~.,!60 60~,J(,j) (·1~360 60~J(.0 

Otbl 

Cnb\'tms 8.0<,..652 7,30 .2~ 7,180.3;() 6 •• 46.570 5.659.H6 

C~ J.Ote 

Ducor 3.219.791 3.069.108 1.903.3(1\< 2.7•3.589 2,(,1)4,1.&0 

ForcstluU 8, 141,911 10,2S1,55 1 9,854.67<) 10,993. 194 9,259.383 

Kcn•~ao 9.061.177 9.869.591 10.253.69'} 12.588.721 11.:164.86-4 

Pirm:.cles 

Pondcro..coa 18.067. 143 16. 157.886 19.123.3?4 24.96 1.238 11,93 •• 99(1 

S~ou 

Sict'1'3 23.072.963 20.97l.9•l 18.901.086 16.~S.092 U.3W.8•6 

VQ:Ic:UlO 1a21900 13487.505 12 918.209 11319 170 11688.41 8 

A\tl"d;lC 8.360.~· 8.1U.J87 8.1 IJ.Hl 8.660.057 7.(>81.!'99 

Median 8,073,281 8a;~S .U7 8a;lril71510 81719,882 7dS9a:!fd 

Q. Do you believe Uuu any othe.r lldjuslments are APJlrOpriate? 

A.. As I explained in a previous section of this testinlony, l believe then a good case can be 

made for assigning a cos110 illiquidity tocap!ure !he lack of marketability in 1he 

6 equi1y of 1he lndependem Small LECs. I have linle ques1ion tha11his facw is 

appropriate because small companies generally rrade at discoonts that reflect a higher 

Pasc 62 of 79 
73 


620PREF63.eps

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16 

17 

18 

19 

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21 

22 

23 

Q. 

A. 

Pasc 63 of 79 

10-1710l-l 

level of risk, as is further corroborated above in the IRS discussions of lack of 

marketability. Some observers might contend that the small-size premium captures 

1his eiTect, but the small-size premium penains to ltquid securities. In this case, there 

is an incremental risk as these companies are both small and illiquid. I have chosen 

nullO u:,t: thi:!> p1~mium, in :-;pit~ uf the: fa'-'L that the: !'iOUH.:c:s iudit;atc: that it ~ 

appropriate. The simple calculation. however. would be to take the recommended cost 

of equity and divide by 0.80 to include the premium. so my recommendation of 18.5% 

cost of equity would be 23.1% if such a liquidity/marketability premium were to be 

included (I 8.5% divided by 0.80) 

Do you belie\' e. thai your cos I or equity estimates nre realistic given thai they 

include the IJOssibility or overall capit;d costs that rise as high as the mid~20

perccnt range? 

Yes. 1 have provided multiple periods and methodologies to assess the reasonableness 

of my fi ndings. as is the practke when I work on M&A transactions. Additionally. to 

test my findings, I turned to the M&A data, which provide compelling confirmation of 

reasonableness. In fact, the transactional marketplace repons sharply reduced 

valuations for small ILECs, which have slipped from approximately 10 times EBITDA 

in 2001 (based on three transactions with publicly-available data) to 4.5 10 5.5 times 

EBITDA over the last severaJ years. Taking a longer view, from the beginning of 

2001 through the end of2007, at least 98 transactions involving small LLECs were 

announced, 20 of which included announcements of public valuation data. as included 

in Exhibit MJ(l - S 11te transactional multiple based on EV to E(llTDA averaged 

8.0x in that period. Assuming no change in the small ILEC industry's absolute level 
74 


620PREF64.eps

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15 

16 

17 

18 

of debt and the cost of debt (which I believe is a realistic assumption) for industry· 

wide carriers as of the period when smalllLECs were valued at 8.0x (i.e. , 2000·2007). 

this collapse in enterprise value implies that the equity value has fallen very sharply, 

and dte near-totalloss of value is absorbed in the markel value of equity.

7S The 

con~.:c:pt is n;li;ttivdy ~i ph: . If a huust! is vcalucd at $ 1 million cmd $200,000 is owed 

to the bank. and then subsequently rhe house vaJue slips to $500,000 and the same 

$200,000 is owed to the bank, the residual equity value has fallen from $800.000 to 

$300,000. Because the deb1 must be repaid at face value, the equily account bears the 

entire Jos.s of value in this scenario. 11lis is 'vhaa L believe is occurring for the 

Independent Small LECs. 

Q. liow dots a contracrion in equily valur afTecl thr. cost of e<tuity. ;U1d dot"S it 

support your conclusions rtlatrd to the cost of equity? 

A. Before responding. I emphasize that the following assessment is a corroboration of the 

analyses above. not the central presentation in Lhis testimony. A critic might argue 

that there is a mixing together of book va1ue and market va1uc. Such an argument 

misses the larger poi1tt, ,vhich is 1hat the size of1he re/(lli\'1! comraction in mlue iu 1/u! 

markelp/t,ce is a clear indication of the stanlingly increased risks in the industry. 

which is the basis for contending that a higher retum on equity is apJ>ropriate. To aid 

7S A simplified illustmtion can illustmte that im estors oda~ a.n: not J>3) ing the S:lme :lmount for the s:une 

re13th'C lc\'cls of C3Sh flows. which me:~ns thru they t\f'C fC<luiring n hig.hcr return on equity bcause of higher 

pctceivcd nsks. lllc allusll':ujori ~p un::d in tJ1e table assumes t.lut afasrn:tii iLEC \\Cre \3lucd io 2007 :u 

SIOOand had 3 capita.! stn•ctun:: " itJt400/odcbl ($40 in this •llusn:uion), then the original cquity\\3S valued at 

$60. owe\'c , a change in enterprise vnlue (debl plus cqui1y) from S.Ox EBITOA to 5.0x EBITDA would mean th:u the cntcrpnse would be wonh 37.5% less today th:ul 10 2007. lfthc value oftJlcdcbt is unch:utgcd, 

the equity v:.lluc \\OUid have fallen from $60 to $22.50 (down $37 SO) fora loss of62.5%ofits \•aluc. Higher 

nsk therefore is translated into higher required rclunls. The m3J'kets are COJlilnuing 1hat equny risk is significantly more ciC\'iltcd 1oday compared 10 pcrcehcd risk eight yean; ago. 

rase 64 of79 
75 


620PREF65.eps

in understanding the concept about what has happened to market equity, I have 

prepared Table 6. below. In the table. I e-xamine the loss in enterprise value (the entire 

company, which again means net debt and equi1y) as transactional multiples have 

4 fallen over the last 10-15 years and notably since 2007. The table analyzes various 

tXfUity tcttiu~ ami v<'u uu~ umhiylt: \AJHtJal:tiuns. \Vhile dtt: taUit: is ..::umph:x, it tuakt:~ 

important points in verifying the reasonableness of the estimates related to cost of 

equity 

Table 6: Jllu~ra itm o{Jitc lrtm.<om:tiolt priCt! dtu!l;;c.'> related ttJ cquil'l' ct>sts 

R t A.:..umrd £9ulh· ruti.t• RD•k 71'W. 61'1~~ 

R2 A$$um«< mltTJX" ~ \--.luc in \"Qr 2000 SIOO.OO StOOOO StOOOO 

:~ (mli!£!i! £gUll\ \•nlu ... • !II llllltl Ill ?(JIX) (RJ ~ K"} ssooo ~00(') ~00 

R4 t..o~l c-n lc-'T'ri"'f' nluc (t,.'V) fmm 8.0l EBI1UA •t turt 

K5 Awtmtn&nt\\ l-.V mull!f!k: o(S,Ch((I-(S.OS.O)):\ K2) SJ7 SO S.17.SO SJ7.SO 

R6 ~~ n,s te\\ l!Vmultlf!k ofS.S-.:(( -(S SS O))~ R2) $3 1.25 $J J 2S SJI 2S 

K7 ~'~~'~111!1 1~\\ BY IW~II!S o(!l <b!!l::lf>O l't Ol} ;s 8"} ~"4!01) ~~fill c:.,~(ll) 

R8 Nl•t nault~ 'tthft' nl'ltl' kl» 

·~ Assulll"'J; AC'\~ EV 1nullaplc of 5 Ox (R3-RS) $.1:!.50 S32 SO S22 3() 

R IO A~ "' I.C\\ b v lntl.lflkl or -.: (~·R4) $18 7S SJ8 7S Sl$..1~ 

Kll A""'"'"""U 1!£\\ f::;V mul'h[!l!;: n(6.Q::; (RJ·R7\ .S5S.OO S45 Oil ~lSOO 

R12 A . ..:s unrdari1o!J •lc-q llityro~ nfupit•l 1201)". 12 01)". 12£10-'. 

Rt3 Ai'Wrmnsne'' 1-.V .,.uiiiJikl ofS.<h ( l 91tl ' Rl2) '22.51)•;. 2...~85% .1:2.00". 

R14 J\timning lte\\ hV tnultiplc of5.h(l IOltl) '( 12) 9.6,·~ 21.63% H.o.r. 

9 ~ "'"~~'~l'1111il~\\ li¥ m'~'l!~oHsts" UUI B:ll:s Rl, l :1~·11 l~ fl~a ~)~r:~ 

10 Q. Plea sr U J)Ia in the ca ble. 

II A. The table addresses the c•·iticism that the estimations of the cost of equity, as presented 

12 on the basis of the Ibbotson/Morningstar and DuiT & Phelps statistics. rely on data that 

13 are somehow distoncd or are too theoretical. This 1able relies on data from am1s• 

14 length sale transactions in the real world and de•nonstrates what happens to equity 

15 value and the cost of capital for local telecommunications companies such as 1he 

16 Independent Small LECs. As an e.xample, if an entire enterprise was worth $100 in 

17 the year 2000 up to 2007, valued at 8.0 times trailing EBITDA. and is now worth 6.0 

Pasc 65 of 79 
76 


620PREF66.eps

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17 

18 

19 

20 

21 

22 

23 

times EBITDA with no change in the amount of the debt, then the Joss of value (S25 in 

this illustratiOil) is entirely subtracted from the market value of the equity. If the 

equity ratio was 80%, then one has to subtract $25 from S80, or if the equity ratio was 

700/o, then the loss of value is S25 from S70. and if the equity ratio was 60%, the loss 

is $2S ftuut $60. The table Ueu :-.t e:. that if lite: t;UIIt:llttuul ti plt: is at;Lmtlly S.S 

times EBITDA. then the losses to equity value are greater. and if the current multiple 

is 5.0 times EBITOA. the losses are greater still. 

Q. Should the Commission care about the loss of equity value over this period? 

A. 

Pasc 66of 79 

10-1710l-l 

In theory, no, but given public policy objectives that the Commission cannot ignore, 

the answer should be .. yes •• One coold argue that the answer is "no" because aJI 

companies irtcur risk in operating their businesses. and operations always result io 

capital appreciation or loss of value for the shareholders. These are privately-owned 

public utilities. so the loss of marl:et equity value is bome by the shareholders and not 

by the ratepayer or the Commission. But che answer is "yes" in this case because these 

carriers are responsible for achieving cenain public poJicy objectives and a strong 

equity position for a utility will beuer assure access to debt-capital and will reduce the 

risk associated with operations Conversely, /oss of market equity value can reduce 

access to debt and raise rhe risk associated wirh operations. One must only imagine 

the problem in refinancing a home when the housing market weakens sharply. Lower 

market equi1y value in ahe home reduces or eliminates the homeowner's access to debt 

capital and may result in higher interest rates. The Independent Small LECs' access to 

the debt markets and their forwarding-looking debt prices are pan of the calculation 

with respect to \VACC. and those factors will have an eflect on 1he costs of equity. 
77 


620PREF67.eps

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9 

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16 

Again, if the Independent Small LECs cannot access capital, the stale's universal 

service and broadband deployment goals will be significandy impaired, and ratepayers 

will suffer 

Q. Please tXJ)Iaio your assessment of how the trnnsacliona_l or M&A data support 

A. 

Pasc 67 of 79 

your findings nbour the cost of equity for the Independent Small L£Cs. 

As the above table indicates, a change in the valuation muhiple 011 EBITDA applied 10 

the enterprise has a direct effect on the 1narket value of equity and an inverse etTect on 

the cost of equity. lf a carrier is 10 achieve a retum on invested capital that is fair and 

CQmparable with what was earned ten years ago, but the market value oftheequity is 

now depressed, then the relative retum (cost of equity) on that market value must 

increase. I provide Table 7 for pcrspeccive on the 1997 Commission decisions and 

resolutions regarding each ofdte Independent Small LECs. with the table presenting 

capital structure. costs of debt and equity at that time. 

Tuhle 7: WACC Ded<dous/Rt!$qlution.'t iu /997 for the lndepemlenl Small U.EC:'t 

Cl)h\ t ft'S 

Cai·Or¢ 

Duoor 

Forest bib 

Kent""'' Pirumclc$ 

J,ondetoS3 

S~ou 

s~rm 

Volc-nno 

A\'entge 

Mt'dhln 

CPUC D«bion De-hi Ecauil\' 

I Rc::«1httinn Rstlin 

097.()J.()34 29.21% 

D97.0J.036 39.98% 

0'17..().1..035 36 6~---

09741.033 25 ()(,{J 

T-160003 l5.~{J 

T·IC.OOO I !S.I.m'o 

T-160005 33_76,0 

T-160006 40.53''v 

097.(U-<JJ2 l069% 

T-I~J007 4K.3~'11 

J2 . .J2•v .. 

31.49% 

Cn~t \ VHI -.·oM R~tin n~t \VHicnd 

3 J.t% 1.00% 70 7~· 12.81% 07~~ 

5..10% 2.16% (,0.02% 

1·~ 

o-;,~ 

5.&.1% 

S.G.I% 

G.O-I% 

624% 

636% 

7 IOo/o 

:'.60% 

~.64% 

1.87% 

1.27'~ 

I.Jl% 

I..& I% 

2.Q..I% 

2.53'~ 

1.32'% 

3..&3% 

1.84% 

l. .a% 

63.33% 

75.00 ~ 

75.00% 

75.0004 

c.G.24% 

59A1% 

79.31% 

Sl 62'~ 

67.!'8% 

68S2% 

13.06% 7.8-1% 

12.811% 813% 

11.&.1% s ?n• 11.45% 8.5\)(t/e 

11..15% 59"~ 

12.02,.. 7%% 

12.;6% 7A7% 

10.9-1% 8.68~'. 

12.73'- (t$7% 

12.1S% 6% 

12.19% 8.36% 

Wcda,·g 

(\VACC\ 

1000% 

10.00% 

10.0()% 

10.00% 

10.00% 

1000% 

10.1)0% 

1000% 

10.00% 

1000% 

(),00°'/,~ 

10.00'% 
78 


620PREF68.eps

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18 

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Q. J•tease use the transactional data to demonstrate how your conclusions are 

r e.:1sonablt. 

A. The demonstration is straightforward. Today's capital structure of the Independent 

Small LECs, on average, is approximately the same as in 1997, as the equity ratio falls 

within tJu: Cuuuuis:t.ion·:. vu:viuu:t.ly•th::fiuetl L.UIIt: uftt:~:t.UIUtiJicnt::"~o:O. whidt, ill 1997, 

was described as 000/o to SO%. and when the cost or equity was. on avcra.ge. ncar 12%. 

as presented in Table 7 76 In Table 6, above, I ~ten test<.'<! my finding of 18.5% using 

the following base formula: [old cost of equity x old marke1 equity] • [new cos1 of 

equity x new matkct equity). The calculatjon anempcs to generate an equity retum 

today that is the same as that generated in 1997. again assuming d1at returns are 

relatively matched with capiral invested If I assume that tl1eold return on C<Juiry 

should approximately equal the new rerum. the new cost of equity is derived by an 

algebraic adjuslntcntto divide the (old cos1 of equity x old market equity] by che [new 

marke1 equicy] lo get 1he [new cost of equicy], as i ndicaced in 1'able 6. Again, l used 

12% as the old cost of equi1y and che ocher calculacions are spelled out in that lable.

77 

Taking the top (5.5 timcs) oftoday's EV valuation range (assuming 4.5 to S.S times 

EBI'fOA), 1he result is chattoday's cost of equity should rise to 19.7% to oOsec the 

loss in equity value if lhe equily ralio is 80'/o or 10 21.7% if the equity ratio is 70'/o. 

Similarly, if we assume che market equity value has rail en 10 5.0 times EBITDA (1he 

76 As l prcv•ously norcd. the zone forthe<XJ.uiry rnrio w:u set 3t 60o/(r80% in the Comnlission·s 1997 rntc C3SCS 

and od:~.y·s ~wcrageequ ity ~tio IS 3bour 70% for the Independent SmaiiLECs. 17 lt1s also consistent With the com mental'\ in each ofdtc 1997 Decisions outlined in the table above, \\here 

the Commission explains .. Upon con.sidc,.;tion. C\"aluation. and weighting of3ppl c~tnt"s and ORA's financi31 

ond risk an:tl)'SCS "ith the abo,-c-mcntioncd obscn.ations of mitig:ued and increased risks, "c find th:tt a 

n:::~.sonablccq ily mngc for sm:1H telephone companies. s·uch as applicant. should be 10.100/o to l4 06o/~·· S......:. 

e.g . Si-c11.1. Tcfe.phone. 19'97 Cal PUC LEXIS 12-lS;. •29. p 8 or 1$. The 12% cost or cquu>· •sthc :tpproxtmalc 

midpoint of the IO\\ ~d high \-:tlues. 

Pasc 6Sof 79 
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620PREF69.eps

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Q. 

t\ . 

Q. 

A. 

Pasc 69of 79 

10-1710l-l 

mid-point oftoday's valuation ranges. shaded in the table), then the cost of C<luity has 

risen to 22.6% and 25.9% for 80% and 70% equity ratios, respectively. As I explain. I 

am currently using 5.0 times EBITDA in my conference preselllations to ILEC 

e.xecutives and boards, as that figure is the mid·poinl of valuation for the smaJier [LEC 

imlustJy. w this ~.,;a t.:uhujon ~uggc;)l.S tlutt the w:st oft:yuity has •i~n<:~Uovt: 200/o. 

Once again. I emphasize that this transactional anaJysis is not intended to be the 

principal cost of capital methodology, but the analysis is corroborative of my other 

CAPM and Buildup findings above as it highlights the increased risk in the 

marketplace. 

Pltase summarize your analysis of the transactional data. 

The likely fully-valued cntel])rise value for the IJldependent Small LECs today is 5.0 

times EBITDA. bml have used 5.5times to be conservative. If I accepr tharthe 

Commission effectively stipulated in 1997 that a reaso1lable capital structure was 60% 

to 800/o equity, and I rake the mid-point of700/o (consistent with today's capital 

srructure for the ~•dependent Small LECs). the implied equity cosr today, using the 

srraightforward cale<•lation in Table 6 is 21.7% 

Should we adjust for thr lowl'r i_nlerest ratts today rompttred with those trn or 

fifteen yc:u-s ago'! 

No. The formula provides for the Commission to input debt costs and determine how 

to adjust the WACC. Debt costs should have no efl'ect 011the calcularion of the 

previous or rhe currenr cost of equity (although the pracrical reality is that the cosrs of 
80 


620PREF70.eps

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I S 

16 

17 

18 

19 

20 

21 

equity could !)e expected to rise if the carri ers have diminished access to debt),78 I did 

review those changes in preparing this testimony. and note that the change in AAA 

corporate bond rates, using the monthly average of20-year corporates between 

Januaoy 1997 and December 2000 compared with June 20 I 5, as reponed by the 

fr.x.Jc.m lltt:~t:rv~ l)ank of$1. l .• vuh;. was about 287 basis point).. which would rt:tluct! 

today's WACC by only 86 basis points (change of287 basis points times 3001.> debt 

ratio). But again. this is a separate input and theoretically does not aO'cetthc 

calculation of the equity cost (excluding the elrccts in increased e<1uity risk),79 

Q. \Vh:H are the fundamrntnl pointS of this tmnlysis? 

A , The recent transactional data tell us thal the cost of equity capital is sharply higher 

than it was previously. This is not speculative or theoretical. but demonstrable in the 

transactional markets I also believe thai there is no sign that valuations will rise. as 

risks remain significant and competition is growing. This assessment leads me to 

several imponant conclusions. First. the figures in the shaded section of Table 6 

confirm the direction and demonstrate the reasonableness ofrhe estimates calculated 

using the lbbotson/Momi ngstar and Duff & Phelps statistical infonnation in the earlier 

CAJ>M!Buildup analyses. Second, the M&A·based costs of equity are higher because 

they likely rcOectthe fact that the Duff & Phelps and Ibbotson/Morningstar analyses 

relied on historical valuation data that were too conservative or did not include other 

risk factors. such as the changing I LEC marketplace as well as liquidity and 

marketability fc-.ctors. Finally. the table makes a suong point in defense of higher 

78To be clear. equity investors ''ould ogic~Hy want~ hjghcr return if debe were umwailablc to a c:lrricr. M the 

perceived risk is incrc~-d in oper.uing Lhc business. 

79 J ha\e SUJ)J>hcd the momhl · AAA 20·)'Car eorpol':lte bond inteccst rn.tcs f'rom the Fedcr.sJ Resen'e Dank of 

St. Louis in E,b,bit MJB · t4. 

Pasc 70of 79 
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620PREF71.eps

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9 

10 

equily capilaJ .. structure ratios. as low equity ratios result in increased risk when market 

equity values arc falling. That is. when market values arc falling. the proportion of 

market equity is also falling relative to debt. which means that the company's debt 

costs are likely to rise in the future and its operating risk is likely to increase. Thus. I 

suggc::~t tlu:lltheConuui ~~ u cou!!-illea whethea tlu:: 1\n auea .t:.oucofaea~uuaUicu~~ 

(60%-80"/o) sh0t1ld be shifted higher above 7CY% and likely to 80% to preserve 

forward-looking access to capi1al and to manage operating risk 

Q. l'l ~ase pro••ide data for the capital structure of the Independent Small LECs. 

A. I provide the data in the following table about the COilll)anies' debt and equity capital 

structure and 1he costs of debt. so 

80 While the debe r.uio is llOt included in the table. il C:.i.IJl be reada ~ calculated as the residual, subtrncting the 

common equity and prdcrrcd equity r::ttios from I 00% in the table. 

Pasc 71 of79 
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620PREF72.eps

J"uhlt· 8: Cilpituf ·''tructure und cost tiftlc.bt uml preferred equit)",/(N .\'ma/1/.EGS 

~~1 0 ~)II ~ou O!J Z!!H Common cquit) r.uio 

Cabvcr.t$ 51.43% S.S..&!)•;. 55. 190/o S6.91,..o (.0.07% 

Cai.Ore IOO.OO'A. 100.00% 100.00% IOO.Ot'Wo 100.00% 

Ou<;or (.0.75% 63. 11% 61.85% 56.-18% 54 0J% 

ForesthUI -11.93% 39.(•1% -12.62% -II.Oii,..o .M.S5% 

Kenn:tn 52.35% 52 33% .11.30% 46.18,..o 49.11% 

Pumacb 98.05% 97.5 ~· 97AO% 97A8% 97.65% 

Ponderosa 58.6.1% 6 1.00% 60.98'/o 5858% 62.62% 

Sisk•you 9'J.I8% 99.21)01. 9'J.31% 9"J.3 1,..o 99.3001. 

Siem• 62.33% 63.90% 6B9% 70.5-1,(1 6SA9'/o 

Volc:mo 51.9'"'1 5912% S7.5R% (1()(,2% 62 % 

j\\'C-ntge 67.66°/o 6?. 16% (13.98% 68.n•;. 70.08% 

MsJism S9.70o/(l 62.(16% 61 . .12°/o S9.60o/., 62.80,... 

PrtJelffil tquie~· r.uio 

P1nn.-..c~ 1.95,, 2A2o/o 2.60% 2.52"· 2.35% 

Ponderosa 1.7.&% 1.32% 1.55% I lW., 1.30,. 

Sisk~ u 0.82% 0.71% 0.690/o 0.6\Wo 0.70% 

Vok;mo -IJJ6% 'U6% 3J 7% 1.75'~ :'(.690/. 

AH'r':lgt 2.14°/o 2.13°4 2,H,0/o 2.06o/o 2.01% 

1\1<-'di:an 1.85°/., 2. 12% 2.08°/., 1.90o/ .. 1.83% 

Cos1 or J)rtftn'ed cquhy 

Pinmcks .\10'/o 5.0001. 5.000/o ).oo-/o !iJIO% 

Ponderosa 6.00'/o 6.00'¥. 6.00% 6.00% (,,()i)% 

Sisk~ u 5.75% 5.75% 5. 75% 5,75'b 5.75% 

Vok:l1-,o 7.00% 7.00% 7.0()% 1.~1 .. i.OO% 

A\'CI"".Ii..'t 5..9J o/o ~.?.J% % 5.9.&% ~.9J % 

li:m s.ss•;., 5.88% 5.8811/., S.88o/e 5.SS% 

Cos-1 or Debt 

C4ltn·crJs 4.66% .. .(,7% ... 51% uw. .uo•;. Cal.(),. 

Oucor 5.1~/.1 5.10"/o 5. 10% 5.ltWo ~~ 

Foros~hal S.IO% 5.08% 5.07% 4.82% J.17% 

Kcmtan ·'-20% 4 10% ).75% 36W. 366% 

Pmn..1C~$ 

Ponderos:. -'.53% 4.16% 3..&2% 3.06% 2.93% 

Sisk u 

Sierra 5.60% 5.58% 5.55% S.52% 5.53% 

Vok:mo 5.2o-"A. 520% 5. 20% u w. 520% 

A\ Cr.l~'t S.ll o/o ol.98% 4. 72% ... 59'Y· ol.55% 

Mt"tti:m S.20o/., 5.20% 10% ~20o/e 5.20% 

Pasc 72 of 79 
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Q. \Vhat is the conclusion from your analyses surrounding the required rate of 

return for Independent Small LECs? 

A. I recommend that the Commission take a realistic view of the expected returns on the 

equity component in detennining rates of return The Commission previously 

autho1i.tc:t.l a hug.:.t \VACC of JOO/o, implying hit aypto.xiwatc: 12% ~,;ost ofc:yuity, ami 

assumed an equity ratio in a zone between 6()0/o and 800Jo.81 As a result of this study, 

my best estimate is that equity costs arc today in a range between 17.5% and 23.0'/o, 

and an more convincing and narrower range is toward the high end. as supponcd by 

the M&A data outlined above. I recognize that a cost of equity averaging 18.5% is 

higher than this Commission has previously adopted, but circumstances have changed. 

and I am confident that this is reasonable as a forward-looking measurement of cost of 

equity. I have been conservative in multiple calculations. which likely compound t.o 

make the estimate far too low. I note that the average of the four analyses provided in 

Table 3 is l8.90A. and withoUI the Risk Premium calculation. the average is 18.1%. As 

a financial analyst. I believe that the dala verify that the estimates I have produced are 

likely understated or at the bottom of a reasonable range. 

I summarize the reasons I believe this conclusion is conservative. No liquidity or 

marketability premium is included. 11le size p1·cmium is 641 basis points lower 1han 

the t l.98% recommended by Dutf & [>helps for the smallest of companies 

(appropriate for a IOz grouping into which these companies clearly fall). The beta 

used in the computation is relatively low at 1.06. as it is drawn from proxies that are 

all substantially larger, more li<1uid, more capable of acquisitions. and more 

8t Sec. e.g .• 0.97.()4.032. p. 5. 

Pasc 73 of79 
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diversified The risk-free rate employed is the lower of the two options (a higher 

result is generated when using total retum on the Treasury). And, the strongest 

evidence of reasonableness. in my judgment. is dte M&A data where I have again 

been conservative. as my experience leads me to the judgment that the multiple on 

EBITDA fu1 Lh~st:~umyau t:s is likely ~lost:.l tu S.O Limes, wllid1 sugg~t~ a hig.l•c• 

cost of equhy than the one I have used. The transactional data indicate that the acaua.l 

cost of equity is between 19.7% and 25.9%, which is well above I 8.5% that I 

recommend to the Commission here. I assume that 1he Commission recognizes that 

risks in chis industry are well higher than they were in 1997. 

Oo you recommend a single target weighted a\•erage cost of capital for the 

Independent Small LECs? 

I leave that decision to the Commission. My testimony is focused on analyzing the 

costs of capital, with a greater focus on the question related 10 the cos1 of equity. I can 

recommend 18.5% as a conseJVative estimate that can be used in a hypmhetical 

structure or it can be used in assessing a specific company's costs of capitaL T11e 

firlancial heahh of each of these companies is imponam to its customers. and the 

Commission should continue co assess how the companies are able to cope with 

important risks many of which are otnside their control. In Table 9, I have presented 

theW ACC calculations for each of the Independent Small LECs based on the twoyear average of their actual capital structure and the two-year average of their coSIS of 

debt. The capital structures of the companies vary significantly, and I believe they 

may become more conservative in the future as the cornpa11ies cope with competition. 

regulatory pressures, and limired access to capital. 
85 


620PREF75.eps

l"uhlt· 9: WACC(or euclt o[the lnd IJ<'J'd llt Sttw/1 J.EC.s 

A\·tnf:S 201312014 

Pn-rtm-d C(Jmmon t or Colit or 

c:qu t~· c:c,ully CoseC)( pref ~d t:onunon 

Debt n~Ho r..ttio rlltio debt £9Ult\ ('QUit\ WACC 

C®n·cms 41.5'). 585% 4.S% 18.5% 12.7% 

C•l.OfC 0.0% 100 " 18 5% 18.S% 

Ducor 4~ 7"4 )5.3% 5 ,,..0 185% 12.5% 

Foresthill 56.2% -l So/~:~ l.~fl 185% lOll% 

Kcnna.n 52.4% -11.6% 3.7V .. Ut5% 10.7% 

Puu~les (1.0% 2A'O 97.6% S.IWo 185% 18.2% 

Pondcros:' J8. 1% 1 .3% 00.6% ~t. 60% 18 5% 12.<1% 

Siskb·ou 0.0% 0.,0 9').3% 5.8% 18. 5% 18...1% 

Sicrm 30.5% 69.5% S.S% 18.5% 14.5% 

VoktHlO ';.,15% 17,... 61~ 5?% 59% IRS% IJ4% 

A\'CntR<' 29.8°/.- 2.0% 69.4% 4.5'% S.7% 18.5°.4 1·1.2'% 

MtdiJ~n 36.3% 1.9% 61.2% .t.so; .. S..R% lk ·A. IJ.J•/ .. 

Q. \Vhal art tht I)Otential issues that arise in applyi11g the accual debl costs to 

SJ>ecific capital structures or the compnnie.~? 

A. My observa1ion in reviewing Table 9 is Jha11here are widely divergem WACCs in 

6 Califomia, Jhe resuiJ dep<!nding on wheJher 1he ILEC has 100"/o equity, or. for 

e.\:ample in the case of foresthill, where there is an equity ratio of 43.8%. I believe 

that providing Foresthill with return on capital set at 10.8% could make it diflicult to 

9 bui ld equi1y during a challenging time for ILECs, and it is possible that customers may 

10 be negaJively impac1ed The evaluation of the public policy import belongs to the 

II Commission. which I believe could make the determination that a \V ACC other than 

12 the actual WACC, lor e.'"mple for Foresthill, does not harm cuslomers as they are 

13 paying the same capital costs as those incurred by customers of other lLECs and such 

14 a WACC may help the cuslomer because clte carrier will be able to build a slronger 

15 financiaJ foundation to serve customers in the future. For companies that fAll 

16 signific:amly outside the Co.n.nissio11 's previ04.1sly defined "zone of reasonableness:· a 

17 hypothe-tical structure would be appropri ate. 

Pasc 75of79 

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Q. \Vh:tl do you recommend if the Comm ission were choose to use :1 hypothetical 

('.AJ)ital struC'Iurt and estJablish a h' rget \VACC? 

A. I would propose that the Commission employ a hypothetical capital structure with 

approximately 70% to 80% equity I use 70% in my calet•lations below. This opinion 

relics on the Commission ·s previous adoption or a zone or reasonableness of 00''/o6 80%. h also renects my conclusion that the market value of equiry has fallen and that 

rhe companies will increasingly ha\re w rely on book equity ratios that arc relatively 

higl1er in the future than in the past In calculating a target WACC, I also assume that 

9 the cost of debt will rise, both because we are going to emerge from the artificially· 

10 low interest rates in today's markets and because I believe the tisk for telephone 

II companies will grow greater in 1he future If the Commission were co posi1 a cos1 of 

12 debt Figure as part of a hypothetical capital structure calculation, I recommend that the 

13 Commission use a hypothetical debt rate of 5.5% for companies without any actual 

14 debt rates. This is above the current median of 5.2% of the Independent Small LECs. 

IS However, it is approximately 1he in1erest rate that Sierra Telepho1te curremly pays 

16 (5.53%), and apprm:imates a rate that might be expected in the future lbr any of these 

17 carriers. although it is vety possible the rates will rise highe-r. Again. this exercise is 

18 purely to arri ve at a target WACC. Using the figures above and the recommended 

19 18.5% cost ofe<1ui1y, a realistic target WACC is 14.6% 

20 FigureS: Calculmion ft~ target WACC 

CapitAl Cost or ..-\ll u~d 

structure Caeital cos-t 

D<:bt 30% 5.50% 1.65% 

tv 70% 18.50% 12.95% 

21 Total 14.60% 

22 

Pasc 76of 79 
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While the target WACC is higher than the current 10.0"/o, it is consistent with my 

transactional analysis. That is. the market collapse in lLEC enterprise value from 8.0 

times trailing EBITDA to 5.5 times trailing EBITDA converts the fomter 10"/o target 

WACC to 14.5% and if the change is assumed to be from 8.0 to 5.0 times trailing 

EBITDA. Ute result is a target w ACC or 16.0% The calculation is IO%•( 1/(5 5/8.0)) 

6 = 14.5%. or IO"!o•(l/{5.0/8.0)) = 16.0"/o. 

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Oo you hnve any c:onduding eonuneuts? 

Yes. The U.S. Supreme Court has been clear about a utility's rig)lts to rates ~tat 

pemtit a risk-adjusted. market-based return on invested capital. Just as important. the 

entire rationale for maintaining support and setting appropriate rates of return is 

focused on C11suring that services are viable today and in the future for customers who 

live in high-cost regions, consistent with the federal policy aniculated in Secrion 254 

of rhe Telecommunications Act of 1996. If the California goal for near·ubiquitous 

telecommunications services. including broadband, is tO be realized across hig)lcr-cost 

regions. then sound financial mechanisms will be required The loss of sound financial 

mechanisms. including the loss of appropriate rctums on equity. will likely assure that 

universal service policies will fail, II is my belief that, if the carriers do not see a way 

to provide service in a manner that produces appropriate returns on invested capital. 

