Event
We are initiating coverage of the RLEC industry with a market weight
rating. Please see our company initiation reports for EMBARQ and
Windstream, also released today.
Key Points
• Industry Commences Consolidation. Over the last 2 years, there
have been more than a dozen transactions worth $15B. We expect
continued consolidation to create significantly larger operators. This
consolidation enables the operators to take advantage of cost
synergies including consolidation of call centers and customer care
representatives and elimination of duplicative corporate front office
overhead.
• Regulatory Uncertainty. Two key areas of uncertainty include the
Universal Service Fund (USF) and Intercarrier Compensation (ICC).
This is important as USF/ICC funding represents ~40-50% of RLEC
revenues. The USF fund has mushroomed over the years driven by
High Cost support that has increased from $2.6B in 2001 to $4.1B
in FY06. Legislation was put forward in April to curb the growth, but
we believe it will not be enacted in FY07 and is more likely to
resurface in FY08. ICC is another complicated area in telecom that
is in dire need of reform. The pricing design is a mosaic of different
pricing mechanisms governed by different regulators. We do not
expect the FCC to take action on this during FY07.
• Improving Trends? Through 1Q07, the industry experienced
improving trends in two key metrics: slowing access line losses and
YOY growth in high speed net additions. The 2Q of 2007 put a halt
to these positive trends. Access line losses accelerated both
sequentially and YOY in 2Q07 and for the first time in nine quarters,
high speed net additions were lower than the previous year. If 2Q07
represents the beginning of a reversal of these trends, the industry
could face increased financial pressures going forward.
• Pension Analysis: Not the albatross many think it is. In FY06, the
industry reported over $6.1B in defined pension benefit obligations
(PBO). To put this in perspective, this would represent about 30%
and 70% of the industry's revenues and EBITDA, respectively.
Does the $6.1B fully represent the potential obligation for the
defined benefit plans and is the pension expense understated?
Based on our analysis, we believe that the liability likely fairly
reflects the true liability for the industry but the pension expense is
underestimated, although adjusting the expense would have a
limited impact on overall EBITDA levels.
• Dividend Risk? Overall, we do not expect declines in dividend
payments in the industry, although it appears that Fairpoint (FRP,
$19.18, NC) is likely to be under pressure to continue its dividend
payment given its high payout ratio.

Table of Contents
Executive Summary ....................................................................................................................................................3
Industry Commences Consolidation............................................................................................................................4
Merger Synergies ........................................................................................................................................................5
Regulatory Uncertainty ................................................................................................................................................7
Improving Trends?.......................................................................................................................................................8
Pension Analysis: Not the Albatross Many Think It Is..................................................................................................11
Target for Private Equity?............................................................................................................................................17
Valuation Section.........................................................................................................................................................19
Price-to-FCF ................................................................................................................................................................20
Payout Ratio ................................................................................................................................................................21
Dividend Yields............................................................................................................................................................22
Payout Ratio to Net Leverage .....................................................................................................................................23
Risks ............................................................................................................................................................................24
Regulatory Uncertainty: Detailed Analysis of the Regulatory Landscape....................................................................26
Potential Changes to USF...........................................................................................................................................33
Rural View of Bill and Keep.........................................................................................................................................36
What Is Intercarrier Compensation?............................................................................................................................38
Relevant FCC Filings on Intercarrier Compensation....................................................................................................40
Potential Legal Issues Related to the Proposed Reforms............................................................................................41
Summary Background on Access Reform ...................................................................................................................50
RLEC Metrics...............................................................................................................................................................51
Appendix: Additional Information on the Universal Service Support Program.............................................................68