BDS Draft Order Not as Hard on Telcos, Cable as Feared, Industry Analysts Say

Analysts said incumbent telcos and cable companies would fare better than expected under the FCC draft order on business data service (BDS) circulated by Chairman Tom Wheeler and summarized in Friday's "fact sheet" (see 1610070052 and 1610070027). "This was never going to be a net positive outcome for the incumbent telcos. But some of their lobbying clearly connected because the scope of price regulation in the fact sheet was narrower than expected. And for cable investors worried about covert network unbundling, Friday was a very good day," Cowen and Co. analyst Paul Gallant told us Tuesday. Others offered similar views in notes to investors.

"Key is moderate annual price declines for legacy services while high-speed services are not subject to price regulation," said Citi analysts. "Large reform ... has seemingly been deferred," they wrote. "The proposed rate reductions and limited scope to pre-existing legacy services appears far less disruptive than the 'asks' by several parties. We see this as a potentially modest headwind but not a thesis changer or dividend buster (by itself) for companies within our coverage group."

The order could be voted on at commissioners' Oct. 27 meeting, analysts said. New Street Research analysts expect Commissioners Mignon Clyburn and Jessica Rosenworcel ultimately will support Wheeler in adopting an order, but also see significant litigation risk.

Wheeler's proposal for regulating BDS "was more benign than originally feared," said UBS analysts, saying the draft's recommended cuts in legacy telco DS1 and DS3 service prices were smaller than those proposed jointly by Incompas and Verizon, which received much attention. "Existing contracts may already be priced below these reduced rates, mitigating the impact," the analysts wrote: "While Ethernet product and services (45 Mbps+) will be subject to a complaint process, there would be no price caps or network unbundling. If passed, we think this proposal would be a win for cable and have a manageable impact on the incumbent telcos" such as Frontier Communications and CenturyLink, and be "not as beneficial" for Windstream, a CLEC/ILEC hybrid.

The draft "appears to be less impactful to the carriers than many feared," said Raymond James analyst Frank Louthan. "Frontier actually quantified the revenue impact as $10 million in 2017, and $20 million in each of 2018 and 2019." Regional Bells, he said, "face the biggest impact, but we note they have some meaningful cost offsets as well as the largest users of BDS themselves, and Windstream's CLEC unit standing to have a net gain. We expect most ILECs to react to the order with offsetting cost reductions, likely concentrated in headcount."

The telecom and cable industries "received some regulatory relief" as the FCC offered a "more moderate framework," said Macquarie Capital analysts. "This is the second piece of good news after set-top box proposals were postponed for further review," they wrote. "Both issues have been an ugly overhang on multiples." Frontier 2017 guidance for at least $4 billion in EBITDA "seems very doable" and the rate cuts "would have a very small impact" on CenturyLink revenue, they wrote. The light-touch regulation of packetized services is "friendly to cable's expansion, particularly as Comcast and Charter Communications start exploring wireless initiatives," they said. But the UBS analysts said "without access to high-bandwidth capacity on regulated rates, 5G providers could face a more challenging business model."

New Street Research suggested nobody "is going to be totally happy." Rural-oriented telcos remain the "worst positioned, relative to the status quo, as they are likely to face material price cuts on a smaller and less diverse revenue mix," wrote the analysts. CLECs such Level 3 and Zayo and pure wireless carriers such as Sprint and T-Mobile "are best positioned, as they are likely to benefit from those price cuts (though not as much as they had hoped)," they wrote. "Cable is likely to be subject to ‘Duty to Deal’ -- we don’t see that as having a significant market impact, though the price reductions will lower the price umbrella for cable entering business services." Wells Fargo analyst Marci Ryvicker said the FCC "leaves cable alone for now but allows for regulation down the line."

Louthan said the telco regulation "will not incent investment, and may further slow the migration to Ethernet and other larger cap[acity] circuits." A senior FCC official offered a different view on a media call Friday. Pushing "supracompetitive" TDM-based legacy prices down to competitive levels, eliminating ILEC lock-in contracts, and avoiding Ethernet regulation would promote the transition to packet-switched IP-based services such as Ethernet, the official said.

Heading toward Oct. 27, "we expect to see a significant amount of lobbying on the issue and could still see some further delay and mitigation of price cuts for smaller companies," as suggested in a Frontier proposal, wrote the New Street analysts. "We think some of the pro-CLEC forces, disappointed in the scale of price cuts, will push for larger numbers but suspect the current number is as high as the combination of data and politics would allow so we don’t think the numbers will move up towards the Verizon/INCOMPAS proposal. We do think Wheeler will be able to get a vote on this, with the two Democrats ultimately supporting a proposal and the two Republicans dissenting."

The "outcome will be litigated, with a significant chance that challengers will succeed," wrote New Street. Louthan agreed there will likely be a court challenge to the order, which "could see difficulties in passing judicial scrutiny."