1he end resuh will likely be reduced service quality, limited service availability, 

impaired service reliability, and, in some cases. a withdrawal from service altogether. 
88 


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This would be harmful or possibly devastating to ratepayers in these regions and likely 

represent a policy failure for all users of the telephone network 

Q. Does th is ('Onc::lude your ttSiilllOrl)'? 

A. Yes. 

Pasc 78of 79 

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89 

APPENDIX 3—CALIFORNIA REBUTTAL TESTIMONY OF MICHAEL J. BALHOFF, CFA 


620REBUT1.eps

BEfORE THE I'UBLIC UT il-ITIES COMM ISSION 

OF THl: STATE OF CAU FORNIA 

Application of 

Calaveras Telephone Company (U 1004 C) 

Cal-Ore Telephone Co. (U 1006 C) 

Ducor Telephone Company (U 1007 C) 

Foresthill Telephone Company (U 1009 C) 

Kemmn Telephone Co. (U 1012 C) Pinnacles Telephone Co. (U 1013 C) 

The Ponderosa Telephone Co. (U 10 14 C) 

Sierra Telephone Company_ Inc. (U 1016 C) 

The Siskiyou Telephone Company U 10 17 C) 

Volcano Telephone Company (U 1019 C) 

for a Determination of Applicants' Cost of 

Ca ita! for Ratemakinf( Pu oses 

A 15-09-005 (Filed September I , 2015) 

REBUTTAL TESTIMONY OF MICHAEL J, BALHOFF ON BEFIALF OF 

CAL AVERAS TELEPHONE COM PANY (U 1004 C) 

CAL-ORE TELEPHONE CO. (U 1006 C) 

DUCOR TELEPHONE COMPANY (U 1007 C) 

FORESTHILL TELEPHONE COMPANY (U 1009 C) 

KERMAN TELEPHONE CO. (U 101 2 C) 

PINNACLES TELEPHONE CO. (U 1013 C) 

TllE PONDEROSA TELEPllONE CO. (U 1014 C) 

SIERRA TELEPUONE CO AN , U'IC. (U 1016 C) 

THE SISKIYOU TELEPHONE C0 !\11'ANY U 1017 C) 

VOLCANO TELEPHONE COi\'II'ANY (U 1019 C) 

("INDEPENDENT SMAL L LECS") 

March I I, 2016 
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RERUrri\L TESTIMONY OF MICHAEL .1. Ri\LtiOFF 

2 I. INTRODUCTION i\Nl> PURPOSE 

Q I. \Vould you plt.ase state your name and position for the record. 

A. My name is Michael J. BalhofT. 

Q2. i\re you I he same Michatl J. BalhoiT who l>rovidw prefiled 

6 opening testimony on September I, 20 15 in th is proceeding? 

7 A. Yes. I provided prefiled 1estimony ("Opening Tes1imony") on 

behalf oflhe i\pplicanls (lhe " lndcpendcm Small LECs").t 

9 n. SllMMi\RY OF REBIJTii\L TESTIMONY 

10 Q3. \Vhat is the purpose of your rebutt:1l trscimony in this 

I I proceeding? 

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A. This rebuuat testimony addresses misconceptions. errors.. and 

policy concerns raised by the testimony of the Office of Ratepayer 

Advocates (''ORA") of the California Public U1ili1ics Commission 

("Commission" or "CPUC") submiued in1his proceeding on 

Februal)' 12,2016.2 

I Opening Tcs1imony of Michael J. Balhotr on Behalf of Applicanls, lndcpendcm 

Small LECs' Application for a Oe1em>ina1ion of Applican1s' Cost ofCapilal for 

Raremaking Purposes in Proceeding No. A. 15-09-005 ("BalhofTOpening 

Teslimony"). 

2 llte Office of Ra1cpayer Advoca1es, Rcpon and Recommendations on the Cos1 

of Capital for Independent Small Local E.xchange Carriers. filed on Fcbn•al)' 12. 

2016 ("ORi\ Testimony"). I note thai ORA"s lestimony is organized as a 
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Q4. Please summarize your rebuttal testimony. 

A. I organize rny response into four sections. 

Response to ~A Testimony about cost of equity. My 

testimony explains that ORA did not provide any 

meaningful substantive response to my testimony. Ralher, 

ORA provided its opinions about inputs for estimating 

equity costs and offered no authority or source infonnation 

for those estimates except for a 2013 repon prepared by the 

FCC Wireline Competition Bureau Staff (the "FCC Staff 

Reportl'') that has never been adopted or endorsed by the 

FCC. and which is now nearly three years old. I will show 

that ORA's reliance on the FCC Staff Report to reject the 

usc of a premium for small companies and the FCC Staff 

Repon's reliance on one citation to a survey anicle (and no 

other citation) t.o justify eliminating such a premium results 

in an exclusion that is demonstrably wrong for multiple 

reasons. In panicular, the survey article itself reports the 

finding that there is a size effect among the smallest 

·'Repon;• but ORA otTers three separate witnesses. each of whom sponsors 

discrete pans. For ease of reference. I will refer to the "Report'' as ORA's 

•·testimony." 

J Federal Communications Commission. Prescribing the Amhorized Ume of 

Return. Analysis ofMethodsji.>r l~tablishing JuM and lleasou<tble !IJllesji.>r IA>Clli 

F:xchange Carriers, DA 13-1 111, released May 16, 2013 available at 

tt J/~A'\VW fcc gov/documentlbureau·releases-rate·rerum-represcription-stafl".. 

WlQn (" FCC Stafl' Repon"). 

1062160.1 
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dcciles_ "hieh indude the lndq><ndent Small lECs at the 

boltom of the 1enth decile The Stafl"s sole source 

therefore arri\'CS a1 a conclusion entirely opposite what is 

proposed in rhe FCC SratT Repon, and thai source ac1ually 

~CIVC.S IU.)UJ.IJIUIIIIIJI lt:.\limauy I.Jyju.'llijyin); dn: iii\; U~ on 

of a premium for size c1Tec1 in ~te cost of equity 

calcularion In my Opening Tesrimony. I provided analyses 

based on all the majOt valuarion resources. including data 

drawn from mulliple periods and using mulliple 

approoches Finally. I eorroborared my findings in my 

Opening Testimony using m<rger and acquisition data, 

which was nol prcscmed as rhe basis for my findings. but 

was presented as an addiaionnl verification of those 

findings. ORA oiTcrs no analysis to respond 10 or aucmpl 

to contradict the principal conclusions in my Opening 

Tesrimony ORA's summary dismissal of my restimony 

relies on sources rhat can be impeached easily and 

etTeeti\ely 

Respoun to ORA Tesrimony oboul debt. My restimony 

explains rhal I recommended the use of actual. embedded 

com for canicrs thai have reponed dcb1 on rheir balance 

sheers. and I rceontntend 1ha1 the rares for that acrual debl 

should be supplied in the carriers' rate cases. I do not 
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recommend imputation of debt or the development of a 

"forccasl'' for debt. liowevcr. in the event that the 

Commission chooses to impute debt costs. I proposed a 

reasonable cost of debt of 5.5%, a rate lowerthan the AAA 

,;;.ust ufll~lJl a.ml igl Jy Uduw lite a.tei.J~iu~ pa.jtJlJy Sie11a. 

Telephone, one of the Independent Small LECs.

4 ORA 

proposes to use a lower figure (4.53%). computed as the 

average of the seven Independent Small LECs that report 

having debt, but in arguing that the carriers have access to 

ine.xpensive debt in a mnge of2.47%-2.82%, ORA does not 

explain why all the carriers have higher debt costS than 

these figures. and five of rhe seven have costs well higher 

than the government-subsidized rates that ORA clail'ns a1·e 

available 10 the carriers. I testify that rates are rising from 

the artificially-depressed levels referenced by ORA and the 

Federal Reserve is currently in the process of casing the 

controls that are depressing those rates. I also explain that 

the largest lender to rural carriers. CoBank with $95 billion 

in assets, has publicly commented on the increased 

regulatory risks that are dampening the credit markets for 

small Incumbent Local Exchange Carriers ("ILECs"), 

meaning that debt is less available for the small carriers. 

4 BalhoffOpening Testimony, p. IO, Iines 7-9; Exhibit MJB-14. 

4 1062160.1 
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CoBank also warns that the all""ed rate of return should 

not be redueed. beeause such an action-ORA's precise 

recommendation in this proceeding- will create even 

greater lhnitations on credit, and poremially render the 

im.lu!!.IIY ta:s "uut lJu "'~lJ t;" 

Response to ORA Testimony about CBJ)ital structure. 

ORA asks the Commission to rely on the companies' actual 

capital structures or to possibly reduce the hypothetical 

equity ratio. but my testimony shows that this approach 

would overlook curront and reasonably foreseeable trends 

tO\>oard more conservath e. equity-based balance sheets 

Carriers are mi~rating to a greater reliance on equily 

because of higher risks attendant to their businesses. Three 

of the Independent Small LECs have virtually 100% equity 

ratios and tive of the remaining seven companies have 

improved their equity ratios by an average of 689 basis 

points from 2010 to 2014 The conservatism related to the 

companies' capital man~ont practices suggesiS 

inereasin¥ caution as induStry risks rise. Since 1997. the 

Comn~ission has relied on o hypothetical capital structure, 

which appears to be a reasonable approach today and, if 

adopted, should rcnect the growing and justifiable 
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1062160.1 

consetvatism in an increasingly risky industry, as I 

e.xplained in my Opening Testimony. 

Commentary •·egarding the FCC Staff Report as the 

f CC considers rrprescribing the authorized rate of 

retu•·n. ln calculating the cost of equity. OR.A relies 

almost exclusively Oil the FCC Staff Report. which is a 

discussion document about potential changes to the allowed 

rate of return, including allowed equity cost, for rural 

carrie-rs. The FCC may issue an Order regarding 

reprcscription. possibly as early as the first half of 2016, 

but the FCC Stan· Repon is an opinion paper from FCC 

Staff, and is not detem1inative at this time. Even ifrhe 

FCC were to rely on the assumptions and data in thar FCC 

Staff Report, this Commission should itself carefully and 

deliberately consider the iss.•es surrounding cost of capital. 

which will have profound effects on the long-term welfare 

of rural California customers. I have demonstrated that the 

data I have supplied in my Opening Testimony are 

accurate, fair and financially justified. It is my strong 

corwic.tion that the FCC Staff's COilCiusions arc 

demonstrably false. and I stand ready to defend that 

professional opinion even if the FCC were to accept some 

or all of the recommendations of its Staff. Specifica.lly, e 

6 
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FCC StafTused a guideline or so-called proxy group with 

characteristics significantly different from those of the 

small rate-of-return ILECs. predetemtining that its analysis 

is unreliable in setting a cost of capltal in this proceeding. 

FUitlt~t . the fCC SutO~uset.l a abk·fu:e tate tlnll was 

distressed and well lower than any suggested by tho major 

professional valuation services. The FCC Stan· also 

rejected the incorporation of key size and marketability 

premia. based on an argumem that we will show leads to a 

very different conclusion. The ORA Testimony that is 

reliant upon the FCC Staff Repon leads to an incorrect 

estimation model. 

14 Ill. RESPONSE 1'0 ORA TESTIMONY A BOUT RETURN ON 

IS EQUITY 

16 QS. ORA expresses concern that your calculation of the cost of 

17 

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1062160.1 

A. 

equity is higher by 50% over the implied cost or equity in the 

1997 rate t .. 1se decisions for the lndtJ>endent SmAll LECs. now 

do you respo nd? 

As I noted in my Opening Testimony. I understand that my 

recommendation is significantly higher than the implied cost of 
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equity range referenced in the 1997 decisions.s However. capitaJ 

markets and ILEC industry dynamics have evolved significantly 

since the late 1990s. as regulawy. political. and competitive 

developments have sharply increased the risk profiles of these 

skepticism regarding my proposal. as the proof of its 

reasonableness lies in its details. 1 was careful in my testimony to 

provide the highest-quality soorces for data and applications of 

premia. rclyh>g on the most respected resources provided by 

Ibbotson/Morningstar and Duff & Phelps. I used not one or two. 

but multiple analytical estimation tools to test and re-test the data, 

including assessments of data across various hisrorical periods to 

appropriately smooth any anomalous rcsults.6 I rejected any 

estimations that might have been intcrprercd as as.gressive. 

Specifically. I was conservative by: (i) applying no incremental 

liquidity or martetability premium; (ii) using a size premium that 

is 64 1 basis points lower than the 11.98% recommended by Dun· & 

Phelps for the smallest of companies (appropriate for a 1 Oz 

grouping into which the Independent Small ILECs cleany fall): 

(iii) relying on an industry beta rhat is relatively low at I .06. as it is 

drawn from proxies that are all S\lbstantially larger. more liquid. 

5 BalhotTOpening Testimony. p. 9. 1ines 10-13. 

6 BalhotT Opening Testimony. p. 53. Table 3. 

8 1062160.1 
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more capable of acquisitions, and more diversified: and (iv) using 

2 a risk-free nue that is the lower of the two options for each of the 

periods studied (a higher resuh is generated when using IOtal retum 

on the Treasury).

7 Finally, I tested the results on the basis of 

M&.A tlaHt wln:re l have again IJe;xn const=rvalivc;, My c;xpc:ric;nce 

6 leads me to the judgment that the appropriate valuation multiple 

based on enterprise value to earnings before interest. taxes, 

8 deprecialion and amortization ("EBITOA") for these companies is 

9 likely closer to 5.0 times. which suggests a higher cost of equity 

10 than the one I used. 8 

II Q6. Oid ORA provide any sources that direcrly addressed the dara 

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and the premia )'OIIJ)rovided in your testimony? 

A ORA provides virtually no sourcing for the estimates or the 

opini011S it offers il1 its testimony. ORA's single source for its 

Capital Asset Pricing Model ("CAPM") equity risk premium is the 

FCC Staff Repon. I will address in detail the deficiencies in the 

FCC Staff Report in a later section of this testimony. ORA also 

reported that it " looked at data collected by Professor Aswath 

Oamordan [sic)," but the detailed company-specific performance 

7 Balhoff Opening Testimony, p. 73, lines 17 ff. 

s Balhoff Opening Testimony. p. 74. lines 6-S: "The transactional data indicate 

that the actual cost of equity is between 19.70/o and 25.9%, which is well above 

18.5% that I recommended." 

9 1062160.1 
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data are not available for my review. 9 f inally. ORA provides 

2 footnote 5 I, which references four reports as the foundation for its 

generalized claim that authorized .rates of rctum for other regulated 

utilities-electric. naturnl gas. and water- have declined. 10 As I 

will dis~:uss, tlu:se utility ~C.:tOI'S a1~ fundamentally di0f:Jt:-nt fron1 

6 the industry of the small, ru.raltelephone companies. 

Q7. Did OR.J\ provide any substantive data in response to your 

8 calt ulations? 

9 A. ORA provided no substantive sources. exceptiO reference the FCC 

10 StaiT Report. to which I respond in detail below. ORA gn~tuitous y 

II supplies its views and opinions, but does not address the clear and 

12 convincing data compiled from authoritative sources that are 

13 presented in my Opening Testimony. 

14 Q8. Does ORA disngree with your genernl Approach to the CAPM? 

15 A. No. ORA relies on a CAPM. which is fundamentally the same as 

16 

17 

IS 

19 

the Build-up Method used in my testimony. but ORA suggests its 

own inputs that are ditTerent from those drawn from the various 

Ibbotson and Duff & Phelps data. II Most surprising, ORA reduces 

the CAJ'M to two inputs. which are the forecasted risk-free rate 

9 ORA Testimony, p. 43, 1ines 12-13. 

10 ORA Testimony, p. 44. 

II ORA Testimony. p. 36, lines 11-21. 

10 1062160.1 
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620REBUT12.eps

and the equity risk premium.tZ There are no other variables. 

2 meaning that ORA recommen ~ that the Independent Small LECs 

have equity costs that are no different from the equity costs in 1he 

general market. This remarkable proposi1ion has never been 

~n vr~d by the lin(lncial wmmuni1y and ha~ never bet:n ~ppvucd 

6 by a regula<ory body, to the beSl of my knowledge. As the data 

show, ORA's anemptto equate the equity cost of these companies 

8 wilh the general equity market can1t0 t be correct. 

9 Q9. What risk-free•·ate does ORA utilize? 

I 0 A. ORA notes that the ten-year reast~ry rate has fallen from 6.68% in 

II 1997to 3.07% in 2014, Then, ORA proposes 10 use the most 

12 recent reponed three-year average rate of2.91%. ORA provides no 

13 citation or authority for its recommended approach, nor does it 

14 comment on today's extraordinarily anomalous rate-environment. 

I 5 Q I 0. Is the use of 2.91°1. nppropriate? 

16 A. No. As I c,,plained in my Opening Testimony, the risk-lree rate 

17 

18 

19 

and the equity premium should be matched in 1em1s of the time 

periods from which they are drawn. as is clear in the valuation data 

provided by Ibbotson or Dun· & Phelps. t3 ORA's estimated equity 

12 ORA Testimony, p. 36, lines I 5-18. 

ll Balhoff Opening Testimony, p. 51 , lines 4-12; the market expects a total return 

I I 1062160.1 
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620REBUT13.eps

premium is apparently based on data from 1928 to 2012, a 76-year 

2 pcriod,14 yet its Treasury rate is drawn from a three ~ year average. 

The resuh is a mismaach thaa is problematic. Even more 

troublesome, however. is the fact that ORA's proposed Treasury 

letlt; is nut a sound Utna point, as it is drawn Crom a pc:1·iv<J in whil;h 

6 the rate is at historically low levels and, according to most or all 

financial experts, is artificially depressed. IS Using a rate that is at 

8 e."remely low levels, and demonstrably constrained by the Federal 

9 Reserve's interventions, docs not provide a good indication of rates 

I 0 that might be projected over extended future periods. h woo.old be 

I I just as wrong as if one were muse the 1981 Treasury Bond rate of 

12 13.72"/o or the five-year Treasury Bond average of 12.09% for 

13 1980 to 1984. Using a shon period with extreme data is not 

14 appropriate as such an approach leads to intellectually dishonest 

15 and unreliable results. ORA's use of these anificially low staning 

16 "risk free'' rates appears to be opportunistic and is, in my strong 

17 opinion. not based on reasoned judgment and informative data. 

18 Qll. How did you determine the appropriate risk·free rate? 

so equity premia must be matched to the risk-free rate. 

14 ORA Testimony, p. 39, lines 9·11; see also FCC StaiTRepon, p. 27, para. 72. 

ts BalholTOpening Testimony, p. 19,1ines I IT.; 2015 Duff & Phelps Valuation 

Handbook: Guide to Cost of Capital, Market Results through 2014, (Hoboken. 

NJ: John Wiley & Sons. Inc., 2015) ("DutT& Phelps, 2015 Cost of Capital"). 

12 1062160.1 
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17 

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19 

20 

A. I matched the tenn of the risk·free rate from several periods with 

1he equity markc1 premium drawn from 1hose same periods. I used 

e."ended periods 10 es1ima1e an appropria1e risk-free ra1e. •hereby 

smoothing data that would otherwise be too high or too low in 

iuiou~ petiot.Js. T1tis is the shmtlanl pHtCii\.ie in \'illualiuus. lcdso 

used mulliplc periods 10 lest 1he findings. The ex1ended lime 

periods used in my lestimony were 1926-2014, 1963-2014 and 

1995-2014, and I provided the source dala from 

Ibbotson/Morningstar and from l)utT & f>helps. so rhe Commission 

can assess SO*ca11ed ... risk·free" rates in different, protracted 

periods. 16 As I have explained, the valuation.-discipline requires 

evaluating data that elimi 1\Cite the distonive effects of extreme data 

poin1s. such as 1he depressed interest ra1es reponed a11he present 

1ime. I have sO<orced the commemary abou11he Federal Open 

Market Committee's comments on the artificiality oftoday's 

Treasury rates.11 h is my professional opinion that ORAfs 

approach cannot be viewed as reasonable. which may explain why 

ORA provides no authorities to affimt its recommendation. My 

1estimony provides 1he Contmission with data. sourus. and 

ahemative rime periods to justify. test. and confirm the results. 

16 BalhotT Opening Testimony, p. 52, lines 5· 1; p. 54, lines 9-10. S1riclly 

speaking, llrere is no "risk-free" ra1e, bu11he U.S. Treasury is generally regarded 

as close 10 "risk-free .. 

17 BalhotTOpening Testimony. p. 19,1ines 6-22. 

13 t062160.1 
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ORA has not responded to my supporting authorities nor has it 

provided any contrary authority, and ORA volunteers a depressed 

rate from a period different from che period used to calculate the 

equity premium. These errors are fundamental ro ORA's approach 

and p10fuundly weOdkeu it~ estimation of the lm ..h: jJt:lld t:- l Small 

LECs' cost of equity. 

Q12. What equity risk prtmium dots ORA propose? 

A. ORA cites to the FCC Staff Report and suggests using the Stafrs 

figure of 5.88%. which it states is a figure comparable to the one 

the CPUC used in 1997; the 5.88% rate is based on the period 1928 

to 2012.18 ORA reports that recent estimates range from 4.51% to 

6.21%, but ORA defaults to the FCC Staff Report proposal of 

5.88%.19 My Opening Testimony provides equity premia that 

were 5.1%. 6.6% and 4.9"1., forthe periods 192()-2014. 1963-2014 

and 1995·2014, respectively, and a.hernative data using tolal 

Treasury returns {yield plus capital appreciation) of 5.7%, 7.4% 

and 8.6%, respectively. which, to be conservative. were not the 

basis of my recommendations. 20 Again, ORA does not consider 

t8 ORA Testimony, p. 39, lines 1>-13; p. 43, 1ines 3-4. 

t9 ORA Testimony, p. 43. lines 4-6. 

20 BalhoiT Opening Testimony. p. 52, lines 5-7; p. 54, lines 9·10. The alternative 

rates were based on total Treasury returns (yield plus capital appreciation), but, 

because they generated higher e<1uity costs of capital. were not used; this is 

ano1her example of the conservative nature of my analysis in 1he Opening 

14 1062160.1 
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620REBUT16.eps

2 

6 

evidence drawn from different time periods and ORA docs not 

respond to the data compiled in my testimony, declining to explain 

why my fi ndings should be rejected or adjusted. In response, I 

once again affinn tJmt the data I used were drawn from the most 

adinbh:: :suual:es nm.J they •. uovill.: tl1e Couuubsion with i:d lt:.lnative 

and confinmatory data. ORA does not provide a rationale for its 

figure. except that it relies on the FCC Staff Repon .. whicl.1 will be 

addressed in a later section of my testimony. 

9 QIJ. l:.lave you reviewed ORA's Aunc:hroent 9. which J)rtsents a 

10 

II 

12 

13 

14 

IS 

A. 

6.43% averaged return on equity? 

Yes. It appears that ORA is attempting to argue that its use of the 

FCC market pre1nium of 5.88% is reasonable by calculating acwal 

retums on equity (''ROE") over the twelve-month period ended in 

June 2015 for twelve telecommunications companies listed in 

Attachment 9. 

16 Q14. Oo tht data confirm the 5.88% return on equity that ORA is 

17 advancing? 

I 8 A. No. The Auachmem is not instructive in any way Founeen 

19 

20 

21 

22 

Testimony. 

1062160.1 

companies are included in rhe Attachmenl., bur only twelve are 

accompanied by a calculated ROE. The data are flawed upon even 

a cursory examination. Aheva is primarily a software company. 

with vinually no ILEC cash flow, and the ROE that ORA reponed 

15 
105 


620REBUT17.eps

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13 

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IS 

16 

was a negative 11.4%. On April 26, 2015, Windstream spunof'rits 

assets into a real estate investment trust which began to trade that 

day as CSA L, so the negative 34.2% ROE resulted from no 

adjustment being made for ~te spin-off. Verizon has a book equity 

that ~t:Ot!ll:t~ tht: ~uwpauy's tuauy a~u :;i tiuns, whil:h .JisW1ts the 

ROE in the Auachment. Frontier has been in the process of 

acquiring large-LLEC assets, includi ng Verizon's California. Texas 

and Florida operations. with the result that integration·related 

expenses skew the ROE. Similarly, Consolidated Communications 

was recently in ~te process (closed October 16, 2014) of acquiring 

and integrating Enventis (the fonner HickoryTech). meaning that 

its results in 2015/2014 included acquisirion expenses. In shon. 

the table provides data that are not inStruclive. and 1hey cenainly 

do no1 suppon ORA's argumen11ha1 " [a]crual earned re1urn on 

equily atlhis level suggests thai ORA's eSiimale for relum on 

equi1y in this proceeding is more reasonable than Mr. Balhoff's."ll 

17 Q 15. Have you re,•iewed I he dala lhnl ORA reporled I hal il had 

18 "looked at" regarding Professor Damoda1·an's calculation of 

19 

20 

21 

22 

A. 

ROE? 

I did not have access to the underlying company .. specific 

perfonnance data because 1he company·specific performance data 

are no1 available in Professor Damodaran's online spreadsheets, 

21 ORA Testimony. p. 42. 1ines 10-12. 

16 1062160.1 
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and I understand that this data was not produced by ORA in 

response to the Independent Small LECs' request for the 

underlying data collected by Professor Damodaran that ORA 

reviewed in connection with its Opening Testimony. I note that 

ORA tt:poth::d that Ptofc::.~ut A:i\\'tdh Dau1uthuan t.:al~.;u ah::tll ntl 

Telecommunications Services companies generated an ROE of 

8.31% in 2014.22 A review of the Professor's spreadsheet reveals 

that he lists global securities, which, when soned. yields 65 stocks 

in the U.S. telecommunications services sector, only 16 of which 

have ILEC businesses. The stocks that are included are so 

disparate-including equipment. long-haul fiber, cable operators, 

standalone Voice over lnrerner Protocol ("Voll'") companies and 

large conglomerates- that the calc.•lated ROE proves meaningless 

in the ORA testimony.ll Without conceding that ORA's citation 

10 Damodaran is instructive or proper, t note that the spread 

berween the Treasury rare proposed by ORA (2.9"/o) and rhe 

generalized reponed Damodaran Telecom Services ROE is abo<11 

540 basis points ('bps"). Even this cmdc merric shows rhc 

reasonableness of my testimony, which repons equity marl<et 

premia of 700 bps, 505 bps, and 684 bps, for the 1hree periods 

22 ORA Testimony, p. 43, lines 13-14. 

23 his necessary to son Professor Oamodaran's spreadsheet to exrract U.S. 

telecom services companies. See 

hrtp://www.srem.nyu.edu/- adamodar/pc/darasetslindname.xls. 

17 1062160.1 
107 


620REBUT19.eps

1926-2014, 1963-2014 and 1995-2014, respectively, and an llEC 

2 beta of 1.06. which is only slightly riskier than the overall market. 

Another saliem problem with the ORA analysis- again noting that 

it is not possible to review the underlying Damodaran company· 

Spt:\:ifi~,; J.'t:"lfouuam.:t: d~La lo assess polt:-Htial uttLlit:-Js- i s Ll1al ORA 

6 is relying on one single year to "sample" telecommunications 

services companies' equity returns. As such. the approach 

employed by ORA is so imprecise that it offers no meaningful 

9 insiglu in this proceeding. Again. to reach accurate results, it is 

10 necessary to use a longer period of years in assessing a comparable 

l l industry group, consistent with the approach employed in my 

12 testimony. 

13 Ql6. \Vhat is your view regarding ORA's proposnlnot to use an 

14 i••duslry-sptcifit adjustment? 

IS 

16 

17 

IS 

19 

20 

21 

22 

A. ORA is fundamentally arguing that the CAPM should be reduced 

to a "proposed·· risk-free rate and a generic market equity return. 

ORA proposes to use a very depressed Treasury rate and simply 

add a low equity risk premium of s.SS%. again employing only 

two inputs to estimate its so-called ''reasonable cost of equity."N 

ORA reveals its fundamema11y flawed .. logic" when it explains 

that " [h]olding all 0~1er variables fixed, one would e.'pectthe cost 

of equity estimates to be lower when a lower risk·free rate is 

242·1 ORA Testimony. p. 3, line 8; p. 38. lines 9-10; 

IS 1062160.1 
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620REBUT20.eps

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10 

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13 

14 

employed in the financial models used to calculate costs of 

capitai."2S According to ORA's proposal, only the change in the 

risk-free rate matters, as it is "holding all other variables fixed," 

meaning that the marke1 return remains essentially the same over 

tlu; prvuactc:d 1928 to 2014 period. ORAd~ not cvit ua ~ i'my 

other variables, and believes that it is sufficient to assign the LECs 

a cost of equity that is the s"m of a lower Treasuoy rate plus a 

market-wide rerum- without any premium for industry-specific 

risk and without an allowance for any other risks. ORA summarily 

rejects market or company analyses. which is an approach that, to 

the best of my knowledge. no professional source endorses. In 

addition, 1 believe the failure to account for industry-SJ>eeific risks 

is inconsistent with the plain language of applicable legal guidance 

from the United States Supreme Coun_ 

15 Ql 7. In what way do you belie,•e ORA's approach to equity risk is 

16 

17 

IS 

19 

20 

21 

A. 

inconsistent with applicable Supreme Court guidance? 

I am not an attorney. but I am familiar with the seminal U.S. 

Supreme Coon cases addressing the legal paramerers within which 

state commissions must examine rate·of .. retum issues. ORA 

acknowledges some of these U.S. Supreme Court authorities in its 

"Cost of Equity" section, but it fails to follow the critical guidance 

25 ORA Testimony. p. 39, lines 15-17. 

19 1062160.1 
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that is evident in those opinions.26 The Supreme Coon caJis for 

industry-specific assessments, including a consideration of relevant 

regulatory risks. ln Bluefield Water Works & /mprowmu!/11 Co. v. 

Public Service Commission of West Virginia. 262 U.S. 679 (1923) 

("81ur;fidd"), tht: Cuun stat~ that a public utility is c:ntith:d 10 

such rates that will pem1it a rerum ·'equal to that generally being 

made a1 1he same 1imc and in 1hc general pan of 1hc counll')' on 

investments in other busine underwkings which are tllteuded by 

the correspondinJ! risks and uncertaimies .. : ·{emphasis added). 

Feder<ll Power Comtmssiou v. Hope NCIIural Gas Company, 320 

U.S. 391 (1944), makes a similar poim. ci1ing "1he rc1urn 10 01e 

equity owner should be comnu!nsurate with J'elllrus ou im.-esltm.>llls 

in 01her emeqJrises havinJ.! correspml(}i"K risks" (emphasis added.) 

Finally. Duquesne Light Company eta/. v. David M. 8ara,.clt et 

ttl., 488 U.S. 299 ( 1989), rci1era1ed 01c s1andard of If ope and 

Bluefield and then added imponan1 new l~c1ors. including 

"rcgula10ry risk." noling lhal a "decision 10 aroilrarily swilch back 

and fonh be1ween me1hodologies in a way which required 

investors to bear the risk of bad investments at some times while 

denying 1hcm 1he bencfi1 of good inves1men1s a1 o1hers would raise 

serious constitutional questions:• From the plain language, lhese 

opinions point co a required assessment of industry-specific risks . 

26 ORA Teslimony. pp. 34-35. 

20 1062160.1 
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620REBUT22.eps

including risks in a period of significant regulatory change, that 

2 should be reflected in cost of equity capital. My experience and 

my reading of these constitutional rulings lead me co believe that it 

is not defensible to argue that the Independent Small LECs deserve 

a u:lutu dutt :>imply mit lUI:> the ov ~.udl muketJ utn fo1 et&Uity. 

6 QIS. What basis does ORA offer for its rejection of a size premium? 

A. OR.A devotes a mere twelve lines in its testimony to the size 

premium, and fails to address the sources and data provided in my 

9 Opening Testimony. ORA dismisses the premium with the 

10 summary comment that because the Independent Small LECs are 

II rate-regulated. the companies experience no risk that exceeds the 

12 overall market risk.27 ORA suppons its view with a single citation 

13 to the FCC Stall' Report that also did not recommend a size 

14 premium.28 Finally, ORA states, .,..;thout further explanation, that 

15 Heven if size was detem1ined to be a relevam factor, it is quite 

16 possible that the relatively small size of the ILECs would afford 

17 them an opponunity to more nimbly adj ust strategy and budgets in 

18 response to competitive forces ... "29 

19 Ql9. bit appropriate to dismiss the size premium? 

27 ORA Testimony, p. 43, 1ines 14-16. 

lS ORA Testimony. p. 43, lines 16-18: footnote 50. 

29 ORA Testimony. p. 43. 1ines 18-21. 

2 1 1062160.1 
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12 

13 

A. No. Significant researc-h supports the validity of enhanced risk that 

is either due to. or closely related to. size. That is. a CAI'M model 

that relies only on a risk-free rate and a market equity risk 

premium is not sufficient to estimate the costs of equity for small 

cv ani~. Again, ORA cites 10 lht.: fCC Sntfl' ftr::pon,JO Nu 

other justification is provided for ignoring this widely-used factor. 

I will explain below that the FCC Staff Report on which ORA 

relies also devotes a mere six lines to the size premium. citing only 

a single source whic-h is a 25-page survey article in 2011 as the 

justification for rejecting the premium. and overlooking the 

article's lindings that the size effect is significantly related to 

illiquidity and concentrated in the three smallest deciles of the 

market.l l The Independent Small lECs fall in the lowe.•;/ quo1·ti/e 

30 ORA Testimony, p. 40, line I. 

3t Crain. Michael A .. A l..ircrawre Review oft/~~: Size litfect(October 29.201 t). ( .. Crain") 

walloble or SSRN: Imp ll:s::m comlab<IQCJ- 1710076 pp. 11-12: 15: 

1062160.1 

Studies ro\'C31 th:tt market liquidity mny be an impOrtant risk flc.tOr 

underlying finn size. Amihud & 1\'lcndclson ( 1986) examine American 

stocks from 1% I to 1980 and find th::u the size effccl is linked to 

liquidity when mc3Sured by bid ..ask spread. lltcy regress stock returns 

on CAPM bela. finn size. nod bid-ask sprc3d: they find that size is 

insignificant. But when 1he bid"sk sptcad variable is OI'OJI!Cd. size is 

significant Amihud & Mendelson reason that firm size is a proxy for 

liquidity. More recently. Amibud (2002) fmds m;:ukcc illiquidity effec-ts 

on rcwn1s a.rc sig.ruficant :~. d stronger in smaller firms, He CX3mincs 

NYSE stocks from 1964 to 1997 by rcgrossitlS rctunls on finn size. market liquidity. nnd otl1cr variables. from the findings. he suggests tJmt 

ren1poraJ \1:triatjO•lS in the size cfT~1 :tre rel:t~ed 10 changes in ll)arl:cl 

liquidity over time. Funhcr. P:\Slor & Stamtxwg.h (2003) examine 

American tinns from 1966 to 1999 and find that markctwidc liquidity is 

:l f.."tclor in cxpl:lining returns by adding a liquidity variable 10 Fama & 

French's ( 1993) three-factor model. Since this thrcc-fhctor model has a 

22 
112 


620REBUT24.eps

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7 

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9 

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12 

13 

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15 

16 

17 

ojlhe smal/esl decile. The article's author, Michael Crain, devotes 

Section 6 of his survey to address findings that the size effect is 

concentrated in the smallest companies. 

Researchers find the size effect, when obs.erved, is. 

concentrated in s.maller fim1s.. h seems the size 

~rrc:~t i:s no t iu~~u a~1os~ listOO fi1111~. Husowit£ c:t 

al. (2000a) observe the size effect seems to occur 

only in smaller listed finns . ... Since Horowitz et 

al. replicate the methodology of Fama & French 

( 1992), chey argue chac che findings of Fama & 

french are concentrated in very small fim1s and not 

across all small fim1s as fama & French claim. In 

another study, Fama & French (2008) observe that 

the size eflett exists in U.S. listed fim1s but it is 

strongest among microcap fim1s using data from 

1963 10 2005.32 

"rui:1ble for finn site. P:tStOr & Stamb.lugh's St dycssenti3 · finds 

marketwidc liquidity is important in addition to fim1 size. SubscqucntJy, 

Liu (2006) eonfinns that mMket liquidity h:..s power in explaining n:1ums 

by examining U.S. stocks from 1960 to 2003. He illustr.ucs that matkct liquidi1y varies significantly over time and. thus, so docs investor 

liquidity risk (Liu 2006. Figure 1). Further. he finds th~u liquidity 

subsumes effe-cts due to size (and other fhctors). In a later study, Chen et 

ll. (2010) e."a.minc AmcricM stocks fcoan 1972 10 2009 and find the 

Jiquidi1y effect dOC$ not completely capture the size effect but th:lt 

liquidity is hisftly correl:..tcd "ith fim1 size. A model'' ithout a variable for liquidity might cnusc the size cff~ct to vary (or. perhaps~ even 

dis:.ppc:..r) :tS n1.1rket liquidity changes over time. HotO\,itz ct :..1. (2000a) arc implicitly ex:unining the liquidity hypothesis when they find the size 

effect dis.1ppc;ars after~ small-cap fund was introduced. That fund 

provided more access and. thus. liquidity to smaller listed fimls. 

Moreover. Amihud (2002) finds that n:cums of smaller firms arc more 

sensiti\'C 10 m:ttkct illiquidity and th:lt smaller finns have more liquidity 

risk than laJ'BCr fimlS. He asscl"l$that such findi11gs may cxpl3in 

variations oflhc size effcCL Market liquidity ch31lges O\'er time. he 

contends. due to shifts in sentiment whercbv investors sometimes flee to 

liquidity, which makes l:ugc s1ocks rc1ativciy more :tttr.:tctivc. Anuhud 

also tinds that market liquidity is consistent over time. unli"c fim1 siu. 

:lS o factor explaining rctums. 

32 Crain, p. t 5. 

23 1062160.1 
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620REBUT25.eps

Thus, the survey article cited by the FCC StaJTin its Report- on 

2 which ORA relics- finds that size effects do exist in the smallest 

fim1s. The Fama & French s1Udy, referenced by Crain, aflinns size 

efltcts in ... microcap" companies which are typicaJiy described as 

wmpa.ui~ witl1 rmukt:L (.;apitali.attiuu:; uf$50 milliuu lo S300 

6 million. For perspective. the 2014 avernge common book equity of 

the Independent Small LECs is $20.2 million and the median book 

8 equity is $ 14.3 million.33 11le Crain anicle. therefore, finds the 

9 exact opposite of what the FCC and ORA is clahning as that anicle 

10 just(fie,.,· a size premium for companies that are even larger than the 

II Independent Small LECs. 

12 Q20. Does other scholarly re.search reject the llddition of a size 

13 

14 

15 

16 

17 

18 

19 

20 

21 

premium? 

A. No. As I have explained. the widely-accepted approach 

recommended by valuation expens and scholars applies a size 

premium to account for increased risks among the smallest 

companies. Data seeking to quantify the ze~effect premium are 

reOected in seminal valuation repons. such as tl1ose released by 

Ibbotson/Morningstar and DuiT & Phelps. In the face of these 

authorities supporting a size premium and/or related factors such 

as liquidity, ORA's rejection of the approach is startling. Indeed, 

33 11te largeSl of the Independent Small LECs is Siskiyou, which reponed 2014 

book equity ofSS9.6 million~ which is still at the bottom of the microcap range. 

24 1062160.1 
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31 

32 

33 

even the article referenced by the FCC Staff Report states that the 

CAPM does not e.xplain the risk associated with all companies, 

particularly timts that are in the smallest de<:iles. The survey 

anicle considers whether there are other factors that better e.xplain 

confim1atory - explanations for the size etTcct.. which include 

liquidity and size factors concentrated in the three smallest deciles 

of the stocks studied. J.l In the final section of his survey, Crain 

summarizes hjs article as rollows: 

When the size effect is observed. theory suggests that 

superior returns in smaller firms arise from higher 

risk in these timts compared to larger firms. 

Researchers do not claim that size per se is a source 

of risk that drives superior remms of smaller firms. 

Instead. firm size may be a proxy for one or more 

underlying risk factors linked to smaller firms. Such 

factors could be endogenous or exogenous and 

explain variations in the size effect. Empirical 

research suggests one such embedded factor in 

smaller firms is liquidity risk. Logically, these 

findings on liquidity seem linked to the emergence of 

small-cap investment funds in the 1980s. Small-cap 

funds increase the liquidity of smaller finns and, thus, 

liquidity risk in these linns ought to be lower on 

average after these kinds of funds launch. It follows 

that superior returns of smaller finns shO<dd decline 

when liquidity risk decreases In addition to the 

discoveries of the size efl"ect and variations in the 

effect, two areas of research are related to these 

findings. First. research shows that when the size 

effect is observed. it is nonlinear and concentrated in 

smaller listed firms. One study finds the effect is five 

times larger in firms in the 20th percentile using 

34 Crain, p. 4. citing a Michou study in 2010. 

25 1062160.1 
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620REBUT27.eps

I 

2 

3 

6 

9 

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II 

12 

13 

14 

15 

16 

17 

18 

19 

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23 

24 

25 

26 

27 

28 

29 

NYSE breakpoints for size and only marginal across 

1he remaining larger fim1s.JS 

ln addition to the sources cited in Crain's article. including those 

referenced in footnote 31, above. the highly-respected valuation 

e.• pens. Sha11non Prau and Roger Grabowski, dedicate cwo e11cire 

chapters and an appendix to size effect- "'Chapter 14: Size 

Efl'cc~" "Chapter 15: Criticism of che Size Efl'ccc," and "Appendix 

I SA· Ocher Data Issues Regarding the Size EITecc'-in their Cost 

of Capital cexl. 36 Pratt and Grabowski report that: 

Two resuhs ofche Si:e Study [of 

lbbotso11/Morningscar and DuO' & Phelps] seem 

strikingly similar. 

I. In spite of the different time period. the size eiTect 

results corroborate the Morningstar results that the 

size effect is empirically observed. 

2. 11\e results are significantly similar for all eight 

measures of company size. 

Ahhough the market va.luc of common equity has 

both che highest degree of statistical significance and 

the steepest slope when regressing average returns 

against size. all size measures show a high degree of 

statistical significance .. .. 

While there have been many criticisms of the size 

cO'ecc, it continues co be observed in data sources chat 

utilize the CAI'M methodology . ... Studies have 

shown the limitations of bela as a sole measure of 

risk. The size premium is an empirically derived 

correction co the ce..cbook CAPM. 37 

35 Crain. pp. 21 -22. 

J6 Shannon Pran and Roger Grabowski, Cost ujCc>fJitcd: Applications aud 

Examples. Fifth Ed. (Hoboken, NJ: John Wiley & Sons, Inc .. 2014). (''Pran and 

Grabowski Cost ofCapical2014"), pp. 301-371. See also Shannon Pranand 

Roger Grabowski, Cast ojCapiwl: Applications and F.xamples, Third Ed. 

(Hoboken. NJ: John Wiley & Sons, Inc., 2008) ("Cost of Capital"), pp. 179·223. 

37 Cost ofCapica12008. pp. 207, 219. Sec also, Pran and Grabowski Cost of 

26 1062160.1 
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2 

6 

8 

9 

10 

II 

12 

13 

14 

15 

16 

In this discussion, "beta" is the company or industry adjustmeno (a 

single number) multiplied times the CAPM equity premium and 

the result is added 10 lhe " risk-free rate." As I explained in my 

O~ning Tati111uny. •·IJc:ta .. is a nu111bt:t usc:ll in the CAPM tu 

adjust the overall market return to account for the greater or lesser 

risk associated with a stock or with an industry relative 10 the 

overall market risk . .I& Notably, in the quotation above, f>rau and 

Grabowski state that the use of an industry beta in the CAJ>M is 

not sufficient, in the absence of a size premium , which is a view 

eonsistenl with my experience and my testimony about the 

necessity for a size-related adjustment Pran and Grabowski are 

criticizing the prop<lsal that the FCC Stan· has made- that a risk· 

free rate plus an industry beta (applied 10 the equity market return) 

\\~th no size premium is sufficient ORA's propos.aJ is even more 

extreme. as it proposes no size premium (md uo iuduSIIJ' 

Capital 2014. p. 361, which repeats the last two sentences of the quotation above. 

38 See Balhoff01>ening Testimony, pp. 23-24; "beta; is a number that represents 

statistical volatility that is caJculated by perfonning regressions on stock price 

changes related 10 the overall equity market and similar regressions for the stock 

or industry in question. If the equity market premium is 6% above the risk-li-ce 

rate, then a stock with a beta of 1.1 is I 0% more volatile (riskier) ~>an lhe overall 

market and should have an equity premium of 6.6% ( 1.1 times 6%), and a stock 

with a beta of0.9 is 10"/o less volatile (risky) than the overall maoi<et and should 

have an equity premium of 5.4% (0.9times 6%). Industry betas are calculated on 

the basis of the beras of the individual s1ocks in an industry, which makes indus1ry 

betas dependenr on choosing companies similar to 1he companies whose equity 

premia are being studied. 

27 1062160.1 
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30 

31 

32 

adjustmelll. ORA's approach contains no citations because, to the 

best of my lu>owledge. there arc no credible authorities available to 

suppon such a me1hodology. 

Q2J. 1$ there e\•idence that a size premium is appropriate for 

A. Yes. Dr. Roger Morin, who is referenced in more than 20 

foom01es in the FCC Stan·Repon. writes the following in his oftcited text. New Regulatory Fiuauc~t 39 

Jnvesune11t risk increases as company size diminishes. 

all else remaining constant. Small companies have 

very different returns than large ones, and on average 

they have been higher. The greater risk of small 

stocks does not fully account for their higher returns 

over many histoJital periods. The size phenomenon 

is well-documented in the finance literature. 

Empirical studies by Banz (1981) and Reinganum 

(19SIA) have found that investors in small 

capitalization stocks require higher refun1s than 

predicted by the standard CAPM .... Tl>e relationship 

between finn size and return cuts across the entire 

size spectrum but is most evident among companies 

that have higher returns than larger ones on average. 

Ibbotson Associates' well-known historical return 

series publication covering the period 1926 to the 

present reinforces this evidence (Ibbotson Associates' 

200S Yem·book. Valutltiou 1:../ition). To illustrate. the 

Ibbotson data suggests that under SIC Code 49, 

Flectric. Gas & Sanitmy Serw·ce.\·, the average re1Um 

for that group over almost an SO-year period was 

14.03% forthc small-cap company group and 10.86% 

for the large .. cap group. more than a 30Q .. basis point 

difl"erence. This is tme for all industry groups .. .ao 

J9 Roger A. Morin, New Regulatory Finance (Vienna. VA: Public Utilities 

Repons. Inc .. 2006) ("Morin"). 

40 Morin. pp. 181-182. 

28 1062160.1 
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2 

6 

9 

10 

Even for utilities that are true monopolies. which the Independent 

Small LECs are no~ Dr. Morin's observed difference in the COSIS 

of equity between larger and smaller companies is striking 

(ap .uux matc1y 300 bps). I am wuvinl:OO tltatth~te sl•ould l>c the 

addition of a size premium. and the actual difference is larger for 

companies in a highly compe1i1ive market, such as 

telecommunications. compared with traditional public utilicy 

sectors. such as water or energy, where there is essentially no 

competi1ion. 

II Q22. Clm you respond to ORA ts clltim that "e\'tn if size was 

12 

13 

14 

15 

16 

17 

18 

19 

20 

21 

22 

A. 

determined co be a relevant factor. ic is quite pos.sible thnt the 

relatively smaller slz.e oft he ILECs would afford them an 

OPJ>Orhn•il)' to more nimbly adjust straregy at•d budge-tS in 

resJlonse to competitive forces, chan ging customer demands, 

and technological innovations, thereby lowering risk"?·" 

Yes. ORA?s conclusion is nothing but speculation and is wrong. in 

my opinion. Small companies have greater risk. particularly in the 

ILE'C industry, which is a high tixed-cosl b11siness in which large, 

long~tenn investments are necessary. Customer losses oflen 

translate to proponionately higher losses of operating cash flows, 

because the plant docs not go away; the result is that operating risk 

41 ORA Testimony. p. 43, line 18 ff. 

29 1062160.1 
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I I 

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15 

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19 

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21 

22 

23 

rises rapidly as competition grows. Greater size pe.nnits carriers to 

spread marginal cos1s over a large number of cus1omers. and 

smaller finns are severely disadvantaged in managing their costs. 

As a result. small carriers require more federal and state suppon to 

supph::uu:mt lheiJ inv~tweuts ami opentliuns. while k\Xping taltz 

within reasonable bounds. Funher. small carriers have relatively 

low diversification of revenues compared with large carriers, and. 

as in a stock portfolio, diminished diversification resuhs in 

increased risk. Finally. small carriers have limited access 10 the 

capital markets. which creates significantly greater risks. Dr. 

Morin addresses 1he grca1er risk for smaller utili1ies. effectively 

responding 10 ORA. 

Smaller companies are less able 10 deal wilh 

significant events that atTect revenues and cash flows 

than larger companies. For example, the loss of sales 

from a few large customers would exert a far greater 

eOec1 on a small company .... Presumably. small 

s1ocks provided less u1ili1y 10 1he investor. and require 

a higher rc1um."2 

ORA•s statement is not only speculative-and offered without any 

citation or justilication-but it is also contrary to prevailin.g 

authority and common sense. 

42 Morin. p. 187. 

30 1062160.t 
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620REBUT32.eps

Q2J. liow do you respond to ORA's comme.ntary that since 1997, 

2 jlUthoriz.ed rates of return for U.S. regulated electric, natural 

gas, and wate•· utililirs b:lVt declined?-ll 

A. The Olher U.S.regulated industries-electric, natural gas, and 

watt:r- have monopoly chanu.:tc: i.s i~ that an; di:.tingubhablt: 

6 from those in the ILEC industry. ILECs are no longer monopolies, 

and even rural carriers arc affected by increasing competitive 

8 pressures. The ILEC industry is challenged by significant Cllpital 

9 e.xpenditure pressures due to technology transitions with shorter 

10 lives, n~ as recent trends in FCC policy amply demonstrate. the 

II LLEC industry is buffeted by regulatory turbulence. These "risks" 

12 create a significantly higheruncenainty, and, hence, higher equity 

13 cost for ILECs. 

14 Q24. Oid you consider ORA's argume111regardi11g rhe dedi11e in 

15 

16 

17 

18 

19 

20 

21 

authorized ROEs for reguluted utilities since 1997? 

A. Yes. While not quantified in ORA's testirnony, 1he 2009 rcpo•1 

from Regulatory Research Associates (cited in the ORA testimony 

at footnote 51), reveals that the average equity retums for electric 

and gas utilities have declined from I 1.34% in 1997 to 10.42% in 

2008, that is, by approximately 92 bps over that 12-year period.44 

In that same footnote. ORA also cites an April 2009 slide 

•l ORA Testimony, p. 44, 1ines 13-15. 

44 Regulatory Research Associates. Regulmoty Focus, (January 12, 2009), p. 4. 

3 1 1062160.1 
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6 

8 

9 

10 

II 

12 

13 

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15 

16 

17 

presentation from Moody's Investors Service ('Moody's"). which 

tracks what appear to be authorized and realized utility ROEs for 

the elec1ric industry. At the time of the presentation, the 

authorized retums were slightly above I 00/o. while the realized 

ROEs Wt;n; gntphed "' h;vds i1ppH.ncimat.;ly 50 bps low~r. •15 1'tu:: 

February 201311Niustry 0ullook report from Moody's. also cited in 

ORA's footnoteS 1. explains that the stable outlook for tl1e electric 

and gas sector is the result of a "s.1stained period of low natural gas 

prices,'' a "flight to quality'' in the capital markets (when investors 

are fearful they usually trade out of riskier securities and flee to 

quality securities that are large, dividend paying and predictable 

equities or higher-grade debt instmments). and anticipated large 

capital expenditures thal"will contribute 10 rate base growth.»46 

ln the 20 15 "Capital Marl<et Conditions" article cited by ORA il\ 

footnote 5 1. Dr Randall Woolridge reports that gas and electric 

companies have authorized ROEs that have fallen to approximately 

9.7% by 201s.

41 

4S Moody's Investor's Service, Estimating the Cost of Capital in Today',.; 

£tx.momi£' & Capiwl Markel Enwronment. 41st Financial Forum. Society of 

Utility and Regulatory Financial Analysts (Apri l 2009). slides 7· 8. 

46 Moody's Investor Services, Industry Outlook: US Regulated Utilities (February 

6, 2013), p. l. 

47 J. Randall Woolridge, Capital Markel Conditions. Aulhori:ed Ulilily ROEs. 

ond Hope and Bluefield Sl(mdards. October 22, 2015, p. 7 (fable I). 

32 1062160.1 
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620REBUT34.eps

Q25. Oo these sources s upport nn argument that the Independent 

2 Smnll LECs' equity costs are (;Onsistent with those of gas :111d 

6 

9 

10 

II 

12 

13 

14 

15 

16 

17 

IS 

19 

20 

21 

electric ulililies? 

A. No. The ORA sources listed in footnote 51 all refer to gas and 

dt:~lJit: t:olnpauie) that have littlem no t:OIIIJ.It:liliou, anti whit:h ale 

readily distinguishable from ILECs. Moody's Industry Om look 

focuses primarily on the costS for natural gas, resulting in reduced 

expenditures that should enable higher generation profitability. In 

contraSI, today's ILEC profitability and cash flows arc shrinking as 

the carriers wort< to respond to competitive pressures and 

regulatory mandates for modem, broadband-capable infrastructure. 

As an illustration of a telling differe•tce between the utilities cited 

by ORA and teleeontmunieations carriers. DuO' & Phelps in its 

most recent Industry Cost of Capital Handbook indicates that, in 

2015, the median cost of equity for the gas and e lectric industry 

(SIC code 493) is approximately 240 bps kMer than the cost of 

equity for the telecommunications industry (SIC Code 48 13), 

which is a clear sign of the greater risk in the telecommunications 

industry:IS So. if Dr. Woolridge is correct that gas and electric 

utilities should have authorized ROEs of approximately 9.7%, the 

uft~ & Phelps data suggest I hat the telecommunications services 

•s DutT & Phelps 2015 Valuation Nandbook. Industry Cost of Capital, (1-loboken. 

NJ: John Wiley & Sons, Inc., 2015); unnumbered pages-SIC Codes 493 and 

4813. 

33 1062160.1 
123 


620REBUT35.eps

2 

industry should slllfl with ROEs closer to 12. 1%, before adding 

size or liquidity premia for the Independent Small LECs. It is clear 

that the electric and gas industry is not comparable with the ILEC 

industry. as the risks for telecommunications carriers are greater 

tllan thlr.it: of monopoly utilities ami a1c: lJt:ll:ominga•guai.Jly t:veu 

6 larger as regulatory uncertainties increase. 

Q26. IJas the CPUC found that there is a difference in risk for 

8 smalltr utilities compAred with larger or1 es? 

9 

10 

II 

12 

13 

14 

15 

16 

A. Yes. In 1997, the CPUC wrote that the Commission "concur[s) 

that applicant's [Foresthill's) risk is impacted by its small size in 

relation to 1he large size of the companies in the study group. "49 

However. the Commission did not adopt an explicit size premium, 

nor did it adopt any specific risk premium, because the CPUC 

chose to approach setting rates in a diOerent way: that is, it 

adopted a 10% rate of return for each of the carriers., independent 

of capital structure or specific costs of debt. 

17 Q27. Does ORA correctly assess the effects of regulation on the risk 

18 profiles of the lndei><ndent Small LECs? 

19 A. No. ORA fails to acknowledge the significant polilical and 

20 regulatory risks attendant to rural telephone company revenue 

21 streams, and ORA wrongly alleges that the companies are 

49 0 .97-04-033 (Foresthill). at 20. 

34 1062160.1 
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620REBUT36.eps

"shielded" from risks by virtue of their access to certain federal 

2 and state high-cost support. 

6 

8 

Q2.8. Does ORA explain how it believes that universal service 

programs ""shield" the companies from risk? 

A. No. ORA !!iilllply cc;:)(!Jls tl1at "'tht! USF u.J CHCF·A (Ct ifu~t~ia 

High Cost Fund A] provide known levels of revenue for the Small 

LECs" and that "revenues derived from revenue requirements 

adopted in general rate eases .. are updated annually.•50 

9 Q29. Do the. USF nnd CHCF·i\ prO\•ide ~'known lt.vtls of re\•tnue" 

I 0 for the Independent Small LECs? 

II A. No. 111e federal Universal Service Fund program and the CHCF-A 

12 

13 

14 

15 

16 

17 

18 

19 

20 

do not guarantee that Independent Small LECs \\i ll achieve any 

particular level of total revenue. The support programs provide 

important revenue satorces for the Independent Small LECs, but 

Independent Small LECs also depend upon revenue from end users 

and intcrearricr compensation. As one reference point. Public 

Utilities Code Section 275.6(bX3) defines small independent 

1clephonc corporations? ''rate design .. to include a .. mix of end user 

rates. high-cost support. and ocher revenue source-s. •· The 

Independent Small LECs do not ··know,.. what their revenues will 

50 ORA Testimony. p. 38. 

35 1062160.1 
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620REBUT37.eps

be from year to year, and the amounts derived from federal higll2 cost suppon and CHCF-A fluctuate from year to year. St 

6 

8 

9 

10 

II 

12 

13 

14 

IS 

Q30. If an Independent Small LEC does not achie\'t re\•enutS 

sufficient to meet its revenue requirement in n given year, do 

the USF or CI:I CF'-A prognuns provide a mechanism to n:mke 

A. 

up for thnt shortfall? 

The federal USF program provides no mechanism to correct for 

revenue shonfalls experienced by program panicipants Similarly, 

subject to a natrow ex<:eptiontha' addresses only a limited subset 

of revenue impacrs. the CHCF·A program has no mechanism for 

supplementing funding to address revenue shonfalls. Each 

company's CHCF-A revenue is ser in its most recent rate case. and 

that annual fu11ding level ren1ains erfective until the company's 

next rate case. subject only to limited annual adjustments based on 

specific factors prescribed in d1e CHCF-A rules. 

16 Q31. \Vhat are the limited annual adju tnu u-? 

17 A. There are fom processes that can alter CHCF-A levels between 

IS 

19 

20 

21 

22 

rate cases. Fi rsr. if a company is projec1ed 10 earn more 1han ics 

1arget rate of return based on seven months of annualized data, its 

CHCF-A funding level for the next year will be reduced by the 

amount by which the company exoeeded the targeL This '-'means 

test" serves to decrease prospective funding levels for "over· 

51 See 0 .91-09-042. Appendix. 

36 1062160.1 
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23 

1062160.1 

earning," but it provides no supplemental funding for .. under· 

earning: · Second. because federal suppol"l for the in1ras~ate 

revenue requirement fluctuates from year to year, and because that 

support may be higher or lower than forecasted in a rate case, 

CHCf-A i!:i adju:>h::d uu a tt:veuut:·m::utral l.lasis to au.:ouut fot the 

differences. If federal funding is higher than projected. the CHCFA will be prospectively reduced dollar for dollar by thai additional 

amounL lf federal funding is lowenhan anticipated, the CHCF-A 

will be prospectively increased by that amount. Third, if a 

company does not file a rate case within prescribed timeframcs 

under tlle CHCF-A rules. CHCF-A funding is to be reduced to zero 

over a three-year period, starting with a 200/o funding reduction in 

the first year of reduction. followed by a contraction to 50% 

funding in the second, and concluding with no funding in the third 

year. The mechanism is known as tlle CHCF-A "waterfall." 

Finally, CiotCF-A funding can be adjusted annually for the revenue 

eOects of" regulatory changes of industry-wide ellect"' that alter 

the assumptions upon which the CPUC set a company's rate 

structure in a rate case. This adjustment for ··regulatory changes of 

in ustry~\vide effect" is lhc one limited and narrow exception 

whereby CHCF-A funding can compensate for a limited subset of 

revenue shortfalls. As reflec-ted in the Commission's most recent 

Resolution establishing funding amounts for the CHCF-A for 

37 
127 


620REBUT39.eps

2 

2016. the only " regulatory changes of industry-wide cnect .. that 

generated annual adjustments were changes to the California 

Lifeline program that shifl:ed Lifeline-related adminislrative 

e.'penses to the CHCF·A program. and changes related to the 

fCC's irut:rcarrkl wmtwn~atiou H;:Conns. 52 

6 Q32. Ooes this fourth mechanism, accounting for the revenue effects 

8 

9 

10 

l l 

12 

13 

14 

15 

16 

17 

18 

19 

20 

21 

22 

A. 

of regulatory changes, "shield" the companies from 

"Ouctuations in revenue."? 

No. ln fact. the effects of regulatory changes are generally small 

relative to the universe of factors that could influence a company's 

cost structure and realized revenue. The limited annual 

adjustments for fundamental regulatory changes do not provide a 

sufficient mechanism for il1creased l\Jnding in response to changes 

in a company's income stateme1H, If, for example. a company 

must spend significantJy more tha.n anticipated to provide its 

employees with health benefits, the CHCF-A provides no 

additional funding. If more customers than expected drop their 

landlincs to re.ly on wireless servi~ the CHCF· A provides no 

additional funding, If a catastrophic event occurs. which requires 

significant additional costs to be incurred, the CHCF-A provides 

no additional funding. ORA is not correco that the CHCF-A 

.. shields" from nuctuations in revenues and therefore eliminates 

52 Se<• Res. T- 17505. 

38 1062160.1 
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620REBUT40.eps

2 

6 

8 

9 

company risk. Moreover. as J noted above. if a company cams 

more than its eamings target, the carrier will lose funding dollarfor-dollar in the next year, 

Q33. Is ir true that revenues are " updated annually,"' as O'RA 

asscrts?S3 

A. No. As I explained. revenues fluctuate based on many factors. and 

there is no mechanism to increase revenues on an annual basis to 

adjust for revenue shonfalls. either revenues nor revenue 

requirements are ··updated annually.·· 

10 Q34. Ooes federal high-cost support provide a mechanism for 

I I 

12 

13 A. 

recouping lost revenues or neucralizing unanticipated costs or 

revenue losses? 

No. USF support is calculated based on specific fom1Uias 

14 designed to recover specific costs. but if those amoun1s prove to be 

15 insufficient to cover actual costs. no additional funding is 

16 provided. 

17 Q35. Are there other risk factors associated wilh fede.ral high·cosl 

18 support and CHCF-A funding thai ORA fails lo txplain? 

19 

20 

21 

22 

A. Yes. ORA ignores the significan1 poli1ical and regulatory risks 

related 10 these programs. In fac~ in my conversations. ic is clear 

that investors and companies have become increasingly concerned 

about the uncertainties affecting small and vulnerable carriers that 

5J ORA Testimony, p. 40. 1ines 8-10. 

39 1062160.1 
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8 

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10 

II 

12 

13 

14 

I 5 

16 

17 

18 

19 

20 

are clearly dependent on support mechanisms. MorespecificaJiy, 

the USF ICC 'l'ransformmiun Order(FCC 11-161) and the various 

subsequent FCC orders have put in motion dramatically more 

unpredictable suppon mechanisms. Those federal refom1s are 

ou~oiug. ~~~ling :.iguilicaul UH~lhtiHtit:s aml1 isks. SiHtihuly, tilt: 

CPUC has adopted changes to the CHCF-A program, and it is 

considering additional changes. 54 In D. 14-12-084,theCPUC 

adopted a rebullable presumption that Independent Smalll.ECs' 

revctlue requirements could not include corporate c.:..:pcnses beyond 

the levels applicable to federal support mechanisms, thereby 

placing a significant limitation on the use ofCHCF-A funding 

Phase II of the CHCF-A nolemaking includes even more sweeping 

proposals for change. including the potential lor imputation of 

unregulated broadband revenues into intrastate ratemaking and 

considerations of·'alternative forms of regulation:~ ss The breadth 

of Phase II of the rulemaking contradicts ORA's claim that the 

CHCF-A "shields" the companies from risk. This regulatory risk 

is further compounded by the political reality that the CHCF-A is 

subject 10 a ·•sunse1" provision, suc.h that the program will 

terminate at the end of 20 IS if ir is not legislatively renewed. 56 

.14 See R.l l-l i-007(CHCF-A rulemaking). 

55 0 .14-12-084. at p. 12. 

56 See Pub. Uti I. Code§ 275.6(g). 

40 1062160.1 
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620REBUT42.eps

2 

6 

Even without changes to the CHCF·A program, the Independent 

Small LECs arc dependent upcn the CPUC's timely processing of 

rate cases to make adjustmenls 10 rate struc1ures to accoum for 

increasing costs" Illustrating this, one of the Independent Small 

LECs, Keuuau Tdevhuue, has a t.:u.uc::.ut nth:: l:a!lot:. that has Ut:eu 

pending for more than four yea.rs.S7 It is my understanding that 

Kennan has been unable to address any of the cost increases tltat 

8 have occurred since 2008. which was the compa•ty's last rate case 

9 "test year." Significam delays in rate cases are major risk factors 

10 for the companies, and funher rebut the c laim that the CHCF·A 

II eliminates risk for the carriers. 

12 Q36. ORA rtjttls the por1ion or your ttstimony concerning merger 

13 and acquisition ("M&A '') data.ss now do you respond? 

14 

15 

16 

t7 

18 

19 

20 

21 

A. ORA summarily rejects the M&A data and analyses that I used to 

test the Ibbotson/Morningstar and OuiT & Phelps calculations. 

ORA contends that the M&A data represents too small a sample 

because only 24 sales or about 20% of all the sales over the period 

were accompanied by public disclosure of data. I respond that it is 

typical that the vast1najority of small transactions are announced 

\\~lh no significant disclosure of valuation informarion. At 1he 

same time. the number oftransaccions about whic-h we do have 

51 See A. ll-12.011. 

58 ORA Testimony. p. 41 . lines 8-14. 

4 1 1062160.1 
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620REBUT43.eps

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6 

8 

9 

10 

II 

12 

13 

14 

15 

data is large and consistent, revealing the collapse in valuation 

over the period. Moreover, the transactions include sales and 

purchases of propenies by sophisticated sellers and buyers. so 

those publicly-disclosed purchase prices provide compelling 

evidem.:c: al.loul Lhe ~lu:uply· owea valuitLiuus. If. fu1 ~autp , 

Verizon were to sell its California assets to Frontier at values 

meaningfully below market value, Verizon would be legally liable 

10 ias shareholders. some of whom would cenainly file lawStaits.5? 

Lf Qwest were to sell to CenturyLink at valuations below fair 

value, it too would be at risk for shareholder actions. 60 The data 

reveal a clear and convincing downward value trend that is in 

sharp contrast to valuations ten years ago. The factual trend cannot 

be dism ssed~ and it provides imponant corroborative evidence 

about the increasing cost of equity renected in the CAPM 

valuation methodology 

59 Frontier reponed Oil Febnaary 5. 2015, when the compa1ly allf'IOtanced the 

transaction to purchase Verizon's California. Texas and Florida wireline 

operations that it was paying 3.7x 2014 estimate pro forma EBITDA. a figure 

below the 4.5x to S.Sx EBITDA that I usod as a typical value in my Opening 

Testimony. See Frontier Investor Presentation, N·ontier Conmumlcotions to 

Acquire Veri:fm Wire line Oper(l(ions iu Ctt!ifnrnla, !·1nridtt and TeXtL'\ (Feb. 5. 

201)), available at 

http·/finvestor frontier com/common/download/download.cfm?comnanyid- AMD 

A-OJWDG&filcid 807528&fllekcY"'D95E.1F23-F896-4B56-AB6C3069DB74DBFB&filename- Fro11tier CommUilications to Acquire Verizoo VI 

ireljne Qperations in California Florida and Te\:DS oor. slide 6 

60 See BalhoffOpening Testimony, p. 47, Figure 4: Qwest sold for S.lx EBITDA, 

whic.h is well below the prices that averaged 8.0x EBITDA from 2001 to 2007: 

see Balhon· Opening Testimony, p. 46. 

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IV. 

Q37. \\'hat about ORA's argument that regulators rely on book 

value and not market value?61 

A. I make the poim clearly in the Opening Testimony: 

I emphasize that the following assessment is a 

corroboration of the analyses above, not the cemral 

ntca tion in thi:;: tc:~ti , A clitic.: migln g\ ~ that 

I here is a mixing together of book value and market value. 

Such an argument misses the larger point, whioh is that the 

size of the re/(lli,•e CCIIfr(tCrion iu Wtlue ln the m(lrkerplace 

is • clear indication of the stanlingly increased risks in the 

indus,ry. which is the basis for come11ding that a higher 

return on equity is appropria .~2 (Emphasis in original.) 

The M&A testimony was not p•·oposed as the foundation for 

sening a rate of return, but as confi rmation of the reasonableness of 

the increase in equity cos1s and the relative size of the change. 

ORA does not respond to these data from the real world which, in 

my view. provide convincing evidence that equity costs have risen 

steeply. These data offer the CPUC an ultimate test about whether 

the rising cost of equity and falling equily va.lues are reasonable. 

RESPONSE TO ORA TESTIMONY ABOUT COST OF DEBT 

Q38. Ooes ORA accurately state that ""the applicants request the 

Commission to use a forward looking debt rate or S.S•!G," 

6t ORA Testimony, p. 41 , 1ines 14-19. 

62 Balhoff Opening Testimony. p. 64,1ines 14-18. 

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including for the chre.e lndel>endent Small LECs w hich do not 

have luty debt on their balance sheets?6J 

A. No. I was rar more precise chan ORA suggests) and it \\1as not my 

1estimony that a 5.5% cost of debt is more appropriate than actual 

debt costs fur carriers that have. debt. 1 stated fio111 the liSt!'t that 

··it is more typical to use embedded [debt] costs which are the 

'actual interest obligations, including amortization or discount 

premium, and expense of the utility's embedded debt 

outstanding. "'6-1 Second. I recommended using 5.5% for the 

carriers that had no debt ... if 1/te Commisslou wishes 10 use a 

h)'1}()1hetica/ capital sJr-uclure. 65 I offered my professiorlal opinion 

and recommendation that such a rate was reasonable because it 

was below the AAA rare and was slightly lower than the rate 

actually being paid by Sierra Telephone.66 And my testimony was 

careful in stating that the rate might be ,·casonable if the CPUC 

were to derermine rhat a hypothetical capital stntcrure were 

appropriate.67 Finally, I explained that the current Treasury rates 

63 ORA Testimony, p. 10, lines 9-13: see also p. IO,Iine 14. 

1\.l BalhoffOpeningTestimony. p. IS. lines 12-14. 

65 BalhofTOpening Testimony, p. 10, lines 13·16; p. 76, 1ines 1·11. 

66 Balhoff Opening Testimony, p. IO,Iines 5-9: see als<>. Exhibit MJB-14. 

67 BalhofTOpening Testimony, p. 76.1ines t t-17. 

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are at levels that are unsustainabJe. a proposition that ORA fai ls to 

addrcss.68 

Q39. Oo you agree with ORA that :octu:ol dtbt eosts should b e used 

for the LECs with d ebt on their balance sheets?69 

A. Yes, I agree that it is most appropriate to use embedded debt eosts 

tor the carriers that have actual debt. 

Q40. ORA cites the current Treasury and Fed eral Financing Bnnk 

("'FFB'•) rates, which are 2.82% and 2.47%, respectively.70 

Are these legitimate rates to use in calculating the cost of debt? 

A. No. As I e..xplained above and in my Opening Testimony. 1he low 

Treasury-based rates noted by ORA arc artifici ally depressed. 

ORA •s use of those rates to demonstrate the conservatism of its 

proposal is not convincing, as those rates are historically low. due 

to the temporary intervention of the Federal Reserve. and will 

almost certainly increase and return to more nonnalizcd levels. 

68 Balhoff Opening Testimony, p. 19. lines 2-10: DuO'& Phelps 2015 Cost of 

Capital, p. 3-3 "11te yields of U.S. government bonds in certain periods during 

and atler the (financial crisis of 2008) may have been artificially repressed, and 

therefore [are) likely unsustainable. Many market participants will agree that 

nominal U.S. government bond yields in recent periods have been artificially low. 

Even members of the Federal Open Market Committee(FOMC) have recently 

discussed the need to ·nonnalize• interest rates." (Emphasis in original.) 

69 ORA Testimony, p. 21 , lines 12- 14. 

70 ORA Testimony. p. 23. 1ines 1-9. 

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Q4t. liow does ORA determine that an imputed cost for debt for the 

2 Independent Small LECs should be 4.53%? 

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A. ORA averages the deb1 cos1s for 1he seven lndependem Small 

LECs 1ha1 have deb1 on 1heir balance shee1 10 arrive814.S3%.71 

ORA auemp1s 10 suppon i1s proposal as purponedly conserva1ive 

based on its belief that the carriers could access far less expensive 

FFB (2.47%-2.82%) or Rural U1ililies Service ("RUS") funding. 

In fact, 01ree of the seven Independent Small LECs have 2014 debt 

coSlS above 5.0% and two carriers have debt costs in the 4.5% to 

4.8% range, and the remaini ng two have 2014 debt costs of2.9% 

and 3.7%. However. all the California carriers have rates above 

those cited by ORA. including five of the seven wi01 rates well 

higher than the government subsidized rates, so ORA's claims 

about the availability of lower debt are not reflected in carriers' 

actual experiences.72 It is my understanding that carriers find 

certain conditions in the application process and in the covenants 

imposed by the government to be unfavorable, and the effect is that 

the govemmenl-subsidized loans are nor as readily available as 

ORA implies. 

71 ORA Testimony, p. 23,lines 1-2. 

12Jd.: Calaveras repons debt cosiS of 4.5%: Ducor repol'1s 5.1%. Fo,·esthill 

reports 4.77%; Sierra repor1s 5.53%; and Volcano repons 5.2%. BalhotTOpening 

Testimony, p. 72, Table 8. 

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Q42. bORA correct in stating that your testimony is inc.orr·ect or 

2 unsubst1mtiattd about the current lending environment, 

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including RUS lo:ms?7l 

A No. The RUS reports that FFB funding has conirncted sharply, as I 

reported in my Opening Testimony. less than one-third of the 

available funds have been placed each year since the federal 

telecommunications refom1s at the end of 20 I I.'" My 

conversations with the RUS have confirmed that the recent federal 

refonns have precipitated changes at the RUS. The federal 

regulatory reforms have prompted the RUS to be more 

conservative, requiring more detailed five-year forecasts and 

extending the approval process from a previous approval period of 

6-12 months to today's 12-18 months. I am aware of !he RUS 

concerns because I was requested to brief the cmire senior 

leadership at the RUS on several occasions regardi ng the 201 1 

refbm1s.. The senior RUS personnel were candid in reporting 

concerns about deteriorating operating and financial perfom1ance 

of the carriers to which they were lending. Because of !he 

concerns. I was also requested to brief the Under Secretary of the 

Depanment of Agriculture. Subsequentl y l was invited to discuss 

the challenging environment in two briefings. one with the White 

'> ORA Testimony, p. 25, lines 14-17. 

74 BalhofTOpening Testimony. p. 49, Table 2. 

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House and the second with the Secretary of Agriculture, in pan 

because of their concern that cenain carriers might fail. Based on 

my professional experience and conversations. I am confident that 

the funding environment has become significantly more difficult 

contraction in ac.tuallending. 

Q43. Oid tht FCC Staff Re1>ort, to which ORA cites, state thattloe 

A. 

small carritrs have acctss to less txpensive debt through 

subsidies, ttlld, httlte, lower-than-market eos1, for loans 

1>rovided by CoBank?7S 

Yes. but CoBank, which is pan of the Farm Credit System and is 

the largest private lender to small LECs. corrected the FCC Staff 

Rcpon within weeks of the release of the study, clarifying that: 

We ask that the Staff Repon be corrected to reflect 

accurately CoBank's requirement to charge a market 

interest rate to all telecommunications company 

borrowers and to remove any comments that suggest in 

any way that CoBank provides Stobsidized interest rate 

loans to 1eleconununications companies. We funher 

ask that the paragraph 49 of the Staff Repon be 

removed in its entirety given it is nlisleadi"g with 

respect to the availability of 1\onding to RLECs [rural 

local exchange caJTicrs) '~ 

75 FCC StatTRepon, para. 49. 

76 Coonments of CoBank. ACB. luthe Ma11er of 1/(lle 1/eprescriptiou Staff 1/epoN. 

Counect Am.,·ica Fund. WC Docket No. 10-90, July 25, 20 13 ("CoBank"), June 

2 1, 2013, available a1 

https://prodnet "~vw neca oru/publicationsdocs/wwpdl762113cobank.pdf p. 5. 

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CoBank also addressed the state of lhe lending environ men!, 

contending that it was misleading for the FCC SaaffRcp011 to state 

that all RLECs have access to "extensive funding•• 

from CoBank under the existing rate-of-return (RoR) 

u~gul~ iuu~. R~gletLal.lly. mauy RLEC:; tlo not ltl\!t:l 

CoBank's lending standards due 10 the various caps 

and limitations on universal service funding and in er~ 

carrier compensation. It is unfortunate that the 

uncertainty of a stable, predictable cost recovel)' 

mechanism is making it increasingly diflicult for 

CoBank 10 extend credit for the purpose of deploying 

ubiquitous rural broadb011d networks. 77 

CoBank went on tootrer a pointed summary about its financial 

perspective on the rural marketplace: 

As CoBank has commented numerous times, ror those 

cornmunication companies serving high-cost areas. 

deploying affordable broadband is not economically 

possible without a sufficient. sustainable, and 

predictable level of support. Co Bank views RoR 

regulation for RLEC cuswmers as an imponam 

component to their ability to continue to service 

existing debt and obtain future access to debt capital. 

RoR regulation is an imponant component ofCoBank's 

evaluation of potential loans. \Vhile incentive 

reb'lllatiOil can wort for larger corlsolidators, the vast 

majority of RLECs are roo smaJI. and operate in areas 

where subscriber density is too low for price-cap or 

other incentive regulation to be viable. \Vith the new 

caps and limitations on Universal Service Fund (USF) 

and the decrease of Interstate Common l..ine Support 

(ICLS) from the USF/JCC Transformation Order and 

Funher Notice. auy reduc11ou in the prescribed RoR 

will j111'1her decrease the ability of IILECs to obtai// 

d(~btcapita/. The authorized RoR is a factor in 

determining USF support and ICLS, therefore 

decreasing lhe RoR will further reduce the cost 

77 CoBank. pp. 4-5. 

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recovery possible. lfRLECs don't have a suffident. 

sustainable and predictable level ofsuppo1t, deploying 

afiordable broadband is not economically possible and: 

therefore, not bankable. 78 (Emphasis added.} 

It is notable that CoBank is not simply indicating that risks have 

increased to the point where lending standards have become more 

restrictive. but CoBank warns against the precise recommendation 

being made by ORA. CoBank states that reduced allowed rates of 

return will create greater limilations on credit. and pote11tially 

make the industry "nol bankable." The comments were provided 

by Robert F West. who is Senior Vice President ofCoBank and 

responsible for all ofCoBank•s professionals in its rural 

telecommunication division. Most iinaneial expens in the industry 

know that CoBank is careful and professional. It is my expen 

opinion that Rob West's commemary is not overstated when he 

points to the increasing risk in the smaii ·ILEC sector, the critical 

imponanceof appropriate rates of return, the greater vulnerability 

of the small caniers compared with larger caiTiers, and the 

growing problem with access to capital. 

21 Q44. l:low do you respo•td 10 ORI\'s rtliance on lht :usertion lh:tl 

22 ·'none of the Independent Small LECs has a pending loan 

78 CoBank. p. 6. 

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application with RUS., and none "has had a loan requesl 

denied from .lanuary 1, 201010 the presenl"?79 

A. The fact that none of the Independent Smaii iLECs has SO\lght a 

new loan is indicative of the regulato.y challenges about which 

Mr. West was writing and the growing concem in the industry 

about the risk of holding debt in a more uncerta.in regulatory and 

capital environment. The lack of pending applications is also 

another data point supponing the sharply-reduced loan totals and 

the increasingly careful review of pending loans at RUS. ORA 

posits that the Independent Small LECs were, at a time in the past, 

able to obtain loans from RUS and that no loans have recently been 

denied (a tautology because the Independent Small LECs did not 

apply for loans). 1ne logic is difficult to follow when ORA 

concludes that RUS' current lower cost of debt provides an 

important marker for the carriers. SO In response, I have cited the 

clear language ofCoBank's senioroflicer. Rob West. who states 

unequivocally to the contrary in his communications with the FCC. 

Additionally. while the RUS is not making public pronouncements, 

this govemment agency is in fac1 reponing that loall lOtals have 

fallen by more than 70% annually, on average, from 2012 to the 

present. Something more ominous is occurring here and ORA 

19 ORA Testimony, p. 24, 1ines 19-22. 

SO ORA Testimony. p. 23.1ines 5-9; p. 24. 1ines 1-22. 

51 1062160.1 
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chooses to dismiss it with the claim that .. no actuaJ evidence .. 

2 exiSIS in support of my testimony that the debt markets are today 

not what they were previously. As I have summarized, my views 

are amply supponed by the statements and actions of actual 

6 Q45. ORA st~ue-s that your t estimony include-s an implied 

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assum1Hion tha t a "'sudden and signifitant increase in 

Treasury ratts i~ inunint11t. ~st Is that a correcl rfl>resentation 

or your testimony Or your OJJinion? 

A. Absolutely not. My testimony is that interest rates are anificially 

and his10rically low due to extraordinary monetary policies. I do 

not expect a sudden and significant increase. but I do expect the 

casing of monetary controls. \\1hich will allow rates to rise to n1ore 

nomtalized levels. 111 fact. ORA's testimony points to the same 

insight., as ORA cites a statement from the Chairwoman of the 

Federal Reserve to the effect that rates will rise in a ·'prudent and 

gradual manner:•s2 aturally. this means that rates will rise. as the 

Federal Reserve eases the repressive controls that have reduced 

those rates. h is my professional view and it is the view of the 

expens to whicl> I pointed in my Opening Testimony that Treasury 

s• ORA Testimony, p. 27, lines 5-8. 

82 Jd. 

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rates today reflect a biased view of lending costs to the extent that 

2 ohosc raoes are proffered by ORA 10 support deb1 esoimaoes going 

forward. It is entjrely reasonable to expect rising rates over the 

next several years. Whether those increases a.re gradual or 

dlaHU2tit;., the likdihuoJ ufiHt;. ea~es defeats ORA's •eliMnt;.e un the 

6 current rates. 

Q46. Please comment on ORA's calculations about the incremental 

8 debonecess••'Y to raise the weighted average cost or debt to 

9 5.5%.83 

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A. My testimony recommends using the embedded cost of debt for 

each of the carriers aoohe time or the carriers' nne cases. ORA's 

t'estimony reflects a misplaced focus on how much incremental 

dcb1 will be necessary 10 cause certain carriers, which have deb1 

already. 10 arrive a1 a weighoed average of 5.5%. I did no1 oesoify 

that such an approach would be appropriate. I testified as follows: 

If the Commission were to posit a cost of debt figure 

as part of a hypothetical capioal strucoure calculaoion, I 

recommend that the Commission use a hypothetical 

debt rate of 5.5% for companies without any actual 

deb• raoes. This is above 1he currem median or 5.2% 

of ohe lndependem Small LECs. However, i1 is 

approximately the interest rate tJlat Sierra Telephone 

currently pays (5.53%). and approximates a ra1e lhat 

migh1 be expecoed in ohe fuiUre for any of ohese 

carriers, although it is vety possible the rates will rise 

83 ORA Testimony. p. 30. 1ines 10 ff. 

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higher. Again. this exercise is purely to arrive at a 

target WACC [weighted average cost of eapita1].84 

h remains my testimony t11at 5.5% is a reasonable estimate iftlu~ 

CPUC chooses co use a hypothetical capital structure. And it is 

still my testimony chat embedded costs of debe remain reasonable 

inputs in calculating a carrier's WACC. To gecche mosc up-co-date 

data related to a carrier's debt costs. the Commission should use 

the debe ~tat is in place acche time ofche company's race case. 

10 v. RESPONSE TO ORA TESTIMONY AIIOUTCAPITAL 

II STRUCTURE 

12 Q47. Did you recommend Challhe CPUC use" hypolhelical or an 

13 

14 

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16 

17 

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20 

actual capital structure in your Opening Testimony? 

A. I am awa1·e chacche 1ndependenc Small LI'!Cs have expressed a 

preference for a hypothetical capitaJ structure, but my testimony 

present·s recommendations for both an actual and a hypothetical 

capital structure. 85 If properly framed, either a hypothetical or an 

actual struccure could be financially and reasonably defensible. My 

Opening Testimony seated. however, thac an actual capital structure 

should not be used if it "is iuconsi.,·teul witltjon••ard-looking 

84 BalholTOpening Testimony, p. 76, lines 11 -14; p. IO, Iines 5-7. 

85 BalholTOpening Testimony. p. 16,lines 3 n·. 

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expec1a1ious: ntgardiug lhe appropriate mix of capital source.\'. "86 

2 (Emphasis added.) If equity should be built up, because it is 

judged to be too low, or if the actual capital Sti\Jeture includes 

excessive levels of equity, then a hypothetical structure might be 

u~cJ. I n::c.:onmu;:m.Jed iluu, iri:t hypoth~:tka1 structure is used, it 

6 would be reasonable to use a hypothetical 70%/30% equity-to-debt 

capital structure. 

8 Q48. Did you "request a single, uniform, hy(JOthetir.al 70% eqnity 

9 nnd 30o/o debt capitlll structure,' for ratemaking puq)oses?87 

10 

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12 

13 

14 

A. No. I proposed that 700/o equity ratio and 300/o debt ratio was a 

reasonable hypothetical capital structure.88 In every instance, I 

made it clear that I relied upon the CPUC' s judgment. but would 

propose such a capital structure if the CPUC were to choose to 

employ such an approach. 

86 Balhoff Opening Testimony, p. 16, 1ines 20 ff. 

87 ORA Testimony, p. ?, lines 10-12. 

ss BalholiOpening Testimony. p. 7l, lines 4-7; "Thus, I suggest that the 

Commission consider whether the fom1er zone of reasonableness (60%-80%) 

should be shifted higher above 70'% and likely to 80"/o to preserve forward· 

looking access to capital and to manage operating risk.'' See also Balhoff 

Opening Testimony, p. 76, lines 1-14; in response to a question "What do you 

recommend if the Commission were choose to use a hypothetical capital structure 

and establish a target WACC", I stated that " l would propose that the Commission 

employ a hypothetical capita.! stnoeture with approximately 70% to 80% equity." 

55 1062160.1 
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620REBUT57.eps

Q49. Oid you request that no specific capital structure should be 

2 mandated for anything mor·e than ratemnking puq)()Ses, as 

ORA has daimt>d?89 

A Such a question was not posed to me in my Opening Testimony 

and I ofl'ered no such opinion. I believe. however. that, whether a 

6 hypothetical or actual strucnare is used~ a reasonable timction of 

that structure is to calculate a resulting cost of capital for 

8 application in the ongoing round of rate cases. 

9 QSO. ORA r e<:onunends the use of a capital structure chat renetts 

10 the five--year average of the Independent Small LECs' capital 

I I structure.?O Is this rusonable? 

12 

13 

14 

15 

16 

A. The Commission's analysis of capital structure should employ an 

appropriate forward-looking view of capital structure.91 The risk 

in relying primarily on the llistoric five-year average. which is 

ORA ·s recommendation. is that the historical data do not properly 

capture higher or lower risk irl an industry that is undergoing rapid 

89QRA Testimony. p. 7, 1ines 12-13 

90 ORA Testimony, p. S, lines 11-13. 

9t BalhoffOpening Testimony, p. 16, 1ines 16 ff.; "his my undemanding that the 

Commission has attempted in the past to arrive at a more generic cost of capital 

that is forward-looking. and therefore the WACC may not be based strictly on any 

single co1npany's actual capital su\lcture. I suppon this goal of determining a 

cost of capital that is forward-looking, and I believe that it would be unreasonable 

to use a company's actual structure if such a s1ructure is inconsistent with 

tbrward-looking expectations regarding the appropriate mix of capita) sources." 

56 1062160.1 
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technological. competitive and regulatory changes. UlusiT8ting 

this, a clear movemCJll is discentiblc toward a higher propOJtion of 

equity, as demonstrated by the companies' reduction of their debt 

load since 2010. There appears to be a deliberate commitment to 

This is the rationale for suggesting a 70130 ratio of equity and debt 

QSI. ORA arg ues that the proxy grOUJl used to estirnate the CAPM 

belli in your Opening Teslimony has hig her debt ratios lhan 

the proxy grou1> used by the CPUC in 1997, and ORA then 

points to your more recent proxy group to question whether it 

is re:tsonable to maintain the 1997 zone of reasonableness 

(60% to 80 ). 2 WhaJ is your response to lhese claims? 

ORA's testimony is nonsensical as it juxtaposes lwo analyses thai 

have nothing to do with each other. except that both employ proxy 

groups. The fi rst proxy group was appropriately employed by the 

Commission in 1997 to detemtine capita.! structure and the second 

was used appropriately in my Opening Testimony to correct fora 

demonstrably incorrect CA PM beta. ORA illogically suggests 

using my beta·relared proxy group to de1ermine an appropriate 

capital StnJCIUre. 

92 ORA Testimony. p. IO.Iines 10 IT. 

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QS2. Why was and is the l997 proxy group helpful in setting the 

jappropriate capital structure and not in adjusting the. capital 

s1ruc:1ure today? 

A. For nearly 20 years. the Commission has relied on its 1997 capital 

structure analysis that has proven to be relatively reasonable, as rhe 

Independent Small lLECs. on average, have maintained an equity 

ratio near60% to 80'%. which was detennined in 1997 to be a 

.. zone of re<~sonab encss ... The CPUC stated in those decisions: 

The capital structures maintained by similar 

companies should reflect their collective efforts to 

nnance themselves so as. to minimize capital costs 

while preserving their financial i•ltegriry and ability 10 

anract capital. Uence. applicant compiled a group of 

ten publicly traded small independent telephone 

companies to arrive at a reasonable capital su\•Cture 

for applicant. The average capital structure of the ten 

comparable small indepe-ndent companies consisted 

or approximately 21% debt and 79"/o equity . . . . ORA 

calculated the 1994 and 1995 average common equity 

for California's eighteen small independent telephone 

companies. This secondary analysis showed an 

average common equity ratio of 70.3% for 1994 and 

75.9"/o for 1995 .... Upon om analyses of the 1994 

and 1995 average common equity for California· s 

eighteen small independent telephone companies and 

e'nlutuiou of a higher et[ltity ratio trend for smllllt>l' 

comtxmies, as demonstrated by comparing the results 

of ORA's large comparable companies to applicant's 

mid-size comparable companies analyses, we concur 

with applicant's assessment that a reasonable range of 

common equity for smaJi telephone companies, such 

as applicant. should be between 60% and 80% 

equity.93 (Emphasis added.) 

93 Dc.:ision No. 97-04·034. Application No. 95-12.075 (Filed December 26, 

58 1062160.1 
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More recently, the Independent Small LECs are becoming even 

2 more conservatively capitalized. which was a similar observation 

in 1997. with equity ratios rising. in spile of the fact that the 

carriers derive no incrementa] benefit in tenus of their rates. The 

~u ty tlio s i~ug lJ~~aus~Jisk i:j im.:aea:>iug.. which i:o. .necisdy 

6 the reason that a forward-looking hypothetical equity ratio should 

not be reduced ORA contends that it is not reasonable "to rely on 

the previously established zone of reasonableness ... " because the 

9 beta-related proxy group in my Opening Testimony yields different 

10 results for a capital structure (reducing the equity ratio).94 Again, I 

II was simply using the group to estimate a more useful figure for the 

12 industry beta. However, when applied to the capital structure. 

13 ORA's argument results in a nonsensical outcome-that the 

14 carriers should be assumed to have greater debt and lesser equity. 

15 Moreover. the markel·based evidence indicates precisely the 

16 opposite-that carriers are becoming more cautjous and increasing 

17 their equity ratios, apparently because the carriers believe that such 

18 conservatism is pn1dtnL 

19 QSJ. Is ORA stating l.bal your l)roxy group is incorrec-t in 

20 generating an appropriate beta? 

1995), No. 1.96-04-0 16 (Filed April 10, 1996). 

94 ORA Testimony. p. t l, lines 1-4. 

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A, No. 1l1e usc of the proxy group that I proposed to generate a beta 

2 is reasonable and unchallenged by ORA. ORA is apparently only 

arguing that the capital structure might be modified, and 1he equity 

ratio assumed for the Independent Small LECs might be reduced. 

Q54. So, is it your opinion that the appropriate proportion of equity 

6 should be higher now for the Independent Small LECs 

eorup:1red with the ratio in 1997? 

8 A. Yes. Risks have increased in the LEC sector since 1997. which 

9 suggests that companies will capitalize themselves more 

10 conservatively today than they did nearly twenty years ago. Rural 

II carriers are auempting to reduce their fixed obligations--including 

12 interest costs-to manage the higher risks associated with growing 

13 compe.tition. rapid technological change. and uncenain regulatory 

14 revenues. Again, it is not reasonable or prudemto reduce the 

IS previously-established range of 60%-80% equity today. If 

16 anything, it should be inc reased to assume relatively more equity 

17 \Vhich mitigates risks 

18 QSS. Is ORA corrett in excluding the 100% equity.finnnctd 

19 companies on the bllsis thai they skew the a\'erage equity 

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structure higher and thus resull iu a higher \VACC or rate of 

return??S 

A. No. ORA presents a table that shows dlatthe elimination of three 

companies with 100% equity ratios results in a lower equity ratio 

of 56.8%, using average statistics from the last five years. This is 

apparently an argument sponsored by ORA wilh a view co reduce 

the 20-ycar-old wne of reasonableness. Of course. it is a 

mathematical cenainty that the equity ratio is reduced when one 

eliminates the three highest equity ratios among the ten I LECs. just 

as certainly as the equity ratio would be raised if one eliminated 

the three lowest ratios. It is un.reasonable to perfonn either of 

these e.xclusions. which serve only to dis ton the data. More 

important. the companies with 100% equity are pan of a clear 

trend roward greaterequi1y. underscoring the increasing risks 

associated with maintaining significant debt burdens. Three of the 

te,11 co1npanies curremly have I 00% equity ratios and live of the 

other seven companies have increased equity ratios in 2014 by an 

average 689 basis points compared with lhe ratios in 2010. This 

suggests a growing financiaJ conservatism that cannot be 

ignored. 96 And. this increasing equity ratio undercuts ORA's 

9S ORA Testimony, p. 14, lines 1-6. 

96 Balhoff Opening Testimony, p. 72, Table 8; Calaveras' equity ratio improved 

from 20 I 0 to 2014 by 864 bps. Foresthill by 463 bps, J'onderosa by 397 bps, 

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argument that debt costs are actually low. LfORA were correct, 

2 the low government-subsidized debt rates assumed by ORA might 

motivate a company to incur increasing levels of debt co benefit 

from the spread between debt costs and equity costs. Contrary to 

h~t ORA ex.pt!l(.:lS, the (.;0111Vi1Uies a1 e lJc::.lntving in a maune t that 

6 clearly communicates !hat it is appropriate to have higher 

proponions of equity in today's higher-risk LEC environmen1. 

Since the Commission has not mandated that any of the companies 

9 actually maintain any panicular capital structure, the carriers> 

10 migration toward equity represents an undeniable trend reflec.ting 

II on the lndependelll Small LECs' views of the capital markets and 

12 the judgment of the carriers regarding prudent risk-miligation. 

13 VI. PROBLEMS WITH THE FCC STAI'I' REPORT 

14 Q56. C:ut you commen1 on ORA's reference to, and reliance on, the 

15 

16 

17 

IS 

19 

20 

F'CC Stafrs Report entitled u.Prescribing the Authorized Rate 

of Return"? 

A. Yes First. the ORA testimony makes reference in i1s "Retum on 

Equity" section to "the FCC's Report." which appears in those 

words or similar words four cimes in its filing.97 However, in the 

second paragraph of the FCC Staff document to which ORA refers, 

Sierra by 616 bps, a11d Volcano by 1.105 bps. 

97 ORA Testimony. pp. 39. 40. 42, and 43. 

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there is the clarification that " [t]he staff of the [FCC's) \Vi reline 

2 Competition Bureau has prepared this Staff Repon to assist the 

Commission a.s it considers prescribing a new at11horized rate of 

return "98 The FCC Staff Repon is a discussion document 

p1 c;pated by the fCC S1afi. anc.l ha~ nol bt:.:n adopled or <J ))provW 

6 by the FCC commissioners. In fact. the FCC Staff Repon states in 

its Introduction that the FCC rules r<.-quire attention to unain costs 

8 and capital structure " {ijjJhe fFCC/ e/ecJs JQrer>rescribe Jile 

9 tmlflori:ed rare ojretum."99 (Emphasis added.) Thus, the FCC 

I 0 Staff Repon reflects an inquiry in process. nOt a final 

I I detem1inarion that could penn it a citation to the FCC's authority. 

12 The document is incorrectly cited by ORA as the " FCC's Repon: · 

13 The Staff Report has no more authoritative value than the 

14 Application that the Independent Small LECs submiued to initiate 

t5 this proceeding. which reflects a specific proposal for how to 

16 calculate cost of equity. ORA's apparent attempt to dismiss a 

17 reasoned analysis of this issue by implying that the FCC has 

18 already reached a conclusion regarding adjustments to rate of 

19 return is misleading and shoold be rejected. 

20 Q57. Bas the FCC token accion to adopt che cc Staff Reporc? 

98 FCC Staff Repon. para. 2. 

99 FCC Staff Repon. para. 5. 

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A. No. As of today, about 34 months after the release of the FCC 

2 Staff discussion paper. the FCC has not yet represcribed the 

allowed ra1e of re1urn. nor, to the best of my knowledge, has it 

opined publicly about the value of any of the content in the FCC 

Staff Report. A revit:w ofthewrrrrrrents in resporm: tu tire FCC 

6 Staff Repon, as compiled on the FCC's website indicates that the 

majority of the replies contest the reductions proposed in the 

8 Repon.IOO h is my opinion1ha1 the commentaries arguing against 

9 lowering the rate of retum provide more substantive analyses and 

10 are better reasoned. 

II QSS. In your opinion. are thtre material flaws in the analysis in the 

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IS 

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18 

19 

20 

FCC Staff Repot·l? 

A. Yes. First. the FCC Staff Repon relies on a proxy group of 

companies that appe-ars to be fundamentally different from rural 

ILECs and cenainly different from the Independent Small LECs 

before the Commission in ~tis proceeding. Second, ~te calculation 

of equity costs does not include necessary adjustments to reflect 

risks arising from site or liquidity/marketability. Third. for the 

CAPM, the FCC Staff Repon uses a very low risk-free rate. which 

is today artificially depressed by economic conditions and an 

IOO While certain commentcrs noted that the criticisms came from rural m1de 

associations, consultants and rural carriers, such input is logicaJ- no1 simply 

because the carriers are self·imerested, but also because they are more 

knowledgeable about the issues and risks. 

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aggressive fiscal policy. 101 Founh, the Staff Repon does not 

2 accurately rellcct rural TLECs' reduced access to the debt markets. 

Finally, the StaO'Repon does not ae<:ount in any way for the 

unique political, regulatoty, and marl<et risks that the Independent 

Small LI!Cs face in California, J bclit:ve the flaws arc so profound 

6 that they render the FCC Staff Repon unreliable. Even if the FCC 

commissioners were to usc the same approach. in whole or in part. 

8 the analysis remains serioosly nawed l11is Commission should 

9 examine the issue more closely and consider the full range of 

10 facrors that I have outlined here and in my Opening Testimony. 

II QS9. What proxy group do.sthe Staff use and why has the sele<tion 

12 been crilitized? 

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16 

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A. The Stan· uses a proxy group of companies identified on 1he basis 

of certain criteria: companies that (i) repon that 10% of their 

overall operations indude price--regulated interstate 

telecommunications services. (ii) serve some n~ral regions, and (iii) 

were ILECs that were judged 10 publish reliable financial data.tOl 

The criteria. therefore, provided a very Tow 10"/o threshold for 

similarity of regulaled operations. failed to ae<:ounl for 1he 

101 FCC Staff Report, para. 65: .. Because we bel ieve the interest rate that is the 

best predictor of the future interest rate on government securities is the current 

interest rate (which is consistent with the hypothesis tl1at interest rates follow a 

random walk). we use the cuiTent rate as the risk-free imerest ra1e.· 

tOl FCC StalfRepon. para. 12. 

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financial challenge when a relatively large proportion of the 

business is rural. and chose to emphasize an analysis of carriers 

that were required to publish significant financial information and 

attrnct financial analytical covernge. Thus, the financial profile of 

tht: uuivetse of~onlpauie.s-- lle strt:allc:~LI .. ptoxy g.uup"- ust:U in 

the FCC Staff Report is, by definition, markedly different from that 

of the Independent Small LECs', which are not remotely as 

diversified as the large carriers. have 100% of their intrastate 

telephone operations regulated, and I 00% of their territories 

focused on rural regions. Based on criteria that support the 

inclusion of patently non-comparnble companies. the FCC Staff 

proposed a " proxy group" that included the large regional holding 

companies-AT&T. Verizon and Century Link. Additionally, the 

FCC included mid-sized companies Alaska Communications 

Systems, Cincinnati Bell, FairPoint. Frontier, Hawaiian Telcom, 

and Windst.ream. Finally, the Staff rounded out the sixteen proxy 

companies with publicly-traded "rurnl" carriers. including 

HickoryTech (which was then Envemis and is now merged into 

Consolidated Communications), Shenandoah Telecommunications.. 

TDS, Consolidated Communications, New Ulm, Lumos and 

Alleva (which at that time owned an [LEC, Warwick Valley). The 

Staff made a judgmcm that the smaller RLECs were less reliable 

proxies. which created an obvious deti ni1ional bias, because fewer 

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2 

6 

analyst estimates were available to use for the Discounted Cash 

Flow ("DCF") model and be<:ause the stocks for those companies 

are 1raded infrequently. In shon, the FCC Staff presents a set of 

criteria that pre-detennines reliance on large public and diversified 

wmpa.ui~ witl1 a 1isk rufil u:~ulatu y Uepemlem.:e. 

diversification of operations .. concentrated service regions. and 

access to capital markets- that is entirely diOerent from the 

Independent Small LECs. 

9 Q60. Oo you have rurther eommen1s about the proxy grou1)? 

10 A. Yes. I recognize the FCC StatTs challenges in choosing a proxy 

II 

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IS 

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group. particularly as so many smaller carriers with publicly-traded 

stocks have been merged into other entities or sold in the last 

decade. Despite these limitations. a rational and knowledgeable 

investor would see no meaningful similarities between the larger 

carriers and the Independent Small LECs. In some ways. the 

businesses of smaller ILECs and the larger carriers may have once 

been more sirnilar, but those similarities have disappeared over the 

last twenty years. Today. the differences are increasingly 

consequential from an operational and financial perspective. 

20 Q61. Pleasee•1>lain the consequential differences that you see 

21 

22 

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between the proxy group :1nd smaller llECs. 

I can summarize the differences. 

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• Verizon and AT&T have wireless operations that have 

generated more revenue than any other segment of their 

businesses, making their businesses very different from 

those of the Independent Small LECs. For2015, AT&T 

reponed that 500/o of its revenues were generated by 

wireless, while Verizon reported 71% of its revenues were 

generated by wireless and the wireless proportion is 

growing. Thus, Verizon and AT&T have growth 

opponunities and meaningful diversification that do not 

e.xist for rum! telephone companies. and those trends are 

moving in the opposite direction for the Independent Small 

LECs-

• Vinually every other carrier on the FCC Staff's proxy list 

has other significant differences from the majority of rural 

ILECs, including and perhaps espeeially from the 

Independent Small LECs. 

o Specifically, as of the time when the FCC StaiT 

Repon was released, Centurylink was a large 

multi·state carrier with significant enterprise and 

data center operations (the legacy ILEC operations 

at the end of 2013 were 42% of total revenues) and 

growth was generated by those two sectors: 

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o Cincinnati Bell serves a dense cluster of customers 

in and around a major metropolitan city. supporting 

a very diOerem regulatory and cost profile: 

o Aheva was an integrated communications provider 

(the :s111aii iLEC opefatio ns oouttibute vittuct.lly uo 

cash now), making the core of that company vastly 

diOerent from the rural carriers: and 

o Windstream relied on multi-state operations with 

diversified data center services and competirive 

local exchange carrier ("CLEC") businesses (only 

22% of total 2013 revenues were from consumer 

services). 

The FCC Stan· explained that the reason for including these 

carriers was the Fcc·s requirement for a large enough sample of 

analysts' estimates to ensure the value of the DCF constant growth 

model. Because the FCC purportedly sc:><oght reliable data. it 

included carriers that had risks and prospects vastly different from 

1he smaller. private rLECs. From an investment t>oint of view. 

which is what should infonn the determination of the appropriate 

retunt on equity and allowed rate orretunt. there are some 

superficial similarities between the proxy group and the 

IJldependent S•nall LECs: however. the significant differences 

require adjustments to the cosr-of·capital estimation models.. 

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particularly because the size and diversified operations of the large 

carriers result in lower equily risk compared with the smaller 

carriers. 

Q62. What about the other problems you note regarding the FCC 

Staff Report? 

A. Two other fundamental problems with the Staff Report 

u11avoidably lead to a nawed analysis. First. the Staff assumes it 

has correctly determined the risk-free rate. which the FCC Stall' 

astonishingly se1s at I. 92% based on the ten·year Treasury note at 

the time. As detailed in my Opening Testimony. the adoption of so 

low a " risk-free rate" in a forward-looking proceeding is not 

defensible because the current interest rates are at historic low 

levels, which arc generally regarded as unsustainable.tOJ I have 

already noted that the major valuation finnsIbbotson/Morningstar and Duff & Phelps- set the risk-free rate 

well higher than the figure in the FCC Staff Report based on the 

f8ct that the current Treasury rates have been managed to 

extraordinarily depressed levels. The FCC does not attempt to 

match the risk·free rate·s term with the equity premium which. is 

tOJ FCC Staff Report, para. 64: " In our detailed analysis below, we take the 

interest rate on the I 0-year Treasury note as the risk free rate because the standard 

deviation of the mean historical equity premium measured relative to returns on 

IO·year Treasury securities is readily available. This rate was 1.92 percent as of 

March 26. 2013." 

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reported to be 5.88% by Professor Damodaran. too A second major 

2 problem is that the FCC uses a DCF valuation, which estimates 

value using dividend and grow~' expectations that should be 

applied to a stable industry, which the ILEC sector is not. 11>e 

ILCC businc;ss rnodd is undergoing a wn:nchin!' set or 

6 technological. competitive and regulatory changes. as I have 

described at I eng~> in my Opening Testimony. The assumption 

8 1ha' dividends will be paid inro perperuity in such an environment 

9 is a highly questionable-and I believe, incorrect- proposition. 

10 Q63. Are those issues the txtent of the pt•oblems with the FCC Staff 

II Report? 

12 

13 

14 

IS 

A. No. 11te problems with the FCC Report include other factors. If 

one studies the FCC Staff Report more carefully, it becomes clear 

that there are other anomalies. For example. the embedded cost of 

debt is higher than the computed cost of equity for six of the 

tOO FCC Staff Report. para 7 1· 72. Aswath Damodaran, Professor of Finance at 

the Stem School of Business at ew York University, available at 

htto 1/pages.stem nYIJ edu/-adnmodar/New Home Page/datafilelhistretSP html. 

See also Professor Damodaran's spreadsheet available at 

hup /fwww <tem "''' edul-adamodarlpc/datasetslindnante xis. While Professor 

Damodaran provides the companies included in. for example. "Telecom. 

Services;· and provides ticker symbols as well as the countries where services are 

provided. there are no data which would pem1it us to understand and analyze the 

summary results which he reports. 

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sixteen carriers. lOS The FCC Staff admit·s that this makes no sense, 

and I agree that it does notl06 However, the FCC Staff Report 

dispenses with the anomalies, stating that when it linds that the 

debt costs are higher than the equity costs.. it is making adjusunents 

to 1fu: c.:os-t of t:<.luity to .:ns-un: that tht: cost of t!(IUity is no luw.:.r 

than the cost of calculated debt. h is my opinion that.. when data 

do not make sense. a more careful c.: ... amination of the assumptions, 

the inp\ns. and the model is needed It is not sufficient to make 

arbilrary adjustments to oO'set irrational results, especially when 

the results are likely signaling that the model itself and the inputs 

are wrong. The FCC Staff Repon, however, chooses to adjust 

certain of the unreasonable outputs, apparently without reexamination of the underlying premises. The FCC Staff Reportand its conclusions-do not provide a reasonable foundation for 

tos FCC Staff Report. p.ua. 84: "We note that theCA I'M estimates of the cost of 

debt for six of the sixteen carriers · New Ulm. Alteva, Alaska. Hawaiian, and 

Frontier· are actually higher than the cost of equity. For New Ulm: the cost of 

debt is 5.4 I percent (versus 4.83 percent cost of equity); for Alleva: 5.89 percent 

(versus 5.0 percent): for Alaska: 7.38 (versus 6.84 percent); for Hawaiian: 7.52 

(versus 6.30 percent): and for Frontier, 8.27 (versus 7.56 percent) ·· 

106 FCC Staff Repon, paras. 86 .. 87: .. (r(equiring l mi11imun1 return to equi~· necessary 10 

ensure :\II carriers· cost of equity is not less than thtircost of debt. we conclude that the 

CAPM analysis suggests the WACC most likely lies between 7.39 and 8.58 percent. Any 

equity premium less Lh:m 7.57 percent n:suhs in a cos• of equity ahat is less tl1an the cost 

of debt for some of our finns. \\hich violates ::t Nnd:uncntal precept of financial 

economics. strongly implying error in our estimates. As an approximation designed to 

remove this onoma . we pcrfonued lhe cost of equity ~1.lcu :uion usmg 7 51 pcrecn1 ilS 

the lower bound of the marlcct premium, obtaining cos1 of equity ranges of8.69·11.3S 

pcrrent:' 

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decision-making by ~1e FCC or by ~1e CPUC. ORA's reliance 

2 upon 1he FCC Sian· Report is misplaced. 

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Q64. Oo you have esrimaces about the illiJ)att on rur:tl earriers ir tht 

eost or eq uity were to beset at the reduced levtls recommended 

in the FCC Slaff Reporl? 

A. I do no• know 1he specific financial effect, bu1 John S1aurulakis. 

Inc. (" JSI"} s1a1ed in an FCC filing. on 1he basis ofi1s analysis of 

IS I cos1-company clients. that the ciTect on rural carriers would be 

to reduce per-line per-month regulated revenues by approximately 

S4.99 or $3.99, depending on whether one assumes the low or high 

rate of return that the FCC Staff proposcs.107 While JSI did not 

comment further. no avoided costs are associated with such a 

revenue reduction, and 11tcrefore the operating cash 11ows should 

fall by the same amount. If one were to assume that the rates were 

S.30 monthly and the EBlTOA margins were 40%, rate reductions 

arising from the ve•y low 8.06% and s.n% allowed return on 

equily capilal proposed by the FCC S1aff would resuh in the carrier 

losing opera1ing cash 11ow per cus1omer 1hat amoums 10 41% or 

33% of its regulated total operating cash flow, respectively. This 

is not an inconsequential reduction. if JSI is correct. I do not 

I07 Com.ncms of John Staundakis, Inc .• On Ra1e of Re1um Represcrip1ion Staff 

Repon, July2S. 2013, available a! 

htto://www jsitel com/filcs/JSI Rate of Return Renrescription Comments.pdf. 

pp. S-6. 

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believe that reasonable im•estment in rural telephone company 

infrasti\ICture eot1ld be sustained at these levels. This was 1he same 

point chat CoBank made earlier \\~len it sugges1ed that che sector 

could become "nol bankable." 

Q65. Ooes the FCC Sraff Reporl make adjuslmeuls 10 I he cosl of 

capital to renect risk :1rising from size, liquidity, and 

marketability? 

A. No. The FCC StaiT Repon does not provide any allowance for 

factors reflecting size or marketability/liquidity premia to adjust 

the CAPM. ln fact, ciling a single source thai purpons to 

summarize other s1udies. !he FCC S1afr suggeSIS 1hat any size 

premium disappea.1'S over 1ime.108 11tis is a s1anling conclusion 

based on one citation. panicularly when that source SUites that 

chere is a liquidity risk for smaller companies and concedes that 

1here is demonstrably higher risk for the sma11est-decile 

companies, as I explained earlier. Most valuation professionals 

rely on the data and resources provided by companies such as 

Montingstar, Inc. (Ibbotson Srocks, Bonds. Bi lls. and lnOa1ion 

lOS FCC S1a1T Report, para. 75: "NECA asserrs that '(e)xtensive research documents that small capital ization tim1s such as the average RLEC also require 

an additional risk premium ofabou1 1.53 percent' However, recent research [the 

FCC S1a1T cites one 20 II repon] indica1es 1ha1 1he size efrecl 'seems to vary over 

time or even disappears.· with smaller finns in the United States not performing 

significantly better than large ones from 1980 onward. Therefore, we do no1 

recommend adding a risk premium based on size to the cost of equity." 

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19 

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('"SBBI" )) and Duff & Phelps, LLC. 109 As I outline below, 

significant authorities have responded to those claims. providing 

spccifocexplanations for the cyclical anomalies. and analyzing 

additional data that refute the 1980s-based data. Both 

bbo ~on Mornin~tar and Otrn~ & Phd ps are clt.!(ll th~l adju:wru;tHs 

should be made for size efTect·s and possibly other factors. For 

e.xarnple, Duff & Phelps in its 201 J Valuaricm H(u«l/x)(}k writes: 

Research tells us that the CAPM often misprices risk for 

certain inveslments. Spe<:ifically, researchers have observed 

that commonly usod methods of measuring risk used in the 

CAPM (specifically, beta) often understate the risk (and thus 

understate the required return) for small company stocks. 

Examination of market evidence shows that within the 

context of CAPM. beta does not fully explain the diftercnce 

between small company retun>s and large company rctums. 

In other words. 1he historical (obse,rved) excess return of 

portfolios comprised of smaller companies is greater than the 

excess return predicted by the CAPM for these portfolios. 

This "premium over CAPM .. is commonly known as a "betaadjusted size p•·e•nitun'' or simply "site premium." ItO 

Dutr & Phelps is clear that research verifies the necessity for 

application of a premium to reflect market-based risk beyond the 

overall equity renam for smaller companies compared \\~th larger 

companies. Ibbotson/Mornings-tar also provides statistics to 

t09 Jbbotson SBBI2013 Valuation Yearbook, Market Results for Stocks, Bonds, 

Bills. and Inflation 1926-2012 (Chicago, IL: Morningstar, Inc., 2013) (" Ibbotson 

2013 Yearbook"); Ibbotson SBBI2014 Classic Yearbook, Market Results for 

Stocks, Bonds, Bills. and Inflation I 926-2013 (Chicago, IL: Moming.star. Inc .. 

2014) (" Ibbotson 2014 Classic Yeart>ook"); Duff & Phelps, 2014 Valuation 

Handbook. Guide to Cost of Capital (Chicago. IL: Dull' & Phelps, LLC, 2014). 

tto Duff & Phelps. 2013 Valuation Handbook. Guide to Cost of Capital (Chicago. 

U..: Duff & Phelps, LLC, 2013), p. 60. 

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demonstrate the effect of size on retums, and explains that .. [i]f 

2 small companies did not provide higher long-tenm returns. 

investors would be more inclined 10 invest in 1he less risky stocks 

of large companies. 111 

Q66. Are the.re eriliques in the current financiallitersuure 

6 addressing the issues raised by the FCC concerning the 

s 

9 

10 

II 

12 

13 

14 

15 

16 

17 

"dis:•ppearance" of the size premium in the early 1980s? 

A. Yes. Prau and Grabowski explain that the methodology of the new 

studies use average returns that obscure "pcrfomtance." lll They 

describe how, using a more appropriate methodology. small stocks 

actually "outperfonned" large stocks even using early 1980s start 

dates (contrary to the argument that small·company stocks 

performed similarly 10 large-company stocks beginning in that 

period), which means that the cost of equity is higlter for smaller 

companies. The exception to this '"outperfonnance" occurred 

when the stan date was 1983 -1 984. whe11 1here we.re. according to 

Hou and Van Dijk, specific cash now shocks in the market that the 

Ill Ibbotson 2014 Classic Yearbook. p. 109. 

m Prau and Grabowski Cost of Capital 2014, p. 352. Exhibit 15. 13: Prau and 

Grabowski posit a $1 investment in Fund A that rises each year by 10% over the 

ten year period except in year 5 when it falls by 70%, resulting in an annual 

average perfonnance of2%. and an ending principal of$0.71 Fund B tises by 

3% in year one, 1% in year two, and then alternates 3% and 1% in subsequen1 

years, 10 average 2% annual returns. but to end the decade with S 1.22. The annual 

averages in 1he two funds were the same 2%, but the "perfom1ance" of fund B 

was superior. 

76 1062160.1 
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2 

6 

8 

9 

10 

II 

12 

13 

14 

IS 

16 

17 

18 

19 

20 

researchers believe explain l.he anomaly concerning relatively 

lower returns for small stocks and higher returns for larger 

stocks. Ill In their most recent edition of"Cost of Capital." Prall 

and Grabowski explicilly respond to the data compiled in the Crain 

s1ill providing superior returns. which means that the estimation for 

their cost of equity requires the addition of a size premium.114 Ln 

its 2013 Risk l'remium Repon, Duff & Phelps responds to the 

critics who contend that the size efl"ect has disappeared since 1980. 

In the most recent periods, say 2000-2012, small-cap 

stocks have outperfonned large·cap stocks signiticantly. 

Referring to Graph 13, a Sl investment in December 1999 

in CRSP decile 10 (small-cap stocks) would have increased 

to $3.79 by tl>c end of December 2012, while a $1 

investment in December 1999 in CRSP decile I (large-cap 

stocks) would have only increased to SI.06 by the end of 

December 2012 . ... The average annual arithmetic return 

of decile I (the largest-cap stocks) was 2.12 percent over 

the 2000-2012 period (and 0.42 percent measured on a 

geometric basis). while the average annual arithmetic return 

ttJ Kewei Hou and Mathias A. Van Dijk, "Resurrecting the Size Effect: Finn 

Size, Profitabi lity Shocks, and Expected Stock Returns." Charles A. Dice Center 

Worki11g Paper no. 2010-1. July 13, 2012. available at 

ll!lp //ssrn com/abstract- 1368705. See. also, Duff & Phelps Risk Premium 

Report 2013, available at htm_//www dufTandphelps com/assets!Jxffsus/publ ications/valuation/C excemt>%2020 13%20duff0/o20ohelps%20risk%20prem 

ium%20reoort pdf, ("20 13 Risk Premium Repon"), p. 34. See Prall and 

Grabowski Cost ofCapita12014, p. 355: " [Hou and Van Dijk' adj usted the 

realized returns [in the 1980s and 1990s) for the cash flow shocks. and the result 

was that the returns of small fim1s on a pro fonna basis exceeded the returns of 

large finns by approximately 10% per annum. consistent \\~th the size premium in 

prior periods." 

114 Pran and Grabowski Cost ofCapital2014, pp. 350-358. 

77 1062160.1 
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620REBUT79.eps

I 

2 

6 

of decile 10 (the smallest-cap stocks) was 16.62 percent 

(and 10.78 percent measured on a geometric basis).HS 

Still. the FCC Staff Report's approach excludes size-effect, citing 

the one article (and its sources) as justification. and summarily 

arguing that cost of capital is fundamentally a market return. 

modified by a teleconununieations industry beta that slightly 

reduces the market return. This approach is contrary to that 

8 recommended by the major fin_ancial sources and it is inconsistcm 

9 with the significant data compiled over multiple periods, includi ng 

I 0 the most recent two decades. 

II Q67. What adjustments typically are made by regulatory 

12 commissions :and financial analysts 10 account for specific 

13 risks? 

14 

I 5 

16 

17 

18 

19 

20 

21 

A. Small companies are assumed to carry greater risk, as explained 

above, which supports an adjustment to the large-company proxy 

calculation by adding a size premium. This straightforward 

rationale is spelled out by the American Society of Appraisers, 

which e.-<plains: 

A discount or premium is warranted when 

characterisrics afTecting the value of the subject 

interest di t'fer sufticicntly from those inherent in the 

ItS 2013 Risk Premium Repo1t. p. 35. 

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2 

6 

8 

9 

10 

I I 

12 

13 

14 

base value to which the discount or premium is 

appliocJ.116 

Ln face, there are material and obvious differences bee ween the 

Independent Small LECs and the FCC StaO'Repon's proxy group 

As e-xplained above, the FCC proxy group includes large. 

diversified carriers wilh services in meaningful growth segments. 

such as wireless, fiber transpon and data cemers.117 Funher, the 

larger carriers in the proxy group are nearly all engagod in 

aggressive acquisition and diversification activities, which provide 

chem 'vith opportunities for cash Oow growth and risk mitigation. 

These factors are size-related "characteristics affecting 1.he value of 

the subjcet interest" such that adjustments to reflect the increased 

risk in the equity cost of the Independent Small LECs are 

required. II& 

116 Shannon Pratt, "Overview of Business Valuation DiSCOUJltS and Premiums and 

the Bases to Which They are Applied .. , p. 2, available at 

http 1/wwvv.shnnnonprau.com/article/ovcrvicw business valuation discounts pre 

milllllS pdf. 

117 The proxy group is presentod in the FCC Staffs Appendix F. Enventis Corp., 

TDS, New Ulm, Shenandoah Telecom, Consolidated Communications. Lumos, 

Alleva. Windstream, Alaska Communications Systems. Hawaiian Telcom. 

Frontier Communications. FairPoint, Cincinnati Bell, CenturyLink. Verizon and 

AT&T. 

tiS Also, see the American Institute of Public Aceoumams. Suaemc!llt on 

Standards for Valuation Service!.·, para 40. available at 

(http:l/www.aicpa.org/lnterestAreas/ForensicAndValuation/Down1oadableDocum 

ents/SSVS_Full_ Version.pdt): "During the course of a valuation engagement, the 

valuation analyst should consider whether valuation adjustments (discounts or 

premiums) should be made to apre.(ldjustmem value. Examples of valuation 

adjustments for valuation of a business. busi1less ownership imeres'l, or security 

79 1062160.1 
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620REBUT81.eps

Q68. Are )'Ou saying that ORA's exclusion of the size effect is not 

2 justified? 

A. Yes. ORA poims Jo literature ll~al ac/ually suppor1s the opposite 

conclusum, wluch ls thai a .,·i:e jaclor should he mcluded ORA 

has provided no jus1ification for excluding a size factor that the 

6 CPUC found to be appropriate in 1997. except to cite to the FCC 

Staff Report. Tlte FCC Staff Report justifies its exclusion of the 

8 size factor only by citing to the Michael Crain literature survey. 

9 However, this study explains that other factors may better explain 

I 0 the size effect. and that the size effect is observable in the three 

I I smallest deeiles. The Independent SmaJI LECs faJI in the smtdlest 

12 <iftlte four qual'liles oftlte tent it or smallest decile. Tllus. ORA has 

13 not only failed to show that a size factor should be excluded. but 

14 has pointed to sources that justify the inclusion of a size factor. 

15 VIII. CONCLUDING COMMENTS 

16 Q69. Please summarize your testimony in response to ORA. 

17 A. I have provided a disciplined and comprehensively sourced 

18 

19 

20 

framework for the CPUC's consideration of capital structure, 

imputed debt costs and an estimation of equity costs. Titc CPUC 

and ORA can assess those sources. data. and the logic based on 

include a discoulll for lack ofmarketahilily 11r liquidily and a discoum for lack of 

comrol." [Emphasis in the original] 

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6 

9 

10 

II 

12 

13 

14 

IS 

16 

17 

IS 

19 

20 

21 

22 

23 

1062160.1 

rigorous and scholarly approaches that test and re.-test the 

conclusions. In response~ ORA has provided virtually no sources 

and does not directly challenge the specific findings in my 

Opening Testimony Withoot valid citations, ORA simply 

vpu~s us~ur~ Ct\PM that is thiveuiJy twu inputs tlu:ll ORA 

believes arc appropriate-a very low three-year average Treasury 

rate of 2.9 1 %- plus 5.88%. which ORA adopted from the fCC 

Staff Report. Contrary to the Supreme Coon opinions and the 

opinions of reputable financi al experts, ORA does not propose 

analysis of any indusuy-specific risks. and ORA rejects importam 

soorces that call for size and liquidity fac.tors. ORA also proposes 

a capital structure that is below the 1997 CPUC-defined zone of 

reasonableness (equity ratio of 60"/o-80%) and ORA relies on an 

average capital structure calculated after arbitrarily excluding the 

three companies with the highest equity ratios. ORA also proposes 

4.53% as the imputed debt costs for carriers that do currently have 

debt. by contrast with our recommendation of S.S%. I believe that 

I have presemed and supponed a balanced and clearly defensible 

se1 of findings that ORA has not refuted. As surprising as the data 

may appear to be, the cost of C<(uity has cenainly risen since 1997. 

The data suppon a cost of e<Juity that is above 20% based on M&A 

data. ~lowevcr, I have relied on the traditional CAPM fonnulae, 

and have found an equity cost of I 8.5% and proposed a W ACC of 

8 1 
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6 

9 

10 

II 

12 

13 

14 

14.6%. As I have e.xplained and sourced. I v.<as conservative by 

applying no liquidity or marketability premium. 1 used a size 

premium that is 641 basls points lower than the I I. 98% 

recommended by Dun· & Phelps for the smallest of companies (the 

tO£ g.•uu.,ing. into whid 1 the lmkpcndeut Suntll l"LEC:s dt:atly 

fall}. I also used a beta that is relatively low at 1.06, in spite of the 

fact that it is drawn from proxies that are all substantially larger. 

more liquid, more capable of acquisitions. and more diversified. 

Finally, I used a risk-free rate that is the lower of1he two options 

(a higher result is generated when using total return on the 

Treasury note). My testimony is well-founded in valuation and 

regulatory practice, and is not aggressive. It should guide the 

Commission's CO•lsideralion of establishing a cost of capital in this 

proccedi ng. 

15 Q70. Does this conclude your testimony? 

16 A. Yes Thankyou 

17 

82 1062160.1 
172 

The CHAIRMAN. Thank you very much. 

The Subcommittee now recognizes Ms. Bloomfield. 

STATEMENT OF SHIRLEY BLOOMFIELD, CHIEF EXECUTIVE 

OFFICER, NTCA-THE RURAL BROADBAND ASSOCIATION 

Ms. BLOOMFIELD. Thank you very much, Chairman Wicker, 

Ranking Member Schatz, members of the Subcommittee. Good 

morning and thank you very much for the invitation to participate 

in today’s hearing. I’m Shirley Bloomfield, CEO of NTCA-The Rural 

Broadband Association. We represent about 850 small businesses 

who are deploying rural broadband infrastructure in 46 states. 

For decades, small rural broadband providers have led the 

charge in deploying state-of-the-art communications services to 

their consumers, who are their neighbors. However, the job is not 

done. As a country, we must both reach the unserved and ensure 

that rural America stays connected in the great challenges that 

face us with distance and density. 

Last year, the Hudson Institute, in conjunction with the Foundation for Rural Service, released a report examining the economic 

impacts and benefits of broadband infrastructure. The report determined that the investments in ongoing operations of small rural 

broadband providers contributed $24.1 billion annually to the Nation’s gross domestic product. The report also found that rural 

broadband investment is an important driver of job growth in both 

urban and rural America. And, finally, the study found that rural 

broadband supported over $100 billion in e-commerce in 2015. 

None of this economic activity would be possible without the Universal Service Fund, or USF, which is essential to making the business case for investment in rural broadband. The High Cost USF 

program is the most successful example of a public-private partnership in the broadband space. Remade as the Connect America Fund 

in recent years, USF helps unleash billions of dollars in private investment in rural markets that are simply uneconomic to serve and 

would not and could not otherwise justify obtaining loans or using 

cash-flows to build broadband to. 

The reforms in recent years also help to ensure that USF support 

is targeted toward areas of real need spent on network investments 

and operations and tied to the delivery of service at very specific 

locations. Unfortunately, despite these reforms, the viability and effectiveness of universal service is in peril. While regulatory uncertainty in the USF program has frankly been a fact of life for these 

small network operators for many years, the effects of a budget 

that has been flat for almost a decade are finally coming home to 

roost for rural consumers. 

There isn’t a day that goes by that I don’t get a phone call from 

one of my community-based providers on how the budget mechanism is having them cancel broadband deployment plans, holding 

their standalone broadband rates simply too high, or they’re laying 

off staff. In Mississippi, instead of upgrades in Fulton, the only investments will be to remain operational. And in the Upper Midwest, a co-op is canceling their 2018 projects, which means 500 people who have never had broadband will not get broadband next 

year. 

173 

There’s concern in Washington and across the country about the 

USF budget shortfall. In May 2017, nearly 170 Members of Congress, including Chairman Wicker and many members of this subcommittee, wrote to the FCC expressing serious concern about how 

the USF budget shortfall will undermine private infrastructure investment and consumer rates. We’re hopeful that such bipartisan 

congressional leadership, we will see these issues addressed so that 

the promise of last year’s USF reforms can actually be realized by 

millions of rural consumers. 

While there are several potential options to address this shortfall, doing nothing is no longer an option if rural broadband deployment truly is going to be a public policy priority. The time to act 

really is now. One option is for the FCC to leverage the existing 

USF mechanism to fill the shortfall. This would involve the use of 

existing USF program funds or reserves, funds that the FCC has 

collected but has not yet disbursed, for USF program purposes. Or 

the FCC could actually increase the USF contribution factor by a 

very small amount to help pay for the shortfall. While not ideal, 

this would result in American consumers paying perhaps the cost 

of one Starbucks coffee a year so that rural Americans aren’t paying tens or even hundreds of dollars more per month for 

broadband. 

Another longer term option could be for Congress to direct infrastructure funding toward supplementing of or at least for use in coordination with the USF program. As Congress starts to consider 

potential infrastructure initiatives, leveraging the USF program in 

some way would be an effective and immediate means of promoting 

rural broadband availability and adoption. 

Finally, one key issue that requires further emphasis is what 

sorts of broadband networks our country should be aiming to promote. If one is paying for it and building an asset intended to be 

future-proofed, that asset should be built to last for a few decades. 

That means not spending valuable USF or other funds on a network that are cheaper on the front end that are going to be obsolete in a few years. 

So in conclusion, small rural broadband providers are eager to 

continue deploying infrastructure and delivering services that rural 

America needs to participate in the digital economy, but a reasonable ability to justify investment, and then recover the cost of sustaining infrastructure in these high-cost rural areas is critical to 

this mission’s success. 

NTCA is honored to participate in this timely conversation regarding rural broadband. We look forward to working with all of 

you and other stakeholders on a comprehensive infrastructure 

strategy that includes the tools to actually achieve our Nation’s 

shared broadband goals. 

Thank you for the opportunity to testify and for the Subcommittee’s commitment to creating an environment conducive to 

broadband infrastructure investment in rural America. 

[The prepared statement of Ms. Bloomfield follows:] 

174 

1 47 U.S.C. § 254(b)(3) (2015). 

2The Hudson Institute, ‘‘The Economic Impact of Rural Broadband,’’ April 2016, (‘‘Hudson 

Paper’’). https://s3.amazonaws.com/media.hudson.org/files/publications/20160419KuttnerThe 

EconomicImpactofRuralBroadband.pdf. 

PREPARED STATEMENT OF SHIRLEY BLOOMFIELD, CHIEF EXECUTIVE OFFICER, NTCA–THE RURAL BROADBAND ASSOCIATION

Introduction 

Chairman Wicker, Ranking Member Schatz, members of the Subcommittee, good 

morning and thank you for the invitation to participate in today’s hearing focused 

on broadband, economic development, and the Universal Service Fund (USF). 

I am Shirley Bloomfield, Chief Executive Officer of NTCA–The Rural Broadband 

Association (‘‘NTCA’’). NTCA represents approximately 850 rural small businesses 

deploying broadband infrastructure in 46 states. All NTCA members are fixed voice 

and broadband providers, and many of our members also provide mobile, video, satellite and other communications-related services to their communities. The small 

telcos like those in NTCA’s membership serve less than 5 percent of the population 

of the United States, but cover approximately 37 percent of its landmass. These 

companies operate in rural areas left behind by other service providers because the 

markets were too sparsely populated, too high cost, or just too difficult in terms of 

terrain. 

Small, rural broadband providers have for decades been frontrunners in deploying 

state of the art communications services to their customers. Services that enable 

local businesses to serve globally and connect rural America to urban America and 

the world. These impacts are felt not only in agriculture, but in all sectors of the 

economy that depend on broadband connections, such as education, commerce, 

health care and government. However, the job is far from finished. Communications 

providers must not only deploy broadband; they must sustain and upgrade their networks to keep pace with their consumers’ growing demands. We also still face the 

challenge, of course, of delivering services to parts of rural America without access. 

Before turning to the USF High Cost Program—also referred to these days as the 

Connect America Fund—and the challenges of deploying and sustaining broadband 

infrastructure in rural America, it is important to understand the economic and 

other benefits that accrue to America as a whole when every American has reasonably comparable access to high-quality communications services at affordable rates. 

Rural Broadband: Economic Development and Job Creation 

Broadband networks facilitate greater interconnection of community resources 

and enable greater participation in the national and global economy. To not have 

access to high-speed Internet today should be unimaginable, yet millions of rural 

Americans have limited or even no access to robust broadband. And while it is critical to deliver broadband to the unserved, it is just as critical that those already 

receiving broadband remain served. There are many places in rural America where 

networks have been built by committed companies like those in NTCA’s membership, but the sustainability of that infrastructure and the affordability of services 

remain in question—putting the sustainability of rural communities in question as 

well. 

In many parts of rural America, the challenges of distance and density are so 

great that they cannot sustain even one broadband network. These are places where 

the market does not work. Section 254 of the Communications Act therefore rightly 

recognizes that our national policy is not merely about deploying infrastructure, but 

also ensuring that such infrastructure, once deployed, means something lasting and 

ongoing for the consumer—that is, ‘‘reasonably comparable’’ services at ‘‘reasonably 

comparable’’ rates for urban and rural consumers alike.1 If a network is built but 

then becomes unsustainable, or if the services offered over it are unaffordable or unreliable or cannot keep pace with increasing consumer demand, then these outcomes 

deny rural Americans the benefits of broadband and represent a terrible waste of 

the resources that help to make broadband infrastructure available in the first instance. This is not about a ‘‘scoreboard’’ of locations served, although public policy 

these days unfortunately seems to take just such a short-term focus all too often. 

Rather, it’s about whether we are building broadband that will make a lasting, longterm difference for rural areas looking to attract and retain residents and businesses, who are in turn betting on the viability of those communities. 

In April 2016, the Hudson Institute, in conjunction with the Foundation for Rural 

Service (FRS), released a report examining the economic benefits of rural broadband 

infrastructure.2 This report determined that the investments and ongoing operations 

of small rural broadband providers contribute $24.1 billion annually to the Nation’s 

175 

3 Id., pp. 13–14. 4 Id., p. 13. 5 Id., pp. 19–20. 

gross domestic product, with 66 percent ($15.9 billion) of that amount accruing to 

the benefit of urban areas.3 The report also found that rural broadband investment 

is an important driver of job growth, estimating that 69,595 jobs—54 percent of 

which are with vendors and suppliers in urban areas—can be attributed directly to 

economic activity of small rural broadband providers.4 These findings confirm that 

investment in rural broadband infrastructure yields returns that reach far beyond 

the confines of rural America. 

Finally, the study found that rural broadband supported over $100 billion in e- commerce in 2015. Nearly $10 billion of that total involved retail sales, and Hudson 

estimates that if the broadband deployment in rural areas was equivalent to that 

in urban areas, sales would have been at least $1 billion higher.5 Such data underscore that not only is the widespread availability of robust affordable broadband important for our national economy, but the direct act of investing in and operating 

broadband infrastructure is itself a substantial economic driver. 

But, there are also jobs beyond the telecom technicians, engineers, materials suppliers and manufacturers that are supported by rural broadband infrastructure. In 

Sioux Center, Iowa, a major window manufacturer built a 260,000 square-foot plant 

to employ 200 people. The company considered more than 50 locations throughout 

the Midwest, but selected Sioux Center in part because the rural broadband provider enabled this plant to connect with its other locations throughout the U.S. 

using a sophisticated ‘‘dual entrance’’ system that could route traffic to alternate 

paths, ensuring that the main headquarters 250 miles away and other facilities 

would remain connected. In Cloverdale, Ind., a rural broadband provider met with 

developers and helped bring an industrial park to its service area. Powered by this 

provider’s broadband, the facility brought more than 800 jobs to the area. In Havre, 

Mont., a rural broadband provider is partnering with a tribally-owned economic development agency to create a Virtual Workplace Suite and Training Center that is 

expected to create about 50 jobs. These stories are repeated throughout NTCA member service areas. 

The Universal Service Fund Successes and Challenges 

Created decades ago and modernized over the past several years, the Federal USF 

High-Cost Program is essential to the business case for investment in rural 

broadband infrastructure—it is the best, most successful example of a public-private 

partnership in the broadband space. Recast as the Connect America Fund within 

the past decade, the USF initiative helps unleash billions of dollars in private investment in rural markets that are uneconomic to serve and would not and could 

not otherwise justify obtaining loans or using cash flows to build broadband. The 

USF does not fully fund (or ‘‘pay for’’) rural network investments; it helps to justify 

the business case for private network investments that totaled approximately $29 

billion (in terms of gross plant in service) just for small rural carriers as of 2015. 

The High-Cost USF programs have recently been reformed to improve their effectiveness and accountability. While they were already successful in promoting increased broadband in rural areas served especially by smaller rural providers, recent reforms help ensure that funds are targeted to areas of real need, that they 

are spent on network investments and operations, and that the locations served via 

USF can be identified. The High-Cost USF program is therefore already a success 

story in many respects, and it is positioned to achieve even greater things in a 

broadband era going forward. Unfortunately, despite all this progress, the viability 

and effectiveness of the USF is at the same time in serious peril. While regulatory 

uncertainty from USF reforms and budgets has seemed like a fact of life for small 

network operators for more than a decade, the effects of a budget that has been flat 

for almost a decade are finally coming home to roost. 

While the Federal Communications Commission (FCC) thankfully took steps to 

provide some level of additional funding earlier this year within the fixed overall 

USF budget for a subset of carriers that elected model-based High-Cost USF support, the funding was insufficient to achieve the goals of the model the FCC designed. An additional $110 million per year is needed to fully fund an alternative 

model that the FCC created to promote broadband deployment. Because of this 

budget shortfall, 71,000 rural locations will receive lower-speed broadband, and 

nearly 50,000 may see no broadband investment at all. 

And the problem is even more dire for those small carrier recipients of High-Cost 

USF that could or did not elect model support. The High-Cost USF has been locked 

at the same budget level overall since 2011, and a lower budget target first adopted 

176 

in 2011 for smaller carriers within that overall budget total is now being enforced 

via a strict budget control mechanism that threatens to wreak havoc on consumer 

rates and network investment. Under this tightly constrained USF budget, over the 

next 12 months, small rural network operators will be denied recovery of $173 million in actual costs for private broadband network investments that these carriers 

have already made. In other words, small rural network operators and the customers they serve will need to come up somehow with $173 million to pay for 

broadband investments that the USF program would have supported just a year 

ago—and that the rules would still have permitted for recovery today via USF had 

it not been for ‘‘haircuts’’ made to enforce an artificial budget target adopted six 

years ago back when the program supported voice services only. 

Because of these support cuts, rural network operators are already increasing 

rural broadband rates for consumers and cutting back on future infrastructure investments. We have had one member company in the Southeast indicate, for example, that it cannot justify seeking a $26 million loan to build high-speed broadband 

infrastructure due to the USF cuts; a project that would have delivered approximately 1,000 miles of fiber to over 7,000 rural customers is now on indefinite hold. 

Similarly, due to the USF budget cuts, a cooperative in the upper Midwest is on 

the cusp of cancelling 2018 construction projects worth several million dollars; these 

projects would have upgraded or delivered broadband for the first time to approximately 500 rural consumers and businesses, but the company now needs to scale 

back future investment because the USF cuts are taking away millions of dollars 

that were counted upon for investments already made in the past. In Mississippi, 

a small rural provider has been forced to hold off indefinitely on plans for future 

investments in communities like Fulton and surrounding rural areas due to the 

USF budget concerns, instead making minimal investments just to keep existing 

network plant operational rather than upgrading that network for higher-speed 

broadband that would help those areas thrive. In Nebraska, a small company with 

only 12 employees that just recently completed a significant fiber-to-the-home 

project has declined to fill four open positions—effectively cutting its workforce by 

25 percent—because of concerns with declining USF support and its impact on the 

ability to pay for the network construction already completed. And in Iowa, a small 

carrier has not been able to lower its prices for standalone broadband because the 

USF budget cuts are effectively wiping out any support for such connections, despite 

the intention of the reforms and the repeated calls for such a fix from Congress. 

And the most insidious aspect of this budget control is that it not only cuts support that the rules indicate should be available, but it does so in unpredictable 

ways. For the last four months of last year, the budget control was 4.5 percent on 

average; for the first six months of this year, it rose to 9.1 percent on average. Now, 

as of July 1 of this year and for the 12 months after that, the budget control will 

on average reduce USF support by 12.3 percent. As if the support losses for investments already made were not bad enough, this lack of predictability makes it even 

harder to justify building going forward—it hearkens back to a cap system the FCC 

adopted a few years ago called Quantile Regression Analysis or ‘‘QRA.’’ Many members of Congress, including many on this Committee, wrote to the FCC several years 

ago expressing grave concern about the QRA caps because they could change in unpredictable ways and thus severely undermined investment incentives. We eventually got rid of those caps, thanks in no small part to the efforts of the members of 

this Committee in pressing the FCC to do the right thing. 

But now with this budget control, we are venturing right back into the kind of 

unpredictability created by the QRA. If a company does not know whether the budget control will be 5 percent or 10 percent or 20 percent next year—and given the 

growth trends, all we can guess is that the budget control will grow—that company 

cannot make informed decisions to invest in capital-intensive broadband infrastructure. Put another way and without hyperbole, the budget control—the USF budget 

shortfall—is the worst thing for promoting rural broadband investment since the 

much-maligned QRA. If it does not get fixed soon, we will be looking at years of 

lost rural broadband investment to the detriment of millions of rural Americans. 

Rather than creating new programs from scratch or taking flyers on untested theories of broadband deployment, why not use a program that has a proven track 

record and has just been improved in recent years? Why starve that program’s 

budget while throwing dollars at new initiatives that might not work or, worse still, 

might conflict with this proven program? If rural broadband is really a priority, good 

public policy would indicate we should be building upon what has worked to promote it, rather than neglecting it. 

It’s not just NTCA that is concerned about the USF budget shortfall. In May 

2017, nearly 170 Members of Congress—including Chairman Wicker and other 

members of this Subcommittee—wrote to the FCC expressing serious concern about 

177 

how the USF budget shortfalls will undermine private infrastructure investment 

and consumer rates. This letter demonstrated the shared bipartisan interest in 

prompt action on this issue, and a window of opportunity exists. We are hopeful 

that with continued congressional interest and leadership we can see these issues 

addressed, and the promise of last year’s USF reforms can be realized by the millions of rural consumers served by smaller rural network operators. 

A Path Forward for the Universal Service Fund 

Solving the USF budget shortfall requires a demonstrated commitment on the 

part of policymakers to rural broadband—but the shortfall is actually just a small 

fraction of the increases that other USF programs have received in recent years to 

further their mission. There are several potential options to address this shortfall, 

but what is clear is that doing nothing is no longer an option if rural broadband 

remains a public policy priority. 

One option would be for the FCC to leverage the existing USF mechanism to fill 

the shortfall. This could involve the use of USF program funds or reserves—funds 

that the FCC has collected but has not yet disbursed for USF program purposes. 

Certain reserves were previously used to help fund the model election referenced 

earlier in this testimony. It is unclear the extent to which other reserves remain, 

but getting a public accounting regarding how much is left in the reserves, if anything, would seem an important first step. 

Alternatively, the FCC could increase the contribution factor by a small amount 

to help pay for the shortfall. While not ideal, this would result in American consumers paying perhaps a few dollars more per year so that rural Americans are not 

paying tens or hundreds of dollars more per month for broadband, which is a clear 

violation of the universal service mandate in the Communications Act. 

Another option could be for Congress to direct infrastructure funding toward 

supplementing of (or at least for use in coordination with) the USF program. As 

Congress starts to consider potential infrastructure initiatives, leveraging the USF 

program would seem the most effective and immediate means of achieving a real 

effect on rural broadband availability and adoption. The USF initiative is up and 

running, so there is no need to ‘‘reinvent a wheel’’ to see results. Sufficient USF 

funding targeted for broadband infrastructure deployment could help fill the specific 

shortfalls mentioned above and accelerate private network investments in the most 

rural 37 percent of the U.S. landmass—while leaving substantial funding also to 

promote fixed network investments in other rural areas, for rural mobility services, 

and for unique challenges on tribal lands. The FCC’s various High-Cost USF programs—the Connect America Fund 2 initiative and the programs that enable service 

delivery in rural areas served by smaller businesses—therefore offer a ready-made 

platform that, with additional resources but with very little additional ‘‘heavy lifting’’ or process, could ‘‘hit the ground running’’ and yield immediate, measurable 

benefits for rural consumers. 

If an infrastructure package including broadband moves forward through Congress and if it is not targeted toward somehow supplementing the USF programs, 

other options could include creation of new grant or capital infusion programs, comparable to what several states have used to address ‘‘market failure areas’’—places 

where the business case for investment is difficult, if not impossible, to make without additional resources. At the same time, creating such programs would require 

more administrative effort than leveraging existing programs, and the rules for any 

such new program must still be informed by ‘‘lessons learned’’ from similar prior efforts at the Federal and state levels. For example, as a matter of program integrity 

and to ensure the most efficient possible use of resources, it would be necessary to 

ensure such a capital infusion program is accurately targeted to unserved areas 

rather than enabling installation of duplicative infrastructure; in effect, this means 

that any new program would still require substantial coordination with the existing 

USF programs, among other things. And although some have alternatively touted 

tax incentives as offering promise—and while there are certainly areas in which 

such incentives might help—such measures are unlikely to make a material impact 

in most rural areas where distance and density make it difficult, if not impossible, 

to justify a business case for infrastructure investment to start. Put another way, 

if there is insufficient USF to help enable the business case for ongoing operation 

of networks and providing affordable broadband in rural areas, a capital infusion 

program or tax incentives may do very little to promote meaningful broadband deployment in many rural areas. 

Regardless of what path might be chosen in developing a broadband infrastructure package, one key factor that requires further consideration is what sorts of 

broadband networks we should be aiming as a country to promote. Presumably if 

one is paying for and building an asset intended to last for a few decades, that asset 

178 

should be built to last a few decades. Of course, in a world of finite resources, there 

is a difficult tension between, on the one hand, trying to reach as many unserved 

Americans as possible with networks that may cost less upfront and, on the other 

hand, deploying more sustainable ‘‘future-proof’’ networks to potentially fewer locations. This is not an easy choice. But NTCA submits that deploying a network that 

may be less expensive upfront—but which consumers will find substandard in just 

a few years’ time, or will require much more to operate and upgrade over time— 

makes little sense for either the consumers who would use those networks or the 

American ratepayers or taxpayers who would ultimately help support them. 

As a more traditional infrastructure analogy that may resonate: if one projects 

that car traffic is doubling every few years on a single-lane road, one likely does 

not rebuild the new highway with only two lanes and then go back to add two more 

lanes a few years later and yet two more lanes a few years after that. Instead, given 

the relatively high costs of infrastructure deployment and the disruption involved 

in repetitious construction, one builds the highway ‘‘the right way’’ the first time. 

The same should be true of our broadband networks. We should certainly look for 

a balanced approach to reach as many locations as possible, but not at the societal 

and economic cost of deploying networks that in only a few years’ time will look obsolescent and inadequate for the users consigned to them. It is therefore important 

that any rules adopted by the FCC in connection with USF and any other new programs created as part of a broader rural broadband infrastructure initiative deliver 

the best, most balanced payback for both the American taxpayer and the users of 

the networks—both in the near-term and over the life of that infrastructure. 

Finally, I should not close without noting that the long-term sustainability of the 

universal service program depends upon rationalizing a contributions framework 

that is not built for a 21st century marketplace. One can have differences in opinion 

on how this should be done, but it is hard to dispute the basic notion that has already driven contributions policy all along—that those who make use of communications networks should contribute to the well-being and universal availability of 

those networks. Today, however, a shrinking base of legacy services that do not represent the majority users of our communications networks are being asked and 

tasked with funding universal service goals that are centered on broadband. Assuming all agree that universal service is an important public policy—and the Communications Act indicates that Congress thinks it is—rationalizing and reforming contributions requirements is essential to firm up the foundation of universal service 

for the 21st century. 

Conclusion 

Small, rural broadband providers are eager to continue deploying infrastructure 

and delivering services that rural America needs to participate in the modern world. 

But the ability to justify and then recover the initial and ongoing costs of sustaining 

infrastructure investment in high-cost rural areas is critical to this mission’s success. 

NTCA is excited to participate in this conversation regarding rural broadband. We 

look forward to working with policymakers and other stakeholders on a comprehensive infrastructure strategy that provides the tools and capabilities needed to 

achieve our Nation’s shared broadband goals. 

Thank you for the opportunity to testify, and for the Subcommittee’s commitment 

to creating an environment conducive to broadband infrastructure investment in 

rural America. 

The CHAIRMAN. Thank you, Ms. Bloomfield. 

Mr. Graham. 

STATEMENT OF ERIC B. GRAHAM, SENIOR VICE PRESIDENT, 

STRATEGIC RELATIONS, C SPIRE 

Mr. GRAHAM. Thank you, Chairman Wicker, and thank you, 

Ranking Member Schatz, for having this hearing today. Thank you, 

members, for attending to discuss this incredibly important topic of 

the Universal Service Fund and rural broadband expansion. 

My fellow panelists so far have done a very good job of talking 

about expansion of wireline networks, so at least in my oral statement, I will turn most of my attention to wireless networks. 

179 

It would be almost impossible to overstate the importance of 

rural areas to a company like C Spire. We trace our roots to 1959, 

when our owners began the operation of a rural independent telephone company providing telephone service to areas of Mississippi 

that otherwise would not have had that service. 

We entered the wireless market as Cellular South in 1988, and 

for 30 years now have been providing wireless services throughout 

Mississippi. We began receiving universal service support from the 

High Cost mechanism in 2003. And little by little, we acquired customers and were able to cobble together enough USF support to expand our networks beyond the more heavily populated areas of 

Mississippi into the more rural parts of Mississippi. 

Today, we operate a wireless network that covers virtually the 

entire state. It covers over 98 percent of the population in Mississippi. What has been done in Mississippi is a USF success story, 

but proceeding on the path that the FCC has chosen to take so far, 

that story will not be repeated in other states. There are two primary reasons for this; the second is an outgrowth of the first. 

The first reason is that the FCC is prepared to move ahead on 

declaring areas eligible or ineligible for future mobility fund support based on insufficient data. This is data that is submitted to 

the FCC based on Form 477, and it’s submitted by wireless operators across the country. So far, so good, except the FCC has never 

established a consistent standard by which that information should 

be submitted. So the FCC doesn’t have an apples-to-apples comparison of coverage in various areas of the country. 

We, as operators, know that the information is bad. Senators 

know that the information is bad. Mr. Chairman, you wrote a letter 

along with Senator Manchin to the FCC addressing this very problem. The FCC knows the data is bad. And if anyone thinks that 

the data might still be good, if you just go to the FCC’s website and 

pull up the map that shows covered areas according to this data, 

you find a disclaimer at the bottom that reads, ‘‘These coverage calculations, while useful for measuring developments in mobile coverage, have certain limitations that likely result in an overstatement of the extent of mobile coverage.’’ By my count, that’s four 

hedges in one sentence, which has to be some kind of record. 

[Laughter.] 

Mr. GRAHAM. Rather than pushing Pause and getting the information correct, the FCC’s attitude seems to be it’s close enough for 

government work, let’s get the money out the door as quickly as 

we can. 

With insufficient data, we have no idea of the size of the problem 

that we’re trying to address, and that’s problem number two, issue 

number two. Without knowing what areas truly are covered and 

which areas lack coverage, the FCC, nor anyone else, can put together a model that shows the cost of covering unserved areas. 

There is no place in the record where the FCC has done an independent economic analysis to see what the cost would be to cover 

areas that lack wireless service today. 

CostQuest Associates made an attempt at this and determined 

that it would take approximately $25 billion to cover unserved 

areas in this country with an additional $1 billion per year going 

to operational support. That’s the only number that’s in the record 

180 

so far. The Mobility Fund today has the maximum amount that it 

could recapture of approximately $450 million. 

Now, quick math will tell you that would take over 50 years if 

we use CostQuest projections. The amount of funding that’s available today is simply not enough. Making matters worse, the FCC’s 

plan at this point is to continue to sweep money from the legacy 

High Cost mechanism, which supports ongoing operational expenses of existing networks, into the new Mobility Fund 2 and use 

that money for new construction. Many networks that are supported today with USF funding for operational expenses are at risk 

of being shut down. This means that you could have scenarios by 

which towers constructed as recently as last year would be shut 

down over the next year due to a lack of support for ongoing expenses. 

Remember, USF would not have supported these towers in the 

first place unless there was no economic case for a private company 

or a public company to do this on their own. This creates a rusty 

tower problem where the landscape of rural America could be dotted with rusty towers that are no longer in use. 

Clearly, the FCC is on the wrong path with its current plan for 

USF, and it will take continued engagement from you, Mr. Chairman, from this committee, and from other Members of the Senate 

if the FCC is going to get this right. 

Thank you again for inviting C Spire to be here today. I look forward to your questions and dialogue this morning. 

[The prepared statement of Mr. Graham follows:] 

PREPARED STATEMENT OF ERIC B. GRAHAM, SENIOR VICE PRESIDENT, 

STRATEGIC RELATIONS, C SPIRE

Good morning Chairman Wicker and Ranking Member Schatz. Thank you for 

holding this hearing, and thank you for the invitation to appear before you this 

morning to offer testimony on The Universal Service Fund and Rural Broadband. 

My name is Eric Graham, and I am the Senior Vice President for Strategic Relations for Cellular South, Inc., the provider of C Spire Wireless services (‘‘C Spire’’). 

We are the largest privately-held wireless provider in the United States with an operating area that primarily consists of Mississippi, but also includes portions of 

southwest Tennessee (including the Memphis area), as well as coastal Alabama (including the Mobile area). Our company also provides both fiber to the home and enterprise broadband at Gigabit speeds, but the primary focus of my comments today 

will be wireless broadband, both mobile and fixed. 

The network that C Spire has constructed is an example of everything that can 

go right with a federally supported infrastructure program when a local company 

has the commitment to provide the latest technology to the people in its region. For 

over fifteen years, our company has participated in the Universal Service Fund’s 

High Cost program and we have used that support to help in building a wireless 

network in Mississippi that covers virtually the entire geography of the state. We 

continue to upgrade the wireless network with the latest generation of technology 

so that Mississippians from Tunica in the northwest to Gautier in the southeast, 

have access to the same techno logy as people in Jackson and Tupelo. For that matter, we ensure that people in Jackson and Tupelo have access to the same technology as people in New York, San Francisco, and Washington, D.C. 

A. Background on C Spire and Wireless Expansion 

Why do we do it? Quite simply, it’s in our DNA to provide telecommunications 

services to hard-to-reach areas of Mississippi. Our company traces its roots to a pair 

of rural independent telephone companies, the first of which our owners began operating in 1959. In that time, in rural Mississippi, telephone service wasn’t available 

everywhere. The Bell incumbent served the easy-to-reach areas, and people living 

outside those areas had no access unless an independent telephone company stepped 

in to serve the area. In one of the areas served by our rural independent telephone 

181 

1See, http://www.usac.org/cont/tools/contribution-factors.aspx 

2Over the years, the Joint Board has addressed contribution reforms on multiple occasions. 

Most recently, in August of 2014, the FCC requested the Joint Board to make recommendations, 

but they have yet to act. See, https://apps.fcc.gov/edocs_public/attachmatch/FCC-14-116A1 

.pdf, at n.5. 

companies, two sisters lived within sight of each other’s houses, but they were separated by a river. Although they could see each other from a distance, they had no 

real way to communicate until our company laid the telephone lines that allowed 

them to call each other. It was an expensive effort, and it would have been far more 

convenient not to provide telephone service to one or both of those ladies, but our 

belief then—and our belief today—is that people in rural and hard-to-serve areas 

need connectivity and access to modern technology just as much as those who live 

in densely-populated, easy-to-serve areas of our country. 

Congress believed the same thing in 1996 when it passed the Telecommunications 

Act. Recognizing that competition results in better service, the Senate and the 

House constructed a new Universal Service support mechanism that promoted competition for the first time and moved rural consumers away from telecommunications monopolies. The FCC adopted rules to implement the 1996 Act, ensuring 

that wireless providers could qualify for Universal Service funding on a competitively neutral basis. The result was tremendous expansion of wireless networks 

across the country, including areas where independent providers such as C Spire 

now had the missing piece of the financial model that made it feasible to build wireless networks in rural areas. 

B. Problems with the USF Structure 

1. Distribution Problem 

There were two important flaws in the USF structure. The first flaw was in the 

way that support was distributed to carriers. Under the distribution mechanism, the 

reimbursement amounts were based on the local landline carrier’s average cost to 

serve a customer. This was a simple exercise of dividing allowable expenses by the 

number of a landline company’s subscribers in its service area, and providing an 

equal ‘‘per customer’’ amount of monthly support to the competitive provider that 

won the customer. 

As wireless networks expanded, cord-cutting became a practical option and there 

was a dramatic decline in the number of landline customers. However, the landline 

companies never lost USF support despite losing almost half of their lines over the 

past 10–15 years. The result was that the competitive carrier (almost always a wireless provider) received USF support to provide service to the customers it won, while 

at the same time the landline carrier continued to receive support for the customers 

it lost. This was a problem in 2009 when I testified before the House of Representatives on the topic of USF, and it remains a problem today. 

2. Contribution Problem 

The second flaw in the USF structure is that contributions are based on a percentage of interstate and international telecommunications (long distance) revenues. 

Today, a small percentage of basic telephone service is interstate or international 

and that revenue base is shrinking rapidly as consumers now use Internet-based 

services to communicate. As interstate/international telecommunications revenues 

continue to decline, the FCC must increase the percentage assessed on the remaining revenue base, because it has no authority to assess intrastate telecommunications service revenues, or on any other service that is not telecommunications 

(such as information services). 

Accordingly, while the size of the Federal Universal Service Fund has not increased significantly over the past seventeen (17) years, the percentage of interstate/ 

international revenues that consumers pay in (the ‘‘Contribution Factor’’) has risen 

from about four percent (4 percent) to nearly twenty percent (20 percent).1 Over the 

years, some mischaracterized growth in the Contribution Factor as evidence of a 

USF crisis, when in fact it is not. Reforming the contribution mechanism has been 

on the FCC’s radar for over fifteen (15) years, and the Federal-State Joint Board 

on Universal Service has recommended multiple solutions that have never been implemented.2 In today’s world, where many connected devices use alternative means 

of communicating that do not use the public switched telephone network, and incur 

little or no interstate/international telecommunications charges the contribution 

mechanism is hopelessly outdated. 

182 

3See, One Nation, Divisible/Rural America is Stranded in the Dial-Up Age, J. Levitz & V. 

Bauerlein, WSJ (June 15, 2017: https://www.wsj.com/articles/rural-america-is-stranded-in-thedial-up-age-1497535841 4See, https://ecfsapi.fcc.gov/file/10217086509033/2017%200216%20CQ%20Cost%20Study% 

20for%20Unserved%20Areas%20FINAL.pdf. 5See, April 12, 2017 Letter to FCC Chairman: https://www.wicker.senate.gov/public/_cache/ 

files/d2d30dd8-76f2-4c45-8d3a-b64c9018265c/041217-fcc-rural-broadband-auctions-task-forceletter.pdf 

C. Compounding the USF Problems 

As shown above, rather than fix the way that Universal Service funds are collected, the FCC has ignored the problem. Its actions to date on distribution reform 

have protected certain classes of providers and short-changed mobile wireless networks that rural citizens desperately want and need.3 Today, wireless consumers 

contribute over half of the $8+ billion dollar annual USF budget, which covers 

schools and libraries, rural health care, Lifeline, and High Cost (Connect America 

Fund and Mobility Fund), yet annual High Cost support going to mobile broadband 

is approximately $600 million (only 7.5 percent of all USF support) and is scheduled 

to be cut back to only $453 million (less than 6 percent of all USF support) when 

Mobility Fund II is implemented. 

Recently, CostQuest estimated the cost of building out a high-quality mobile 

broadband network throughout the unserved/underserved areas in rural America to 

be approximately $25 billion, with another $1 billion of support needed for annual 

operating costs.4 And these figures don’t even touch the coming 5G revolution. Does 

an annual budget of $453 million sound like the FCC has a sense of urgency to help 

build out modern 4G LTE networks in rural America? At that pace, it will take 

more than twenty years to get the job done, and even then, rural America will be 

further behind than it is today. 

Providers like C Spire, and many other small independent carriers who participated in the Universal Service program in the early years, used that support to expand and maintain their networks and were able to compete aggressively for customers in areas where networks improved. But starting in 2008, the Federal USF 

mechanism was capped, artificially preventing prevented many carriers from constructing comprehensive networks. That lack of coverage continues today in many 

of your states, and the FCC is proceeding down a path that will make the problem 

worse. In fact, history is about to repeat itself, as the new Universal Service mechanisms for broadband have two structural flaws of their own. 

D. Flaws in Current USF Reform Plans 

1. Lack of Accurate Data to Direct New Network Construction 

First, the Commission is preparing to distribute funding without an accurate view 

of where support is needed. This will be the second time in the past five (5) years 

that the FCC has done this. The Commission intends to base funding decisions for 

Mobility Fund Phase II on data submitted by wireless providers across the country 

purporting to show where broadband exists or is lacking. This sounds reasonable on 

its face, but if you scratch slightly below the surface, you find that the FCC never 

established a consistent standard for how wireless carriers provide coverage information. This is a serious problem. Some providers submitted data showing coverage 

that an engineer would guarantee at all times and under all conditions, while others 

submitted data that would make a marketing department blush. To be clear, these 

differences are not necessarily malicious. Theoretical coverage, outdoors, in a lowfoliage, flat landscape will always appear greater than real-world, indoor coverage 

in rolling terrain. While both coverage simulations have legitimate purposes, the 

problem is the FCC permitted providers to submit data using factors the providers 

chose, and the resulting maps show either accurate, overstated, or understated coverage, depending upon how each carrier presented their respective mapping data. 

Members of this Committee have taken note and have pushed the FCC to take 

corrective action. Mr. Chairman, you and Senator Manchin recognized this problem 

in a letter to FCC Chairman Ajit Pai in April of this year, where you wrote: 

. . . the Commission’s efforts [to promote broadband deployment in unserved 

and underserved areas] must accurately target every area that is in need of support so that no one is left behind. Residents, first responders, businesses, public 

institutions, and travelers in rural areas need reliable mobile broadband access. 

To that end, collecting and using reliable, standardized coverage data are critical steps toward ensuring consumers in the most rural and remote communities 

have access to the comparable services that Congress mandated for Universal 

Service. 5

183 

6See, S.1104, 115th Congress, introduced May 11, 2017: https://www.congress.gov/115/bills/ 

s1104/BILLS–115s1104is.pdf 7May 11, 2017, Press Release, ‘‘Manchin Introduces Bipartisan Bill to Expand Broadband Deployment Using Accurate Coverage Maps’’: https://www.manchin.senate.gov/public/index.cfm/ 

2017/5/manchin-introduces-bipartisan-bill-to-expand-broadband-deployment-using-accurate-coverage-maps. We note that Congressman Dave Loebsack of Iowa has introduced similar legislation (H.R. 1546) aimed at improving the quality of mobile broadband coverage data. See, H.B. 

1546: https://www.congress.gov/bill/115th-congress/house-bill/1546/text. 8 June 15, 2017, Press Release, ‘‘Heller, Manchin Introduce Bill to Expand Access to Rural 

Broadband’’: https://www.manchin.senate.gov/public/index.cfm/press-releases?ContentRecord_ 

id=A3E25E12-1A27-47B9-B1E5-BB9B93738916 9 Id. 

10See, February 2, 2017, letter to FCC Chairman Pai: https://www.manchin.senate.gov/public/index.cfm?a=files.serve&File_id=4B24485D-D61A-40D8-AE03-867D0139A37E 

It is also clear that this Committee understands what is needed to correct this 

problem because you, Mr. Chairman, Ranking Member Schatz and Senators 

Manchin, Fischer, and Moran introduced legislation in May of this year to help 

solve the data problem facing the FCC.6 That bill, the Rural Wireless Access Act of 

2017, directs the FCC to establish a methodology to (1) ensure that wireless coverage data is collected in a consistent and robust way; (2) improve the validity and 

reliability of wireless coverage data; and (3) increase the efficiency of wireless coverage data collection. In introducing the bill, Senator Schatz put the need for its 

passage succinctly: ‘‘We can’t close the digital divide if we don’t know where the 

problem is.’’ 7

Additionally, just last Thursday, Senators Heller and Machin introduced the 

Rural Broadband Deployment Streamlining Act.8 This legislation, as Senator 

Manchin noted upon its introduction, ‘‘includes an assessment of whether the data 

in the National Broadband Map accurately reflects the broadband coverage currently available to rural consumers and . . . is a critical step towards ensuring that 

the infrastructure necessary for broadband coverage in unserved and underserved 

communities is more quickly deployed.’’ 9

We are grateful for these efforts to correct this known problem, and we are hopeful that the FCC will recognize your concerns and amend its plan accordingly, but 

we believe it will take your active participation in this issue and vigilant oversight 

in order for the FCC to get it right. 

To the FCC’s credit, the Commission opened a proceeding this spring seeking comments on how to get more accurate data before the upcoming Mobility Fund II auction. C Spire participated in stakeholders’ workshops to develop a set of standards 

that work for the industry and that could be adopted by the FCC in their entirety, 

or with minimal changes. The working group submitted its suggestions to the Commission last month, but we have no indication those recommendations will be adopted. At this point, it is unclear whether the Commission is prepared to make the 

hard but necessary decision to require all carriers to submit improved coverage data 

based on a consistent standard. 

As part of this Committee’s oversight responsibility, we urge you to see that the 

FCC does not spend $4.6 billion dollars until it has a clear picture of which areas 

will deliver the biggest bang for the buck for all Americans. 

2. The FCC’s Current Reform Plan Will Reduce Existing Coverage 

The Commission’s current plan to proceed with its overhaul of the Universal Service Fund is fatally flawed because it eliminates operating support for the very networks that the Universal Service Fund helped to construct. This could have the perverse effect of forcing carriers to decommission cell sites over the next year that 

were constructed with Universal Service Support as recently as last year, thus reducing coverage and leaving towers to rust. This ‘‘rusty tower’’ scenario is very real 

because the whole purpose of the High Cost mechanism was to help wireless operators across the country construct and operate towers in areas that cannot justify the 

expense of continuing operations without support. Indeed, ensuring that networks 

in rural high-cost areas are maintained is one of the core purposes that Congress 

set forth in Section 254(e) of the Communications Act, 47 U.S.C. § 254(e). Consumers with dependable wireless broadband today could find themselves on the 

wrong side of the digital divide tomorrow, unable to access services they currently 

use for everything from social connectivity and directions to telehealth services and 

reaching first responders in times of emergency. Mr. Chairman, this result is exactly 

the opposite of the goals that you, Senator Manchin and twenty-eight (28) of your 

Senate colleagues set forth in a February letter to Chairman Pai.10 In that February 

letter, nearly one-third of the Senate—both Republicans and Democrats—provided 

this guidance to the FCC: 

184 

11 Id. 12 USDA, Economic Research Service, Population & Migration Overview: https://www.ers 

.usda.gov/topics/rural-economy-population/population-migration/ 13 CBPP, Legacy of the Great Recession, June 9, 2017: http://www.cbpp.org/research/economy/chart-book-the-legacy-of-the-great-recession 14See, https://www.whitehouse.gov/blog/2017/06/16/secretary-perdue-hosts-inaugural-ruralprosperity-task-force-meeting 15 Id. 16See, https://hudson.org/research/12429-hudson-institute-releases-report-on-economic-impact 

-of-broadband-in-rural-communities 17See, http://digitalcommons.ilr.cornell.edu/ilrreview/vol66/iss2/2/ 18See, https://www.commerce.senate.gov/public/_cache/files/86a9b24c-e124-4b4b-a701-f0fe16 

5be074/F3297DD6CC57D51B9EA2A54F209F07E3.darrington-seward-testimony.pdf 

As you move forward with MFII, we ask that your efforts help to incent wireless 

carriers to preserve, upgrade, and expand mobile broadband in rural America, 

rather than degrade and reduce competition in areas that need it most. Competing in a capital-intensive environment, wireless carriers need long-term certainty of ongoing support to invest, deploy maintain and update their networks 

that provide vital mobile broadband services in rural areas. 11

The combination of these two flaws in the new Universal Service mechanism— 

the failure to gather accurate, standardized data and the failure to protect the Universal Services Fund’s decades of existing investment in rural areas—is a recipe for 

tremendous waste as funding will be directed to areas that do not require it while 

portions of existing networks will be turned off and cell towers will be abandoned. 

At this point, it will take leadership from the Senate and the House to ensure that 

the Universal Service Fund promotes broadband deployment in a way that preserves and expands network availability in rural areas. 

F. Effect if FCC Stays on Current Path 

If network coverage and quality are reduced in rural areas, modern initiatives 

such as remote patient monitoring and precision agriculture are at risk along with 

many critical applications like distance learning and telecommuting that help people 

in rural areas participate in the todays digital and information economy. This is tremendously important because, according to the USDA’s most recent figures, over 46 

million Americans live in rural communities. That’s fourteen percent (14 percent) 

of the total U.S. population living in seventy-two percent (72 percent) of the Nation’s 

geography.12

During the Recession, almost 9 million jobs vanished from our U.S. economy, GDP 

shrank by more than five percent (5 percent),13 and our rebound has been uneven. 

Many of America’s urban and coastal populations have recovered, and today they 

are generally ahead of where they were ten years ago. But, that’s not true for tens 

of millions living in rural Americans, which remains well behind where it was before the Recession, some ten years ago. 

Just last week, Chairman Pai participated in the inaugural Rural Prosperity Task 

Force meeting,14 where he outlined how important policies that support broadband 

availability in rural areas are for demonstrating that the Federal Government cares 

about rural America. As he articulated, providing connectivity nationwide is at the 

core of why the FCC was created in 1934.15 Chairman Pai shared examples of economic growth powered by broadband with the task force, including remote monitoring in a meat processing plant in Nebraska, feed lot monitoring of cattle in Kansas, connected combines and field monitoring in Maryland, and healthcare, education, and job creation advances all made possible by broadband. 

These examples are not purely anecdotal. The Hudson Institute recently found 

that the investments and ongoing operations of small rural broadband providers 

contribute $24.1 billion annually to the Nation’s gross domestic product, with sixtysix percent (66 percent), or nearly $16 billion, of that amount benefiting urban 

areas. The same report also found that an estimated 70,000 jobs can be attributed 

directly to economic activity of small, rural broadband providers, underscoring how 

broadband is an important driver of job growth.16 A separate report has found that 

when a county gains access to broadband, there is approximately a 1.8 percentage 

point increase in the employment rate, with larger effects in rural areas.17

In testimony before this subcommittee last year, Mr. Darrington Seward, a Mississippi farmer, estimated a minimum ‘‘10–15 percent loss of efficiency when connections are disrupted’’ for their farm machinery alone.18 New remote patient monitoring services can save millions for rural hospitals and state Medicaid budgets. In 

fact, C Spire has partnered with the University of Mississippi Medical Center on 

a diabetes monitoring project that has the potential to save Mississippi Medicaid 

185 

19See, https://www.fcc.gov/faces-connected-care-mississippi-story 20See, 47 U.S.C. § 254 (b)(3). 21See, ‘‘Bringing the Benefits of the Digital Age to All Americans,’’ Remarks of Chairman Ajit 

Pai at Carnegie Mellon’s Software Engineering Institute, March 15, 2017: https://apps.fcc.gov/ 

edocs_public/attachmatch/DOC-343903A1.pdf 

over $189 million a year in hospitalization costs.19 Secondary education, technical 

training, and even university degrees are available online, but only accessible for 

Americans with broadband services that support delivery of materials and facilitate 

interactive classes. The future of rural economic growth is directly tied to the availability of mobile broadband. 

We see examples nearly every week that demonstrate how we are, in many ways, 

living in a time of two Americas. Our most recent national election showed that 

there are millions of Americans who feel like they have been detached from the 

process and are being left behind, and many of these live in rural areas. I certainly 

won’t claim today that wireless broadband availability alone will solve that complex 

problem, but I truly believe that if we do not connect our fellow citizens in rural 

areas the way that we have in urban and coastal parts of our country, economic and 

social divides will get worse. The good news is that policymakers can choose to connect these Americans if USF is properly channeled to support broadband in rural 

areas. 

G. Options to Promote Rural Broadband Deployment 

The FCC’s biggest USF shortcoming has been its unwillingness to aggressively 

pursue the core goal that Congress set before it: that rural citizens should have access to modern services that are reasonably comparable to those in urban areas in 

both quality and price.20 The FCC’s timidity in this area is a bipartisan problem, 

stretching back more than a decade. If the FCC cannot bring itself to do the job 

Congress gave it by increasing investment to close the urban/rural broadband access 

gap, then Congress must act. 

Chairman Pai has suggested that, ‘‘any direct funding for broadband infrastructure appropriated by Congress as part of a larger infrastructure package should be 

administered through the FCC’s Universal Service Fund (USF) and targeted to 

areas that lack high-speed Internet access.’’ 21

Given the big gap that exists and the efficiencies that can be gained from using 

an existing mechanism that would not require creating a new program or bureaucracy, one way to provide a big boost to rural broadband is to make a special USF 

appropriation in each of the next five years, targeted to rural infrastructure, and 

with accountability protections. Projects could be funded as soon as the FCC accurately determines the areas that are most in need. 

Alternatively, Congress could implement a fix to the contribution mechanism to 

spread the cost of universal service more equitably. This would provide the FCC 

with more flexibility than it has now to meet the needs of rural America because 

the Universal Service Fund would have a contribution base that is reflective of today’s broader network usage, and a greater amount of funding available to provide 

support for rural broadband networks that our country clearly needs. 

What cannot happen is more of the same. Rural America has fallen behind and 

we need policymakers to demonstrate a sense of urgency to fix this problem now. 

H. Conclusion 

Let’s return, for a moment, to where I began my testimony this morning. I shared 

with you how C Spire has spent its history providing connectivity and modern telecommunications services to people in rural and hard-to-reach areas. Today, we’ve 

built an advanced fiber optics network that provides ultra-fast broadband 

connectivity to some of the most rural communities in Mississippi. We have almost 

5,000 miles of fiber throughout Mississippi that can be a foundation to extend connections to rural communities. We’re engaged in field trials of 5G equipment that 

can deliver wireless speeds of multiple Gigabits per second without needing a physical connection to a household or business. In the millimeter wave spectrum bands, 

technology has caught up with spectrum availability, and equipment is now available to utilize spectrum that has been fallow for decades. The missing piece is the 

financial model that proves in the deployment of advanced wireless networks in 

rural America. That’s where support from the Universal Service Fund can, as it has 

throughout its history, bridge the gap. In order to do that, policymakers must solve 

the problems that I highlighted earlier: accurately map broadband availability so 

that support can go where it is truly needed, and preserve the networks that the 

Universal Service Fund has helped to build. 

186 

Thank you again for inviting me to be here today. I welcome your questions and 

look forward to our dialogue this morning. 

The CHAIRMAN. Thank you, Mr. Graham. 

Dr. Rheuban. 

STATEMENT OF KAREN S. RHEUBAN, MD, 

PROFESSOR OF PEDIATRICS, SENIOR ASSOCIATE DEAN, 

CONTINUING MEDICAL EDUCATION AND EXTERNAL AFFAIRS; 

AND DIRECTOR, UNIVERSITY OF VIRGINIA CENTER FOR 

TELEHEALTH 

Dr. RHEUBAN. Chairman Wicker, Ranking Member Schatz, members of the Subcommittee, thank you for the opportunity to provide 

testimony regarding the FCC’s Rural Health Care Program established by the Telecommunications Act of 1996. 

I’m a pediatric cardiologist, Co-founder and Director of the Center for Telehealth at the University of Virginia, past President of 

the American Telemedicine Association, and Board Chair of Virginia Medicaid. 

UVA is home to the HRSA-funded Mid-Atlantic Telehealth Resource Center, through which we provide technical assistance to 

providers and systems across eight states and the District of Columbia. From these perspectives, I offer testimony regarding the 

critically important role of the Universal Service Fund. 

As committee members know, telehealth is the use of technology 

designed to enable the provision of health care services at a distance. Telemedicine effectively mitigates the significant challenges 

of workforce shortages and geographic disparities and access to 

care; supported by secure broadband communications services, a 

critical underpinning of any telehealth program. 

The UVA telemedicine program was established more than 20 

years ago to address the pervasive health disparities faced by rural 

Virginians. The same is true for Mississippi. We connect with 153 

facilities across the Commonwealth of Virginia. Our program spans 

more than 60 different clinical subspecialties ranging from prenatal 

services to emergency and acute care consults, follow-up visits, and 

chronic disease management using remote patient monitoring tools. 

More than 200,000 different health care services have been provided, and we have reduced the burden of travel for Virginians by 

many millions of miles. Most importantly, we have improved patient outcomes. We rely on the FCC Rural Health Care Program 

for connectivity between facilities. Absent the program, our ability 

to provide these services would be severely constrained. 

As an example, not long after we launched our telemedicine program in 1996, we received a grant from NTIA, which I understand 

falls under this committee’s jurisdiction, to connect health care facilities in Appalachia to UVA. For that grant, the cost of a 1.54 

megabit connection to one small rural hospital was unaffordable, at 

nearly $6,000 per month. 

After passage of the Telecommunications Act, through the Rural 

Health Care Program, we have secured discounts that allow us to 

purchase greater bandwidth for a fraction of that cost. That hospital and others participate in our telestroke program, facilitated 

by the rapid transmission of CT scans and high-definition video 

conferencing that informs mutual clinical decisionmaking and 

187 

treatment when time is brain. Lives have been saved and disability 

avoided. 

Affordable broadband connectivity is without question foundational to our telemedicine program. Between 1998 through 2016, 

the Commonwealth of Virginia has received support of more than 

$23 million in USAC funding for health care programs, and we 

have more to go. 

USAC has accelerated its outreach efforts and streamlined the 

application process amongst other changes consistent with program 

modernization, but we have a way to go. 

Utilization has greatly increased, and recently the $400 million 

funding cap established by the Commission in 1998 was exceeded. 

The Commission has recently reduced support by 7.5 percent, and 

this has created hardships for many states, and in particular for 

Alaska. There is much more to be done. 

For this reason, we urge the FCC to expand the funding cap that 

it established nearly two decades ago. If this is not feasible, we 

urge Congress and the FCC to explore additional Federal options 

to support costly infrastructure buildouts for rural health care providers. The FCC should prioritize rural providers in the Rural 

Health Care Programs, and further simplify the administrative and 

application processes. 

Additionally, we recommend expanding eligible health care providers under the program to include emergency medical services 

providers, consistent with the public health and public safety provisions of the Act. 

We also recommend including wireless technologies as eligible 

under the Rural Health Care Program, especially as we strive to 

improve chronic disease management with remote monitoring tools. 

But it is important to note that the success of any telehealth program relates to factors that include, but also extend beyond the 

cost of broadband connectivity. Elements that contribute to the success of any telehealth program includes payment by government 

and private payers. Unfortunately, for both our rural and non-rural 

seniors, access to quality telehealth services still remains stifled by 

Medicare payment barriers related to originating site restrictions. 

Improving that will increase demand for services. 

We strongly support the CONNECT for Health Act, the Chronic 

Care Bill, and the FAST Act, along with other bills that include 

provisions to expand the use of telehealth and remote monitoring 

in Medicare. 

In summary, telehealth affords patients enhanced access, lowers 

the overall cost of care, and improves efficiency, quality, and clinical outcomes. The Rural Health Care Program is foundational to 

a modernized health care delivery system and, as such, along with 

other efforts, must be continued, expanded, and further modernized 

to fulfill the promise of health care in the 21st century. 

Thank you so much. 

[The prepared statement of Dr. Rheuban follows:] 

188 

1 Agency for Healthcare Research and Quality. Effective health care programs. https:// 

effectivehealthcare.ahrq.gov/ehc/products/624/2254/telehealth-report-160630.pdf. Rockville, MD 

2016 2 Institute of Medicine, Committee on the Future of Rural Health Care. ‘‘Quality through collaboration: The future of rural health care.’’ (2004). 3Lustig, Tracy A. Institute of Medicine, The role of telehealth in an evolving health care environment: workshop summary. National Academies Press, 2012. 

PREPARED STATEMENT OF KAREN S. RHEUBAN MD, PROFESSOR OF PEDIATRICS, SENIOR ASSOCIATE DEAN, CONTINUING MEDICAL EDUCATION AND EXTERNAL

AFFAIRS; AND DIRECTOR, UNIVERSITY OF VIRGINIA CENTER FOR TELEHEALTH

Chairman Wicker, Ranking Member Schatz, members of the Subcommittee on 

Communications, Technology, Innovation and the Internet, thank you for the opportunity to provide testimony regarding the Federal Communications Commission’s 

(FCC) Universal Service Fund and in particular, the Rural Healthcare Support 

Mechanism established by the Telecommunications Act of 1996 (the Act). 

I am the co-founder and Director of the Center for Telehealth at the University 

of Virginia (UVA), past President of the American Telemedicine Association, and 

current Board Chair of the Virginia Telehealth Network. UVA is also the home of 

the Department of Health and Human Services’ Health Resources and Services Administration (HRSA) funded Mid Atlantic Telehealth Resource Center, through 

which we provide technical assistance to providers and systems across 9 states including the District of Columbia. It is from these related perspectives that I offer 

testimony regarding the critically important role of the Universal Service Fund in 

advancing access to high quality care to rural Americans through telehealth related 

programs and services. Although the focus of this hearing relates to the Rural 

Healthcare Support Mechanism, I will also touch upon the multifactorial issues that 

continue to impact the adoption of telehealth nationwide. 

As Committee members know well, telemedicine is not a new specialty, a new procedure or a new clinical service . . . simply defined, it is the use of technology designed to enable the provision of healthcare services at a distance. 21st century telemedicine services can be provided live, via high-definition interactive videoconferencing supported by high resolution peripheral devices; asynchronously, using store 

and forward technologies, or through the use of remote patient monitoring tools. 

Telemedicine has been demonstrated to effectively mitigate the significant challenges of workforce shortages, geographic disparities in access to care, while improving patient triage and timely access to care by the right provider at the right time. 

Telemedicine tools foster patient engagement and self-management where appropriate. 

Rural healthcare 

Where local specialty care services are not available, particularly in rural and underserved regions and health professional shortage areas, telemedicine offers timely 

access to care and spares patients the burden of long distance travel for access to 

that care. Telemedicine supports an integrated systems approach focused on disease 

prevention, enhanced wellness, chronic disease management, decision support, and 

improved efficiency, quality and patient safety.1

Although rural communities face the same basic challenges in access, quality and 

cost as their urban counterparts, they do so at far greater rates, attributable to a 

host of factors. ‘‘Core health care services’’ such as primary care, emergency medical 

services, long term care, mental health and substance abuse services, oral health 

and other services are considerably less accessible in rural communities.2 Lack of 

access to specialty care services is an even greater challenge. Rural communities 

lack sufficient patient volumes to support specialty and subspecialty practices and 

primary care providers are often overwhelmed with complex patients with acute and 

chronic illness. Telehealth technologies offer ready access to such services when 

rural communities and providers partner with tertiary and quaternary care facilities 

and where appropriate, with one another.3

Attracting health professionals to rural communities remains a daunting task and 

retaining those health professionals to practice in rural communities is equally difficult. Strategies to recruit and retain clinicians to practice in rural and frontier 

communities must also include innovative applications that enhance the management of patients with acute and chronic illness, and reduce the chronic sense of isolation experienced by those practitioners by affording enhanced connectivity to colleagues and educational opportunities. 

Telehealth technologies should be viewed as integral to rural development. In our 

program, more than 90 percent of patients seen via telehealth remain within their 

community healthcare environment, resulting in reduced burdens for patients and 

189 

4Texas A&M University, Rural & Community Health Institute (2017) What’s next? Practical 

suggestions for rural communities facing a hospital closure. 5https://www.fcc.gov/health/maps 

6Thomes, Cynthia. ‘‘The National Broadband Plan: Connecting America. Administered by the 

Federal Communications Commission, 445 12th Street SW, Washington, DC 20554. Retrieved 

October 15, 2010, from http://www. broadband. gov.’’ (2011): 435–436. 

their families. These benefits include a reduction in unnecessary transfers, and related transportation and housing expenses for patients and family members. In addition, a reduction in hospital lost revenue (as might occur with patient transfers) 

can lead to enhanced economic viability of the rural community hospital. A viable 

community healthcare environment supports jobs, provides incentives for the relocation of industry, and enhances community economic development. 

The aging of our population has already created increased demand for specialty 

healthcare services to address both acute and chronic disease in the elderly. These 

challenges are exacerbated in rural communities. As an example, rural patients experience 25 percent higher death rates from ischemic heart disease than do their 

urban counterparts.4

The FCC’s Connect2Health Taskforce has created a searchable database to overlay health status indicators with broadband availability. Not surprisingly, according 

to the Taskforce, close to half of U.S. counties are ‘‘double burden’’ counties—that 

is, areas with high levels of chronic disease and need for more broadband. More 

than 36 million Americans live in these double burden counties, according to the 

FCC report, where the fixed broadband access rate is 55 percent. The FCC also 

found that in these counties, as an example, the prevalence of obesity is 19 percent 

above the national average, while the prevalence of diabetes is 25 percent above the 

national average. A lack of Internet access is also connected with challenges in seeing health professional. ‘‘Most of the counties with the worst access to primary care 

physicians are also the least connected,’’ according to the FCC report.5 The 2010 National Broadband Plan sets achievable targets for healthcare connectivity.6

Although the challenges of unfavorable geography and distance tend to be uniquely rural, socioeconomic issues, health disparities, and other serious barriers to access to quality healthcare are also, of course, compelling in urban areas. Poverty, 

unhealthy behaviors and adverse health status indicators are also highly prevalent 

in our urban communities. Wait times for access to specialty care services adversely 

impact our urban insured beneficiaries as much as they impact our rural insured. 

Isolated vulnerable urban patients suffer from high rates of chronic illness. A bus 

ride across town with a long wait in an emergency room can be as challenging for 

an isolated, vulnerable uninsured urban patient as is a long ride for a rural patient. 

Telehealth tools can help to mitigate health disparities and improve outcomes in 

urban populations as well. 

The University of Virginia Center for Telehealth 

The University of Virginia Health System is a 610 bed state-supported academic 

medical center, and one of the two safety-net hospitals in the Commonwealth. The 

Health System is comprised of the UVA Medical Center, the UVA School of Medicine, the UVA School of Nursing, and University Physicians Group, our practice 

plan. Our UVA telemedicine program was formally established in 1996, as an effort 

to improve access to high quality care for all Virginians, regardless of geographic 

location. Recognizing the limited availability of broadband connectivity in rural regions of our state, we were early advocates for the Rural Healthcare Support Mechanism prior to the passage of the Telecommunications Act of 1996, and have since 

worked with the Federal Communications Commission by participating in Commission hearings, hosting members of the Commission at UVA and in the form of comments to multiple FCC proceedings. My UVA Center for Telehealth faculty colleague 

Colonel Eugene Sullivan served on the initial FCC Healthcare Advisory Board and 

Katharine Wibberly, PhD, Director of Research at our Center currently serves on 

the Universal Service Administrative Company (USAC) board representing rural 

healthcare. 

Since the establishment of our telemedicine program, we have developed collaborations that connect the UVA Health System with 153 sites across the Commonwealth using high definition video-teleconferencing, store and forward technologies, 

remote patient monitoring and mobile health tools to improve access to healthcare 

services for the citizens of the Commonwealth. We connect with hospitals, clinics, 

federally qualified health centers, free clinics, community service boards, health departments, medical practices, dialysis facilities, correctional facilities, PACE programs, rural schools, and skilled nursing facilities. Our telemedicine program has 

reduced the burden of travel for Virginians by more than 17 million miles, saved 

190 

7 Universal Service Administrative Company 2016 Annual Report 

8 47 U.S.C. Section 254 (C) 1 A,D 

lives and fostered innovative models of care delivery and workforce development. We 

have launched a care coordination and remote patient monitoring program for patients at home that has significantly reduced hospital readmissions by more than 

40 percent regardless of payer. UVA telemedicine spans more than 60 different clinical subspecialties, spanning the continuum from prenatal services, to emergency 

and acute care consultations and follow up visits, to chronic disease management 

and palliative care. We have facilitated more than 65,000 live interactive patient 

consultations and follow up visits using high definition video-teleconferencing, monitored more than 3,000 patients at home with remote monitoring tools, screened 

more than 2,500 patients with diabetes for retinopathy, the number one cause of 

blindness in working adults, used our connectivity to support more than 100,000 

teleradiology services and through our electronic medical record, EPIC, facilitated 

more than 2,500 e-consults between providers. These programs and partnerships are 

dependent on reliable broadband communications services and in the majority of 

cases, we rely on the FCC Rural Healthcare Program for connectivity between facilities. Absent the Rural Healthcare program, our ability to provide these services 

would be severely constrained. 

As an example, not long after we launched our telemedicine program in 1996, we 

received a grant from the U.S. Department of Commerce NTIA TIIAP program. 

Prior to the passage of the Telecommunications Act, the cost of a 1.54 megabit connection to a small rural community hospital in Appalachian Virginia was 

unaffordable, priced nearly $6000 per month. After passage of the Act, with enhanced competition and through the Telecommunications program of the Rural 

Healthcare Program, we secured discounts that allowed us to deploy telehealth services to that same hospital with greater bandwidth for a fraction of that original cost. 

Lives have been saved. That community hospital participates in our acute telestroke 

program, facilitated by the rapid transmission of radiographic images and CT scans 

and high definition videoconferencing that informs the mutual clinical decision making processes. By benchmarking against urban sites, we have secured subsidies as 

high as 89 percent for some eligible rural partners through the Telecommunications 

program. Since the inception of the Rural Healthcare Program in 1988 to 2016, the 

Commonwealth of Virginia has drawn down support of $23,588,000 in USAC funding for healthcare programs.7

Affordable broadband connectivity is without question, the requisite underpinning 

of our telemedicine program, and as such, these efforts have changed the standard 

of care in rural Virginia. However, in light of the complexity of the program applications, we established a process by which we applied on behalf of our telemedicine 

partners across the state. Few small hospitals or federally qualified health centers 

could easily navigate the complex process inherent in the Program. 

In 2002, in response to a notice of proposed rulemaking, and in the face of low 

utilization of the Telecommunications Program nationwide, we proposed that the 

Commission consider inclusion of rural for-profit hospitals with an emergency room 

as eligible for subsidies. Our justification was that many of those rural hospitals 

were financially strapped not-for-profit hospitals later acquired by for-profit entities, 

the only healthcare facility in the rural community, were bound by EMTALA (Emergency Treatment and Labor Act) and as such, inclusion of those facilities in the 

Rural Healthcare program was consistent with the public health and public safety 

provisions of the Act, which identified the relationship between universal service 

and public safety was clearly addressed. ‘‘The Joint Board in recommending, and the 

Commission in establishing, the definition of the services that are supported by Federal universal service support mechanisms shall consider the extent to which such 

telecommunications services (A) are essential to education, public health, or public 

safety . . . [and] (D) are consistent with the public interest, convenience and necessity’’.8

The Commission agreed, and in its subsequent rulemaking, included as eligible 

entities for-profit rural hospitals with emergency departments. Using a similar argument, we also suggested the Commission consider funding emergency medical 

services providers (EMS) however, the Commission demurred. 

In 2007, UVA was awarded a FCC Pilot Program to expand our telehealth and 

telestroke network across the Commonwealth. The pilot program provided 

broadband discounts of 85 percent, and for the first time, permitted inclusion of a 

limited number of urban entities. Our Pilot program ends with Funding Year 2016, 

on June 30, 2017 and we will apply as a consortium to continue through the 

Healthcare Connect Fund. 

191 

The Healthcare Connect Fund (HCF), a modernized Rural Healthcare Program 

was established in 2013 to allow for consortium applications, for funding up to three 

years which reduces the cumbersome annual reapplication process. The Commission 

recently added skilled nursing facilities as eligible entities both for both the Telecommunications and the HCF fund. The HCF provides 65 percent support and limited urban support within consortia. 

USAC has accelerated its outreach efforts and by streamlining the application 

process (amongst other changes consistent with program modernization), utilization 

has greatly increased, such that in Funding Year 2016, remarkably, the $400 million funding cap was exceeded. Hence, to ensure equitable use of the program, the 

Commission has reduced support in Funding Year 16 by 7.5 percent. This has created hardships for states such as Alaska that currently draw down more than $100 

million to support their extraordinary needs to expand telehealth programs within 

rural and frontier regions of the state. We fully support an expansion of the $400 

million cap established by the Commission for the Rural Healthcare Program in 

1998. If that is not feasible, we would suggest consideration of additional Federal 

options for infrastructure build out. 

Sustainability of telehealth 

It is important to note that the success of any telehealth program relates to factors that include but also extend beyond the cost of broadband connectivity. Elements that contribute to the success of program operations and sustainability include payment by private and government payers, tracking of clinical and process 

quality metrics, workforce capacity, and careful analysis of outcomes. All play a role 

in institutional commitments to sustaining a telehealth program. Return on investment must be considered in the context of organizational mission and programmatic 

alignment with that mission. 

The UVA Center for Telehealth tracks a broad range of process and quality 

metrics to include such metrics as time from consult request to completion of encounter, data transport metrics (as they relate to the transfer of medical images and 

quality of service of the connection), clinical outcomes measures, miles of travel 

avoided, patient satisfaction, provider satisfaction and other organizational metrics. 

Examples of clinical outcomes include the following: 

a) Our stroke telemedicine program has supported the evaluation and treatment 

of more than 1,000 rural Virginians, resulting in TPA (Tissue Plasminogen Activator) administration rates now exceeding >20 percent in rural partner hospitals. These TPA administration rates align with the rates of TPA administration for stroke patients treated in our own emergency department. This compares favorably to statewide TPA administration rates of <1 percent prior to 

the initiation of our stroke telemedicine program and others within the Commonwealth. In addition, we have more recently accelerated time to treatment 

by connecting EMS providers to our stroke team further accelerating time to 

treatment when ‘‘time is brain’’. The human toll and cost to society (and the 

payers) of a lack of access to such therapies is enormous. 

b) Our high-risk obstetrics telemedicine program serves rural high risk pregnant 

women. We, like others, have documented a reduction in NICU hospital days 

for the infants born to these patients by 39 percent compared to control patients, reduced patient no-shows by 62 percent and reduced patient travel by 

these pregnant women by 200,000 miles. 

c) With our partner, UVA Remote Care Solutions,, using care coordination and 

remote patient monitoring tools, we launched a program to prevent hospital readmissions for patients with heart failure, acute myocardial infarction, chronic 

obstructive pulmonary disease, pneumonia, stroke and joint replacement, and 

have reduced all cause 30 day readmissions by > 40 percent. 

d) Store and forward ophthalmologic screening for retinopathy, the number one 

cause of blindness in working adults has been provided to underserved adults 

with diabetes. Over the past two years, more than 2,500 ophthalmologic 

screens have been performed, with 46 percent of patients identified as having 

abnormal studies, requiring follow up or sight saving intervention. 

e) Our telepsychiatry program represents the number one request for services. 

We offer child and adolescent, adult, emergency and substance use services. 

These programs have been shown to be effective, with high rates of patient satisfaction and rely upon high definition videoconferencing technologies supported by reliable bandwidth. 

192 

Issues for consideration 

There remain significant barriers to the broader integration of telemedicine services into everyday healthcare that impact provider utilization. More than 16 different Federal agencies report engagement in telehealth, be it through research and 

other grant funded opportunities, through the establishment of broadband communications networks, clinical service delivery, and even device development and regulation. In the face of a multi-billion dollar Federal investment in telemedicine and 

broadband expansion in support of access to healthcare, those good faith efforts 

have also been stifled by 20th century Federal and state barriers to widespread 

adoption and a lack of alignment across the programs. 

Reimbursement 

Medicare: Payment coverage restrictions remain a major impediment to the broader adoption of telehealth by providers. Congress, in 1997, through the Balanced 

Budget Amendment, and later in 2000, though the Benefits Improvement and Protection Act, authorized the Center for Medicare and Medicaid Services (CMS) to reimburse for telemedicine services provided to rural Medicare beneficiaries across a 

broad range of CPT codes and services. However, those Medicare telehealth provisions, as established in the Section 1834 (m) of the Social Security Act limit eligible 

patient originating sites to rural, and have not evolved to take advantage of subsequent analyses of best practices, outcomes data, and new paradigms of healthcare 

delivery, even following enactment of the Affordable Care Act. The Medicare definition of rural for purposes of telehealth coverage remains as non-Metropolitan statistical areas and Health Professional Shortage Areas which are aligned with primary 

care shortages but not adequately for specialty workforce shortages. 

Medicare reimbursement of telehealth services remains woefully limited. The Center for Telehealth and e-Health Law (CTeL) reported that in 2015, Medicare allowed 

$15,664,543 in distant site reimbursement and $1,937,453 in originating site 

charges NATIONWIDE. Medicare payment data in the fee for service program are 

shown below, courtesy of CTeL. 

The Center for Medicare and Medicaid Innovation has funded pilot programs that 

incorporate broader telehealth reimbursement; although some Accountable Care Organizations remain limited to the rural originating site restrictions. 

The Connect for Health Act (S 1016/HR 2556), the Chronic Care Bill (S 870) and 

the FAST Act (S 431/HR 1148) along with other bills include provisions to expand 

the use of telehealth and remote patient monitoring in Medicare by reducing originating site restrictions. 

The American Medical Association Digital Medicine Payment Advisory Group is 

currently working to align telehealth taxonomies with use cases, and make recommendations to the CPT Advisory Panel and the RVUs Update Committee (RUC). 


620RHEUB1.eps
193 

Medicaid: Currently nearly every state Medicaid program provides some form of 

reimbursement for the delivery of telehealth facilitated care to Medicaid beneficiaries. Medicaid innovations adopted by many states in addition to video-based 

telemedicine consults and follow up visits include coverage for remote monitoring, 

home telehealth, store forward services. 

Private pay: Thirty three states plus the District of Columbia require that private 

insurance cover telehealth services. Many of the ERISA plans have chosen to cover 

telehealth services. 

Other Federal payers: The Office of Personnel Management offers some telemedicine benefits for individuals covered under the Federal Employee Health Benefit 

Plans. The Veterans Health Administration has long integrated telehealth solutions 

as has the Department of Defense. 

Standards and practice guidelines 

Telemedicine does not create a new field of healthcare, but rather allows duly 

credentialed clinicians to provide care at a distance using technology. That being 

said, the American Telemedicine Association and its >9,000 member supported Special Interest Groups, Committees and Discussion groups have developed standards 

and practice guidelines to address technical applications, and clinical practice guidelines, endorsed by specialty societies. Many of these standards and practice guidelines extend beyond the practice guidelines that currently exist for traditional 

healthcare. 

Acceptance of advanced technologies 

Patient acceptance of the use of telehealth technologies for consultation and ongoing acute and chronic care has been remarkably positive, attributable in part to the 

obvious benefit of timely access to locally unavailable specialty healthcare that 

spares patients the burden and expense of travel to remote tertiary and quaternary 

healthcare facilities. Indeed, we have collected data that demonstrates that for pediatric tele-psychiatry services, the telehealth ‘‘no-show’’ rate is considerably lower 

than the in person clinic ‘‘no show’’ rate. Provider acceptance of advanced technologies and telehealth tools has been equally gratifying for patient consultation, 

patient education, distance learning opportunities, for acquisition of timely information services and for clinical decision support. High bandwidth and high quality connections remain the underpinnings of successful telehealth encounters. 

Recommendations 

1. Continue the Rural Healthcare Programs and expand the $400 million funding 

cap established by the Commission in 1998. There is no statutory requirement 

that the fund be capped at that level. 

2. If the $400 million funding cap cannot be increased, explore additional Federal 

options to support costly infrastructure build-outs for rural healthcare providers. 

3. Additionally, if the funding cap cannot be raised, prioritize rural providers in 

the Rural Healthcare programs. 

4. Further simplify the administrative and application processes for rural 

healthcare providers 

5. Expand eligible providers for the Rural Healthcare program to include emergency medical service providers and community paramedics, consistent with 

the public health and public safety provisions of the Act. 

6. Coordinate with the effort being undertaken by the NTIA Department of Commerce with FirstNet to create a nationwide public safety wireless broadband 

network for Emergency responders. 

7. Include wireless technologies as eligible under the Rural Healthcare Programs. 

8. Further eliminate barriers to telehealth payment in the Medicare program 

such as geographic and other originating site restrictions so as to allow the 

nearly 80 percent of Medicare beneficiaries currently not covered for telehealth 

services to avail themselves of the benefits of telehealth mediated care. 

9. Allow for Medicare coverage of home telehealth and remote patient monitoring 

services, in particular, for patients with chronic illnesses. Allow as eligible providers for telehealth services otherwise eligible Medicare providers such as 

physical, occupational and speech and language therapists. 

10. Improve coordination amongst the Federal agencies such that our national interests in population health, improved health outcomes, emergency preparedness, workforce, and health information exchange, enhanced by connected 

health tools and strategies. 

194 

In summary, telehealth affords patients enhanced access, lowers the overall cost 

of care, and improves efficiency, quality, clinical outcomes and population health. 

The Rural Healthcare Program is a critical underpinning of a modernized 

healthcare delivery system in the digital era and as such must be continued, expanded and further modernized to fulfill the promise of healthcare in the digital era. 

The CHAIRMAN. Well, thank you all for your excellent testimony. 

You were very helpful to the Subcommittee in keeping to the time 

constraints, and we really appreciate that. 

Mr. Graham, let me begin with you. You mentioned your support 

for the Rural Wireless Access Act and the problem with getting the 

right data collected. Let me drill down on that. How does the FCC 

currently collect mobile coverage data to determine areas eligible 

for USF support? Why is this data collection process inadequate? 

Finally, how would standardizing collection methods at the FCC 

help truly identify areas that are unserved or underserved? 

Mr. GRAHAM. Thank you, Mr. Chairman. Currently, the FCC has 

wireless operators file a Form 477, which shows how the operator 

views its coverage in a given area. Now, operators will measure 

their coverage in different ways. They’ll either measure indoor coverage or outdoor coverage or they can run simulations with leaves 

on trees, without leaves on trees. The terrain makes a difference. 

There are theoretical maximums that are real-world speeds that 

you see, real-world coverage that you see. 

And each operator can have a different view of what their coverage looks like and what the same coverage looks like just based 

on their internal metrics. There are some operators that would submit data that only an engineer would stand behind anywhere and 

at all times. There are other operators who submit data that a 

marketing department would maybe look crossways at because it 

may overstate things slightly. And it’s not necessarily malicious 

that the data is different, it’s just different, there’s not an applesto-apples comparison. 

The FCC needs to pause and tell operators how this information 

should be presented. Let’s agree on what the signal strength should 

be. Let’s agree on whether this is indoor coverage or whether it’s 

outdoor only. Let’s agree on the time of year. All of these factors 

make a difference in what wireless coverage looks like, and that 

needs to be standardized if the FCC wants to have an accurate 

view of what coverage looks like in a given area. 

Another example quickly is that in the display, it gets down to 

the actual pixels that carriers use on their maps. Some carriers 

will use larger pixels which show coverage in an area—more pixels 

that shows coverage in an area where it doesn’t actually exist because other carriers choose to reflect that in smaller units. 

So right now we don’t know where coverage truly exists, we don’t 

know where coverage is lacking, and the FCC’s answer is, ‘‘Unless 

you can come back and challenge the process and show us that 

we’re somehow off with this measurement, we’re going to assume 

that it’s correct even though we acknowledge that it’s not.’’ 

The CHAIRMAN. Who’s doing the better job right now? Can you 

point to someone who’s collecting data better than the FCC? 

Mr. GRAHAM. I will tell you that our company obviously. 

The CHAIRMAN. Oh, I am shocked. 

[Laughter.] 

195 

Mr. GRAHAM. We stand behind our coverage maps. We don’t have 

a marketing coverage map and an internal coverage map that 

shows where we really have coverage. We submit true data. We 

know that there are companies out there that compile other carriers’ data, but the technology exists today for wireless devices to 

actually feed anonymous information back into a program to provide mapping of data, mapping of coverage areas, so you get a better sense of where coverage truly exists. 

The CHAIRMAN. You mentioned that the Commission seems to 

want to get the money out there quickly even if it’s not sent to the 

right places. Do you worry that what you’re suggesting will delay 

the process in a way that disadvantages rural America? 

Mr. GRAHAM. My fear is that moving forward without delay is 

going to disadvantage rural America, and here’s why. 

The CHAIRMAN. How quickly can they get it right? 

Mr. GRAHAM. I don’t know how quickly they can get it right, but 

when they make this decision, it will be locked in for a decade, 

meaning if they’re wrong in any area that’s lacking in coverage, 

that area is locked out, universal support, universal service support, for a decade. 

The CHAIRMAN. Let me just ask you, what’s the difference between mobile broadband and fixed wireless broadband? From a 

consumer perspective, does that difference matter particularly as it 

relates to a consumer’s access and the use of telemedicine? 

Mr. GRAHAM. So we have built our network to support mobile, 

but in doing so, technology has advanced to the point that our network can support fixed wireless at this point as well. Mobility obviously will take care of that customer anywhere they go that’s in 

that coverage area. With fixed wireless, we can increase speeds 

point to point up to speeds that rival what’s available over certainly coaxial cable and even fiber, and even our mobile network 

can deliver 100 megabits per second. 

The CHAIRMAN. Senator Schatz. 

Senator SCHATZ. Thank you, Mr. Chairman. 

Ms. Bloomfield, thank you for your testimony. You know that 

Hawaii’s unique geography makes it difficult and more expensive 

to deliver broadband services, and I know a lot of people are at this 

dais because they have their own unique geography. I worry that 

the way the FCC has implemented its USF mandate does not always account for that uniqueness. Can you comment on what you 

think the different USF programs should accommodate for the significant cost differences between various geographies and 

topographies? 

Ms. BLOOMFIELD. Absolutely. And you do have your own unique 

challenges. That lava rock is pretty hard to bore some fiber into, 

much less an ocean that you have to carry your traffic out from. 

So there are—you know, and I look around the dais, and absolutely, you’ve got different topography, you’ve got different build 

seasons. You know, what you can do in terms of construction in 

Montana is very different than what you can do in South Carolina. 

Those windows also change the cost of actually the infrastructure 

that you’re building. 

So one of the things that the FCC, you know, I think has been 

very interested in is trying to create a model that becomes kind of 

196 

a one-size-fits-all, and the problem is you can’t have a one-size-fitsall, it simply doesn’t work that way. 

So they did recognize when they did the reforms that there’s a 

model approach, which a number of carriers took, but an even larger number of carriers that said, ‘‘You know what, our variations 

are simply—our swings are too great, our construction costs are too 

varied, that we’re actually going to stay on rate of return so that 

we can actually try to measure our actual costs.’’ So that does continue to be a challenge, and certainly something that we appreciate 

your recognition of. 

Senator SCHATZ. A quick change of topics, Ms. Bloomfield. You 

know, we’re talking about the various uses of the USF fund, and 

I think we all advocate for all of the various uses, from E-rate to 

telehealth to broadband deployment in rural areas. 

I think the elephant in the room is contribution reform. You 

know, we don’t talk about it enough. And here we have all of these 

wonderful uses of deploying the dollars that come into the Fund, 

and a decreasing percentage of the American population that pays 

into the Fund. And so I would like you to comment on that, Ms. 

Bloomfield, and maybe we can start to have an adult conversation 

about how to spread out the revenue, spread out the contribution 

into USF? If we’re talking about deploying rural broadband, we 

can’t possibly have it paid for by people who pay for long line, long 

distance telephone service because at some point we’re going to run 

out of money. 

Ms. BLOOMFIELD. Senator Schatz, what a timely question. In my 

prepared remarks, I really do address a little bit more in terms of 

contribution reform. The FCC at the time had a decision to kind 

of go forward with contribution reform. Where do you get the appropriate funding from or distribution, how you’re going to actually 

distribute the funding? So they went with distribution first, which 

didn’t appropriately size the pot of the resources available. 

And you’re absolutely right, it’s tacked on to a diminishing pool. 

And when you think about broadband and how when all of us are 

talking about broadband services here, the fact that broadband is 

not adequately captured. 

However, I will share with you, this has been bantered around 

for about 10, 15 years, we’ve been talking about contribution reform, how incredibly important it is. It seems to be a little bit of 

a political hot potato. I would love to see Congress address it. The 

immediate needs now that you are hearing from folks at this table 

is that we simply cannot build the infrastructure without dealing 

with some immediate resolution. 

So I would say that’s critically important, but I would also say 

we’ve got to look at what is really right on the table at this point 

in time, and I don’t think these carriers and I don’t think rural 

Americans can wait 2 or 3 years for us to kind of go through the 

process that we’ll need to go through on contribution reform, which 

I do hope we do, but I think that the immediate need is more urgent. But absolutely, we welcome that discussion. 

Senator SCHATZ. And I agree with you. I think that we have to 

be able to do things in the distribution side of this, and contribution reform is a challenging topic, but it’s not just a matter of the 

fact that we’re going to not have enough revenue relatively soon, 

197 

it’s also deeply, deeply unfair to the remaining people who are paying into this fund for services that they may or may not receive. 

In the interest of time, I’m going to reduce a couple of questions 

for Dr. Rheuban to write in for the record. I appreciate the work 

that you’ve done on telehealth, and I want to recognize the Chairman, Senator Capito, and others who have gotten on the CONNECT for Health Act. We have a lot of bipartisan support. And 

there is a Commerce Committee nexus here. We look forward to 

working with you and getting your expertise. 

Thank you. 

The CHAIRMAN. Thank you. We are joined by our Ranking Member, Mr. Nelson. Sir, you are recognized. 

STATEMENT OF HON. BILL NELSON, 

U.S. SENATOR FROM FLORIDA 

Senator NELSON. Thank you, Mr. Chairman, and I’ll be quick because I want you all to have the opportunity to continue. I will insert opening comments into the record. Obviously, we’re here dedicated and want very much to get broadband out into the rural 

areas. 

Technology changes so fast. So Elon Musk has a business plan 

where he is going to put up a constellation of 400 satellites to distribute broadband all over the globe. Whenever that occurs down 

the road, is that going to solve the problem? 

Ms. BLOOMFIELD. Well, I’ll take a crack at that one. So satellite 

technology has its challenges, right? And I don’t know if anybody 

sitting in this room actually has satellite broadband, but you’re 

really subject to a lot of latency issues. You are subject to the 

whims of weather, lines of vision. There are a lot of things that 

make actually satellite a lot more complicated than it seems. So it 

seems easy out of the box. 

I will tell you, you know, it would be fabulous in a number of 

years if that technology hits that point in time. It is not there yet. 

And when we think about broadband, whether it is fixed wireless, 

whether it’s wireless, you know, right now the fiber connectivity 

really is the most important building block that we have. 

Mr. BALHOFF. I would agree with that. I was a financial analyst 

following Motorola and Iridium, which was, of course, the original 

satellite deployment plan, and it was found that there were so 

many technical difficulties. Now, obviously technology continues to 

move forward, but I would even suggest that with the fixed wireless or mobile wireless solutions that people talk about, there’s a 

reason why AT&T and Verizon have spent over $20 billion on fiber 

in their networks, and that is the future-proofing of their network 

and the kinds of demands, because fundamentally, if you build it, 

they will fill it. 

And so with wireless, what you tend to find is that there are certain limitations eventually that people bump against in those 

cases, which is not to say that wireless is not extremely valuable 

in that plan. So C Spire and others have done a very, very good 

job in that regard, but fiber continues, as Shirley has mentioned, 

to be the building block going forward. 

Mr. GRAHAM. I will also, if I might, say I think that satellite has 

the opportunity to be a very good tool in the toolbox of ways that 

198 

broadband is provided across America. We have in our hands right 

now fiber, as my other panelists have said, and wireless and technologies that work today, and if satellite can come in and can improve and supplement that, I think that would be a great use. We 

have a wireless network. We also deliver gigabit fiber to the home 

as well as fiber to businesses. We also continue to operate the rural 

independent telephone companies that I referenced earlier in my 

testimony, and we operate a cable company. So every terrain is different, every use case is different, and it’s an issue of matching the 

right tool in the box to the job at hand. 

[The prepared statement of Senator Nelson follows:] 

PREPARED STATEMENT OF HON. BILL NELSON, U.S. SENATOR FROM FLORIDA

Broadband use is an essential part of our everyday lives—but according to the 

FCC, millions of Americans throughout the country still lack access to an adequate 

high-speed broadband connection. Even in Florida—where we are blessed to have 

some of the most advanced networks in the country—there are still areas where our 

residents do not have access to high-speed broadband or struggle to have access to 

even the most basic of broadband services. This is unacceptable—plain and simple. 

Those who do not have access are being left behind. The plight they’re facing to 

find good jobs, learn new skills and provide a foundation where their children will 

fare better in the future than themselves is being hampered by few broadband options and slow service in an Internet-driven economy and society. And it’s only going 

to get worse unless we get serious about ensuring all Americans have access to fast 

and affordable broadband. 

All of the FCC’s universal service programs are vitally important to our longstanding efforts to close this lingering digital divide. The FCC has undertaken massive and thoughtful modernization and updating of the universal service program 

funds over the past few years. While many of these changes are beginning to deliver 

substantial benefits to companies, schools, libraries, health care facilities and consumers, I look forward to hearing from our witnesses today on how we can do better 

to deliver for Americans who aren’t connected and have been left behind. 

But, let me be clear, the FCC’s universal service fund alone isn’t the only answer 

to providing broadband access to every nook and cranny of this country. All of us 

on this committee should get behind the idea of including Federal funding to 

jumpstart deployment of broadband services and Next Generation 9–1–1 in any bipartisan infrastructure bill. Our rural communities and neighbors need and deserve 

our help. Mr. Chairman, I remain hopeful that we’ll all come together and will indeed provide these Americans with the broadband access they and their families 

desperately need. 

The CHAIRMAN. Thank you. 

Senator Klobuchar. 

STATEMENT OF HON. AMY KLOBUCHAR, 

U.S. SENATOR FROM MINNESOTA 

Senator KLOBUCHAR. Thank you very much, Mr. Chairman and 

Senator Schatz, for holding this hearing. We have worked very 

hard to expand broadband. We have our Senate Broadband Caucus. 

I see Senator Capito, who is one of the co-chairs along with myself. 

And I want to thank you so much for being here. 

I’m going to start with standalone. Ms. Bloomfield, you know 

that Senator Thune and I have worked to reform outdated Universal Service Fund rules. We got the FCC to make some changes 

after we got a number of people from this committee and other 

places to support that model. But shortfalls in USF funding have 

prevented the new model-based support from offering services to 

rural consumers at comparable rates. There are still problems. Do 

199 

you have a sense of how many locations did not get served because 

of the model budget shortfall? 

Ms. BLOOMFIELD. So, first of all, thank you very much for your 

leadership. It was very timely, Senator Klobuchar. 

Yes, there is definitely, as we talked before, and in my written 

testimony, there’s a budget mechanism that is currently in place. 

And so because universal service is actually helping folks recover 

cost of investments they’ve already made, what we’re seeing is that 

the standalone broadband piece, because of the gap in the programs, for example, on the ACAM, which is the model side, there’s 

a shortfall of about $110 million for this year. On the rate-of-return 

side, it’s about $173 million. 

So the problem with that shortfall is there are a couple of things. 

We know on the model side, for example, that there are about 

71,000 people who will not be getting the higher speeds that my 

carriers had intended to be able to provide this year. And in addition, there are about 50,000 consumers that will actually not be 

getting broadband at all. 

On the non-model side of the house, you know, I am hearing 

from folks that on average—we just did a survey, and on average, 

the cost of standalone broadband right now still stands at about 

$160, $170 a month. That is simply not affordable. So we have not 

been able to get that differential. And I do attribute all of that to 

the budget mechanism just simply holding down those numbers. 

Senator KLOBUCHAR. And how would you fix it? 

Ms. BLOOMFIELD. So I would fix it. I think there are a couple of 

immediate things that we could do, but I think that, you know, the 

first thing I would say is looking to the FCC with hopes that there 

are reserves there in the universal service program and that those 

reserves be put forward to help support some of the gap. They were 

able to do a little bit of that on the model side early out of the box. 

They did not do that on the rate-of-return side. 

The second thing would be to take a look at the contribution factor. I know they held it down for good reason, but I think again 

just a slight uptick in that will be enough to sufficiently fund this 

program. We’re not talking about a lot of money. 

Senator KLOBUCHAR. OK. Thank you. And I also appreciate 

NTCA’s support for the bill that I’ve done with Senator Capito, Sullivan, and others on measuring the economic impact of broadband, 

and I think that’s going to be helpful as we work to get more funding either in a major infrastructure package or in some of the ways 

that you just discussed. 

Mr. Graham, in your testimony, you highlighted a letter that I 

signed along with several of my colleagues to Chairman Pai regarding Mobility Fund 2. We expressed concern that Mobility Fund 2 

should encourage carriers to preserve upgrade and expand mobile 

broadband and not degrade it. How significant could the loss of 

service be in rural communities if sufficient operating support is 

not provided? 

Mr. GRAHAM. Well, quite simply, support—excuse me—coverage 

will be turned down, carriers like us, like C Spire, who have been 

participants in the Universal Service Program for a long time, used 

the support that we receive to extend our wireless networks into 

200 

rural areas and introduce coverage, introduce networks that then 

form the foundation for advanced wireless services. 

Today, our receipts from the Universal Service Fund has been 

cut to the point that expansion is no longer an option. What we’re 

doing now is maintaining what has been built. The FCC plans to 

take the rest of that universal service support away from providers 

like C Spire, and when that support goes away, the operating expense dollars go away. It is literally that dire. Defunding existing 

networks in order to fund the expansion or construction of new networks will have that effect. 

Senator KLOBUCHAR. OK. One last with a quick answer. I’m CoChair of the Next Generation 911 Caucus. The ability to reach help 

shouldn’t depend on your ZIP Code, as you know. In your testimony, you mentioned that some coverage maps, that the FCC overstate coverage. Could this result in an inability to call 911 in areas 

that appear to be served? 

Mr. GRAHAM. Yes, it absolutely could. My answer is as simple as 

that. 

Senator KLOBUCHAR. OK. Very good. And I had a question regarding a letter Senator Fischer and I did on comparable rates in 

urban and rural communities, and I’ll ask that in writing, Ms. 

Bloomfield. 

So thank you very much for your work, all of you. 

The CHAIRMAN. Thank you, Senator Klobuchar. 

Senator Peters. 

STATEMENT OF HON. GARY PETERS, 

U.S. SENATOR FROM MICHIGAN 

Senator PETERS. Thank you, Chairman Wicker and Ranking 

Member Schatz, for holding this hearing. And I would like to certainly thank all of our witnesses for your testimony here today. 

I represent the state of Michigan, which has vast rural areas in 

Northern Michigan, and, of course, our beautiful Upper Peninsula, 

and this is an incredibly important issue for the folks up there. I 

actually like to think of universal broadband access as something 

very similar to access to electricity. If you live in a rural area, we 

made a major focus as a country to make sure that every inch of 

this country was electrified, believing if you lived in a rural area, 

you should have equal access to electricity as someone in an urban 

area, and I think that is every bit as true in terms of this technology in order to advance those communities to allow for economic 

development going forward. 

But before we talk about some of the reforms, I also think that 

it’s very important that we address the issue of incomplete and inaccurate coverage data, and there have been some real issues in 

Michigan in relation to that. So I was happy to join Mr. Wicker on 

your bill, the Rural Wireless Access Act of 2017. I appreciate your 

leadership. I’m very proud to be a cosponsor with you of that legislation. Hopefully we can get Chairman Thune and Ranking Member Nelson to take it up shortly in the broader committee because 

I think that’s absolutely essential for us moving forward. 

But my questions are for Ms. Rheuban, and I appreciate your 

testimony regarding expanding telehealth services into rural America. You have called for expanded Medicaid coverage in those servVerDate Nov 24 2008 09:27 Jul 24, 2018 Jkt 075679 PO 00000 Frm 00204 Fmt 6633 Sfmt 6601 S:\GPO\DOCS\30768.TXT JACKIE
201 

ices, and, in fact, Senator Gardner and I introduced the Telehealth 

Innovation Improvement Act, which seeks to do just that, which 

would require the Department of Health and Human Services to 

allow eligible hospitals to test telehealth services through the Center for Medicare and Medicaid Innovation. It would also allow telehealth models to be covered by the greater Medicare program if 

they meet independent evaluation for cost effectiveness and improvement for quality of care, which I believe a lot of these programs will be able to do. Certainly the folks that I represent sometimes have to drive hours to get basic medical care. And now this 

promises to change that pretty dramatically, but, of course, you 

have to have access to broadband in order to do that. 

My question, though, is, what type of criteria do you believe a 

telehealth program should meet in order to match a national standard of care? 

Dr. RHEUBAN. I don’t believe telehealth programs should be held 

to any higher standard of care than what we do with everyday 

health care. The National Quality Forum right now is doing actually an analysis of the quality metrics for telehealth programs. 

There are practice guidelines that have been developed both by the 

specialty societies in partnership with the American Medical Association and the American Telemedicine Association. And the Agency for Health Care Quality and Research are looking at the quality 

outcomes of telehealth services. 

So I would push back a bit and just say we should not be held 

to a higher standard in the provision of telehealth services as we 

are for everyday health care services. 

Senator PETERS. Well, as a follow-up, as we push to expand 

Medicare to cover these new innovative services, how can we collect 

better data and conduct enforcement to ensure that these programs 

are truly the best that we can offer? 

Dr. RHEUBAN. Well, currently, when we bill Medicare, we bill 

with specific modifiers, so that data is available, but there are even 

flaws in the review by Medicare. We had a recent example at the 

University of Virginia with one of our really great telestroke initiatives and partners, and we had payment retracted by a Medicare 

intermediary because the originating site didn’t bill Medicare for 

the service, where there is nowhere in statute or in regulation that 

requires the originating site to bill for the originating site fee. 

So there’s a lot of misinformation, quite frankly. And I think we 

can certainly, as telehealth providers, document the outcomes of 

the services we provide. We bill with the appropriate modifiers, 

and the Agency for Health Care Research and Quality is evaluating 

those outcomes. 

Senator PETERS. Are you familiar with the legislation that I mentioned that I’m working on with—— 

Dr. RHEUBAN. No, I’m not. 

Senator PETERS. Well, I would certainly look forward to having 

an opportunity to discuss that further with you, if you had an opportunity to review that bill and give us any input as to how we 

can make it better. 

Dr. RHEUBAN. I would love to. 

Senator PETERS. I appreciate your work on this and look forward 

to working with you. Thank you. 

202 

Dr. RHEUBAN. Thank you. 

The CHAIRMAN. Thank you, Senator Peters. 

Senator Hassan. 

STATEMENT OF HON. MAGGIE HASSAN, 

U.S. SENATOR FROM NEW HAMPSHIRE 

Senator HASSAN. Thank you, Mr. Chair and Senator Schatz, and 

thank you to the witnesses for appearing today. It has been a very 

informative panel. I obviously come from a state, New Hampshire, 

where we have granite to go through. So he has lava, I have granite, and they both present their challenges. 

And you’ve answered a couple of the questions I had, but perhaps 

starting with Dr. Rheuban and then if the other panelists want to 

chime in. Obviously, universal service support for rural health care 

programs is something that we all care a great deal about, and I 

think we’re beginning to gain a growing appreciation of how important and useful it can be. 

In states like New Hampshire, not only do we have rural health 

care programs that could really leverage this technology, but right 

now in the middle of the opioid epidemic, we’re looking for every 

single tool we have, and certainly in rural areas, telehealth is incredibly important, and the Healthcare Connect Fund will provide 

Federal support for state and regional broadband health networks. 

It’s my understanding that the amount for the support last year 

exceeded the amount of support available for the program. So how 

should the FCC prioritize this program while balancing the needs 

of other USF programs that Granite Staters and people across the 

country also rely on? 

Dr. RHEUBAN. Senator Hassan, that’s a very appropriate comment. This is a public health emergency, the opioid epidemic. For 

our program at the University of Virginia, a full 50 percent of our 

encounters relate to behavioral health services needed by rural patients, and I think this is critical. 

The Commonwealth of Virginia has just launched a project 

ECHO-like model that will connect providers to do case presentations with experts in substance abuse or substance use mitigation, and I think this is a critical element. And as we look to the 

public health safety component of the Telecommunications Act, we 

should also then include additional services for rural health providers who choose to participate in such programs. 

Senator HASSAN. Thank you. 

Ms. BLOOMFIELD. If I could also jump in. So one of the things, 

too, that’s important in these rural areas is that you also have to 

have that underlying network that helps to connect the clinics to 

the teaching hospitals and the other infrastructure. 

When we look at the rural areas, my folks are community-based 

companies, so they have every motivation to keep their communities alive and vibrant. And probably one of the biggest keys, with 

an elderly population, a lot of American vets, is access to health 

care. So we are—and we worked the good doctor a number of years 

on some of these initiatives because we see a lot of synergy between broadband providers and the ability for them to connect 

these community-based entities that really make a difference in the 

quality of life. So we look to be supportive as well. 

203 

Senator HASSAN. Thank you. 

Mr. Graham? 

Mr. GRAHAM. Yes, and I’ll just add, this also gets back to the 

data coverage, the bad data issue, that we’ve talked about. In the 

Mississippi Delta, there as a diabetes monitoring trial that was 

run, it’s referenced in my written testimony, and when the monitoring units were sent to the patients, they were sent to patients 

for a particular carrier based on coverage maps that showed coverage in that area. Coverage didn’t exist in that area, which is how 

C Spire ended up in the pilot program, a pilot program that based 

on projections in my written testimony, could save the state of Mississippi $200 million a year in Medicaid. 

Senator HASSAN. Sure. Thank you. Well, I appreciate it very 

much. 

I guess the other couple of thoughts I have, and, Dr. Rheuban, 

maybe you can address this, is one of the other challenges with the 

opioid epidemic that we have is physician training because a lot of 

physicians haven’t been trained in either pain management or the 

science of substance use disorders. So I’m wondering if you see, you 

know, if your rural hospitals have very strong coverage and access, 

whether this is a way we could also leverage broadband so we 

could do more physician training around this issue. 

Dr. RHEUBAN. Actually my other hat is I am the Associate Dean 

for Continuing Medical Education. 

Senator HASSAN. Yes. 

Dr. RHEUBAN. And so we have used our networks in the Commonwealth of Virginia to do training. Now, we also have to do more 

training in Suboxone prescribing, and that’s one of our goals actually in the Commonwealth of Virginia. And so I agree completely 

with you. The Commonwealth has also mandated, it’s not much, 

but several hours of training for licensure renewal in pain management. And, again, telehealth technologies are a great tool to be able 

to provide distance learning and educational tools for providers 

who wish to learn more. So I agree completely. 

Senator HASSAN. Well, I thank you all. I think what we’re hearing this morning, and I thank the Chair and Ranking Member, is 

we can all agree on the incredible possibilities that making sure 

that our entire country sees broadband, has broadband coverage, 

and is treated as a true utility, there are great possibilities ahead, 

we just have to find a way to do it. Thank you. 

The CHAIRMAN. Thank you, Senator Hassan. 

Senator Fischer. 

STATEMENT OF HON. DEB FISCHER, 

U.S. SENATOR FROM NEBRASKA 

Senator FISCHER. Thank you, Mr. Chairman. 

Ms. Bloomfield, my colleagues and I have heard frustration about 

the prices for and also the availability of standalone broadband, 

and even after the reforms to the Universal Service Fund, many 

operators are unable or they’re unwilling to offer such services because the prices are still very high. Recently, 57 of my colleagues 

and I sent a letter to the FCC Chairman expressing our concern 

about the lack of sufficient resources and the reformed High Cost 

204 

mechanism. So how has the FCC’s treatment of standalone 

broadband impacted deployment in our rural communities? 

Ms. BLOOMFIELD. So I think we’re going to start to see that, Senator Fischer, and I think it’s terrific you’ve been hearing from your 

carriers. The state of Nebraska is going to be impacted to the tune 

of about $3.6 million this year in terms of money that folks had actually invested that will not be coming back in on the non-model 

side of the house. 

So what folks are doing, we actually, as I mentioned, just on the 

survey, we found that 65 percent of our companies are now pulling 

back on their investments. So things that they had planned to do, 

infrastructure they had planned on putting into the ground, they 

are no longer going to go forward with, or where there were areas 

they thought they were going to hit higher speeds, they are not 

going to be able to go forward. 

And to your point on standalone broadband, the price point simply is not there because of these budget mechanisms. So we need 

to find a way. And, again, it’s such a small amount, but it’s so critical to these carriers that have already made these investments to 

get those fully funded. 

Senator FISCHER. OK. Thank you. 

For the entire panel, we had the Department of Transportation 

Secretary here before the Committee not too long ago, and Secretary Chao has said that broadband deployment could be included 

in the administration’s infrastructure package. As Congress considers infrastructure priorities, what role do you believe that the 

states should play in order to support broadband buildout? And 

should the Federal and state funding have different roles? 

Who would like to begin? 

Ms. BLOOMFIELD. All right. I’ll do the buzzer. So I will be honest 

with you, when we’ve been talking a lot to many folks across town 

about infrastructure, and I think it’s a little bit of a longer term 

proposition, but the one thing I will say is to be looking at a mechanism that is in place already. So that’s where I immediately go 

to universal service because you’re not creating a new program. 

Now, granted, states may have a role, and we already see states 

having Universal Service Funds that help to supplement, which I 

believe you may have in Nebraska, that supplement the cost on the 

back end. I think there are ways to be looking at completely 

unserved areas; that’s something that I know a lot of folks have 

looked at NTIA or RUS or some of these other entities for. But I 

will say I think we’d be really remiss to not look at the FCC and 

universal service with the mechanism that has now been reformed—— 

Senator FISCHER. Is that High Cost? High Cost? 

Ms. BLOOMFIELD. High Cost, and I think, you know, potentially 

even wireless. I see the button getting ready to go. Because there 

are some needs, and we know where the needs are, and they’re 

ready, it just needs the infusion into the system. 

Senator FISCHER. OK. Mr. Graham. 

Mr. GRAHAM. Yes, I would agree. There’s a role for the states to 

play, and currently some of the states do play that role in certifying eligible telecommunications carriers who can receive universal service support. I know in Mississippi, we receive input from 

205 

the Public Service Commission routinely about areas that they 

have identified that lack coverage, and we work together on what 

our coverage plan will be for the coming year. 

So there’s a role for states to play, and I think states in particular can determine some of those areas where coverage is lacking and then find local providers then who are willing to make that 

initial investment to get broadband into these rural areas that are 

unserved or underserved either through fiber or through wireless 

or other technologies. 

Mr. BALHOFF. On the basis of the financial issues that exist out 

there, most of the carriers will look at grant monies as a one-time 

type of thing, but ultimately their real concern is, what can they 

expect over the longer period of time? So the kind of support. 

And it actually goes back to what Senator Schatz was talking 

about before, which is a contribution mechanism. We have to find 

a better solution so there is more predictability. So the carriers 

that we provide advice to—and there are a very, very large number 

of those across the country—they wrestle with the unpredictability 

of the monies that will be there for operating the networks. 

So building the networks is one thing, which everybody pays attention to, and they don’t really understand the nature of the problem. I will suggest the data collection problem is not simply the one 

that we are dealing with here where there is service or there is not 

service, it’s to understand the evolving problems that are coming 

in rural America. 

So, for example, a number of the carriers are terribly concerned 

about the amount, the volume, and the over-the-top video services 

that are there, and so they’re finding themselves more and more 

pressed without the necessary revenues to be able—that is, universal service—to be able to support these problems. 

The problems are different today than they were 10 years ago or 

20 years ago. So when I first started providing financial analyses 

to these communities, it became obvious to me that things were relatively stable. Today things are changing so rapidly, and the pressures on the networks are very, very significant. So we need to understand the nature of the problems that are affecting broadband 

deployment and ongoing operating costs, and that’s more than a 

single—— 

Senator FISCHER. Should the Federal Government be responsible 

for one of those roles and the state funding then be responsible for 

another; one for construction, one for operation? 

Mr. BALHOFF. Well, I will tell you I have a bias toward the states 

because the states are very, very close to the problems that are 

there. So the Commissioners that I’ve worked with at the state 

level are usually very sophisticated. I will admit somewhat candidly, and it’s impolite to say this, that the bench at the state level 

is much thinner than it used to be. 

So it used to be that there were a lot of telecom commissioners 

who understood the nature of the problems. More and more of the 

commissioners are paying attention to the energy issues than the 

telecom issues, so we find not as good an understanding at the 

state level today as it was 5, 10 years ago. And this is my judgment. 

Senator FISCHER. Thank you, sir. 

206 

Thank you, Mr. Chairman. 

The CHAIRMAN. Thank you, Senator Fischer. 

Senator Capito. 

STATEMENT OF HON. SHELLEY MOORE CAPITO, 

U.S. SENATOR FROM WEST VIRGINIA 

Senator CAPITO. Thank you, Chairman Wicker. Thank all of you 

for being here today. I think what you hear on both sides obviously 

is we’re unified in our concerns. We have very similar concerns, 

which is interesting. You’ve heard a lot of different bills that have 

been introduced. I’m from West Virginia, and we don’t go through 

lava, we go through mountains and coal, and we have some of the 

lowest deployment of high-speed Internet in the country, if not the 

lowest. Consequently, you’re left behind. I used to say it’s economic, 

it’s medical, it’s education, but I’ve now added tourism and agriculture, as I listen to my colleagues talk about the challenges in 

different areas. 

I recently introduced the Gigabit Opportunity Act to get to the 

money issue, which would seek expedited deployment of broadband 

services in low-income, rural, and urban communities. It gives the 

states flexibility, streamlines existing regulations, and eliminates 

barriers to investment to try to bring more private investment to 

go with the Universal Service Fund investments that we see in the 

states. I’m encouraged that Representative Collins, over on the 

House side, has introduced a companion bill. 

One of the questions that I have comes after hearing NTIA mention the FCC and rural development along with USDA rural development. We’re dealing with three different Cabinets. I don’t want 

to say maybe too far displaced from one another, but we have $38 

million now coming to support 89,000 eligible locations across our 

state for the Universal Service Fund. I’m concerned when I hear 

the reporting and the 477 data issue because in a recent OIG report, it said that the BTOP funds now say we had showed $4.7 million in costs that were unallowable. So accountability is what I’m 

getting to here. 

I guess, what would you say are the checks and balances that 

would make you feel like mistakes like that aren’t going to happen 

again? 

Mr. Graham, I’ll start with you. 

Mr. GRAHAM. Thank you for the question. I think, as Ms. Bloomfield said, using an existing program such as the Universal Service 

Fund prevents you from having to stand up a new program and 

create checks and balances. The Universal Service Fund includes 

audit provisions, USAC audit provisions. And we were audited, 

since 2008, we were audited, I believe it’s seven times, including 

a couple of onsite visits in back-to-back years. These were random 

audits that happened to spring up at the time when USF reform 

was hot and heavy, and we were very involved in it. But the auditing provisions are already in place in this existing program. 

Senator CAPITO. On the auditing side, are you talking auditing 

just on the financial side or are you talking auditing on the reporting side as to actual service deployment? How accurate are those 

numbers? Are you audited on that? 

207 

Mr. GRAHAM. On the onsite visits we were, so we had auditors 

who came, camped out in our office, went through the financials, 

and then verified that—— 

Senator CAPITO. Was that service delivered at the levels that it 

was promised? 

Mr. GRAHAM. That’s right, the locations. And also the Public 

Service Commission, who certifies us as an ETC designee each 

year, verifies that the equipment that we claim to have put in service is in service. 

Senator CAPITO. Is there any clawback mechanism in that? If 

you’re not delivering the service and if you’re found to not be providing the service, are there clawback funds? 

Mr. GRAHAM. I’m not aware. I’m not aware of a clawback provision other than just the practical penalty of having equipment deployed because the money is spent up front. 

Senator CAPITO. Right. 

Mr. GRAHAM. So there is no incentive to deploy the equipment 

and then not provide the level of service that the equipment is designed to provide. 

Senator CAPITO. Did anybody else want to answer? 

Ms. BLOOMFIELD. So I would also just jump in. I completely 

agree with Mr. Graham about that, and between the NECA pool 

oversight, the USAC audits. 

The other thing that I think is going to be really helpful, and 

particularly in a case such as West Virginia, is that with the reforms that the FCC approved last year, you literally now have to 

geocode where your infrastructure is going. So it is literally—you 

know, when you’re doing new locations or you’re doing upgrades, 

that is all geocoded to exactly where you are committing to spending the money. So I think we’re going to see even more accountability and transparency going forward. 

Senator CAPITO. Thank you. 

Dr. Rheuban, telehealth holds great promise for a state like 

mine, many of ours. We’re an elderly state, too. I’m wondering if 

in your experience, if you find that a barrier for your older patients, as remote patients. How is the acceptance level with that? 

And what kind of ideas you might have there for the deployment 

of telehealth for more seniors? 

Dr. RHEUBAN. Thank you, Senator. Actually, our seniors love 

telehealth. First of all, telehealth reduces the burden of travel. 

We’ve reduced the burden of travel in our UVA telemedicine program by more than 17 million miles for 60,000 clinical encounters. 

They love remote patient monitoring, so we’ve deployed a remote 

patient monitoring care coordination program to the home for our 

patients, many of whom are seniors and Medicare beneficiaries, 

and they love it. The adoption rate is great. The continuation is 

great. And so I find that our seniors are very much supportive of 

receiving high-quality care, whether it’s in home settings or in 

their community setting. It’s easy and it’s well done. 

Senator CAPITO. Well, you’re making a better case then for better 

and broader broadband deployment to the rural areas especially 

where a lot of our seniors live. 

Dr. RHEUBAN. Absolutely. 

Senator CAPITO. Thank you so much. 

208 

The CHAIRMAN. She surely is. Thank you, Senator Capito. 

Senator Baldwin. 

And a vote is taking place, but I think we can squeeze this in, 

and they’ll wait just fine. 

STATEMENT OF HON. TAMMY BALDWIN, 

U.S. SENATOR FROM WISCONSIN 

Senator BALDWIN. Very, very good. Thank you, Mr. Chairman. 

This sort of flows well from the questions that Senator Fischer 

was asking about appropriate role of the Federal level and appropriate role of the state level. But, in particular, I wanted to share 

a reflection of a roundtable with stakeholders that I had in northern Wisconsin. 

Eagle River in Vilas County, it’s about as far north as you can 

get without being in the Upper Peninsula of Michigan, and they 

have been doing some really interesting things there. First of all, 

surveying their summer residents, and asked, ‘‘If there were 

broadband access, would you stay longer?’’ and found on average 

that probably about 2 weeks a year would be the estimate of how 

much longer people would stay, with probably an enormous impact 

to the local economy. 

But the other thing that they were motivated to do in that community is in addition to the regular planning that governments go 

through—budget planning, infrastructure planning, et cetera—they 

put together a technology plan for their county. And from what I 

got to hear in our short time together, it was pretty visionary. But 

their frustration I think is that the Federal programs that are set 

up don’t necessarily give their plans and their vision a voice. 

So, Ms. Bloomfield, I’m wondering if you agree that there should 

be more engagement with local and state planning processes especially where the local ones exist. And if so, what could or should 

that look like in USF programs or other ways in which we might 

invest in broadband in the future? 

Ms. BLOOMFIELD. It’s an excellent question, and I know there’s 

a lot of frustration in areas that are currently unserved or underserved today. One of the things we’ve been trying to do, one of the 

things we find, is the first part is getting people to talk to each 

other and having these conversations, right? So you’ve got folks in 

Eagle River. There probably are—the state of Wisconsin has about 

30 independent providers out in the state. You know, it’s getting 

folks together who can actually have these conversations about, 

‘‘What are your needs? And how can we help?’’ 

One of the things that we actually just released about a week ago 

is a Web portal called Partnerships in Broadband, where we are literally opening it up to electric cooperative communities, to municipalities, to folks who are looking to have some of those critical conversations about, ‘‘We have a need, but we need somebody to potentially partner with because, frankly, broadband is really expensive 

and it’s very tough to do. You’ve got to do a lot of assessments, 

you’ve got a lot of regulations you need to comply with.’’ 

So one of the things we’re trying to do is take that middle piece 

out and say, ‘‘We’ve got a need. How do we connect people with 

needs to possibly entities that might be interested and able to come 

in and support some of those needs themselves and provide that 

209 

service?’’ My carriers could frankly use more customers, and I 

think that rural Americans living in those remote communities 

have needs. 

So we’re trying to think a little bit out of the box. But how do 

you actually connect these dots in a way that makes sense on a 

local or a state level? Where USF comes into play, you know, obviously I would see some of those areas increasing the needs even 

further, but we’d be happy to at least get enough momentum to 

start having some of those discussions as well. 

Senator BALDWIN. Thank you. Pivoting now, Dr. Rheuban, in 

your testimony, you highlighted the progress that the University of 

Virginia has made in improving stroke evaluation and treatment 

through telemedicine. I’ve been particularly concerned about access 

to quality stroke care for our Nation’s veterans, especially those 

veterans living in rural areas in Wisconsin. And unacceptably, 

there have been cases in which veterans have died or have suffered 

severe injury due to lack of timely stroke diagnosis and treatment. 

How can we strengthen and improve USF programs to make this 

type of care available to more veterans in particular? And would 

greater support allow your center to partner and work with more 

institutions including the VA facilities in providing telestroke care 

to veterans in rural areas? 

Dr. RHEUBAN. There is a tremendous opportunity with telemedicine in terms of reducing the burden of and complications of stroke. 

We would love to work with the Veterans Health Administration, 

and we have reached out, and we do have partnerships with the 

VHA hospitals in the Commonwealth of Virginia. We have a Virginia State Stroke Systems of Care Task Force. And, in fact, our 

FCC pilot program, funded a number of years ago, was built 

around our need to expand access to stroke services. It was the Virginia Acute Stroke Telemedicine Initiative. 

We have done some phenomenal work, as have others. It is really 

now considered the standard of care for stroke patients. And I will 

tell you that in our telestroke network, patients at a rural community hospital can receive TPA, the clot-busting medication, at the 

same rate they might receive it because of telemedicine if they had 

been a Charlottesville-based patient who showed up in our emergency department. 

The other element that we have also integrated into our telestroke program is access to stroke neurologists from the EMS vehicles, so that our stroke neurologists are actually evaluating patients the moment they set into the ambulance and traverse the 

distance to UVA, so that it can reduce the time for treatment, 

which is a 3-hour window for TPA administration. There are other 

services that can be informed by telemedicine, such as device retrievers and other things that can be done. 

So absolutely we all need to be at the table together. This is the 

standard of care for stroke patients. And how we can incent hospitals and providers to collaborate is a really important opportunity. 

Senator BALDWIN. Thank you. 

The CHAIRMAN. Thank you, Senator Baldwin. 

Senator Cortez Masto. You got me worried there. 

210 

STATEMENT OF HON. CATHERINE CORTEZ MASTO, 

U.S. SENATOR FROM NEVADA 

Senator CORTEZ MASTO. Thank you. Thank you, Mr. Chair. And 

I’m so sorry I wasn’t here for the initial start of the hearing. I have 

a competing hearing going on, and so I was trying to make sure 

I covered both. And thank you for your comments that I was able 

to take a look at prior to the hearing today. 

Let me just say I’m from the state of Nevada. We have rural and 

urban communities. Rural broadband is key, and it is so important. 

I believe we need to invest in this infrastructure to open doors to 

services that we know are challenged in our rural communities, 

and one of those is this telemedicine that is so important. 

And so let me follow up on the question that was asked by my 

colleague, Dr. Rheuban. And you may not know this, and let me 

open it up. But can you give me a sense of how advanced or fast 

the broadband infrastructure needs to be in these communities in 

order to utilize these types of services? 

Dr. RHEUBAN. For our telestroke network, we have deployed 100 

megabit connections, and they are affordable, quite frankly. Where 

hospitals might, you know, without the Universal Service Fund, 

spend $3,500 a month, we now, with the Universal Service Fund, 

have been able to reduce that cost to $350 a month for that hospital, the net cost, which is affordable for a community hospital. 

$3,600 a month is pretty pricey. So, you know—and we need to do 

a lot with that connection. So that hospital is sending CT scans, 

which are imperative for stroke services, as well as deploying highquality video conferencing. Could we do it with less? Yes, I think 

we could do it with less, but the more we have, the better we are. 

The higher the quality, the higher quality video conferencing can 

be supported with a higher bandwidth. 

Senator CORTEZ MASTO. Thank you. And let me just throw this 

out here as well because it’s not just telemedicine, it’s education—— 

Dr. RHEUBAN. Sure. 

Senator CORTEZ MASTO.—that we could bring to communities, 

right? It is treatment services, it is social services. There are so 

many benefits that we know that particularly our rural communities are challenged to get professional services in those communities. 

Let me jump onto another subject, which is siting issues. In Nevada, 85 percent of the land is public land, and we work very closely with our Federal partners, but there are challenges, as we all 

know, that, yes, we want to bring broadband, but there are siting 

issues. And so let me open this up again to a question on how we 

should be looking at better coordination to address this issue so 

that we can open the door for the infrastructure? 

Mr. GRAHAM. That’s an excellent question. I’ll address it because 

our company is involved in permitting issues for both fiber construction, which we do, but also wireless construction. And anything that can be done to streamline that process, to let a report 

that’s done for environmental impact, for instance, be shrunk to 

begin with, and then be enough to satisfy multiple agencies, would 

be a great start. 

211 

Streamlining the process would make a tremendous difference 

for us, and we’re on the larger end of a lot of the wireless providers 

that are not the big four. Smaller wireless providers have it even 

worse. And we also are on the larger end of some of the fiber providers, and on the smaller end of that, they have it even worse because the reports cost the same whether you’re large or small, it’s 

based on the size of the project. 

Senator CORTEZ MASTO. Right. 

Ms. BLOOMFIELD. I completely concur, Senator. And what we’re 

finding is as you have to go through multiple agencies, multiple 

hoops, it really delays the time of actually the expansions. So what 

we’re seeing is it’s actually holding down things that actually could 

be done immediately are taking that 12 to 18 months to get some 

of that permitting done. And what we find is everybody again has 

different processes, so if you’ve got to get something that’s through 

RUS and through BLM and maybe you’ve got to go through some 

NEPA hoops, it’s just very tough to get a project up and running. 

So streamlining that would be extraordinarily helpful. 

Senator CORTEZ MASTO. Thank you. And thank you all for being 

here today. I appreciate the conversations and the comments. This 

is an important topic. Thank you. 

The CHAIRMAN. Thank you, Senator Cortez-Masto. 

The hearing record will remain open for 2 weeks. During this 

time, Senators are asked to submit any questions for the record. 

Upon receipt, the witnesses are requested to submit their written 

answers to the Committee as soon as possible. Give your own definition for that. 

[Laughter.] 

The CHAIRMAN. We would appreciate it within 2 hours, I think, 

or longer if you need be. 

So thank you very much. This has been a very good hearing. And 

this hearing is now adjourned. 

[Whereupon, at 11:19 a.m., the hearing was adjourned.] 

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