Rural Communications Market Defies Economic Struggles

Episode ID S2E01
November 9, 2022

While inflation and surging interest rates pummel other sectors, rural communications appears unscathed. One driver is the essential role broadband plays in consumers’ lives – and investors’ ensuing interest. In this episode of All Day Digital, Jeff Johnston explores the economic angle with colleague Andy Smith, CoBank managing director and long-tenured expert in banking the communications industry.


Andy Smith: There's a lot of opportunity to create a lot of value and this opportunity's probably only going to come around once in a lifetime. While interest rates certainly, there's some pain points there, I can't really say at least at this point we've seen any great impact in people's scaling back plans because of interest rates

Jeff Johnston: That was Andy Smith, managing director at CoBank regarding his thoughts on how the current interest rate environment is impacting rural communication network builds.

Hi, I’m Jeff Johnston and welcome to the All Day Digital podcast where we talk to industry executives and thought leaders to get their perspective on a wide range of factors shaping the communications industry. This podcast is brought to you by CoBank’s Knowledge Exchange group.

The parabolic move in interest rates is wreaking havoc on many industries, and creating a great deal of uncertainty for CEOs across the country. Questions about whether we’re already in a recession, or if we’re headed into a recession and if so, how deep will it be are on the minds of many business leaders. I invited Andy to the podcast to discuss how all of this is impacting the rural communications market, regarding valuations, M&A, and capital planning.

Andy’s extensive experience in banking the communications industry, and his birds-eye view of what’s going on, made him the ideal guest for this important topic.

So, without any further ado, pitter patter, let’s see what Andy has to say.

Jeff: Andy Smith, welcome to the podcast. It's great to have you here today.

Andy: Jeff Johnston, it is a pleasure to be here. I appreciate you calling on me to put this together for you.

Jeff: Oh, absolutely. No, I'm excited to have you here and all your great insights. We can obviously cover a lot of different topics with you, Andy, as it relates to communications and technology and rural communications. But, what I'd like to talk about today primarily are interest rates and the impact that they are or aren't having on how rural communication operators think about their business and how investors think about the space because we've just seen this unprecedented spike in interest rates.

I guess they've come off a little bit as we record this today on the 27th of October, they've come off a little bit off their highs, but they're still pretty high relative to where they were, call it a year ago. So, how are interest rates impacting rural communication companies in terms of their capex planning or network build planning and things like that?

Andy: Jeff, I think you hit the nail on the head with the way interest rates have moved and they move quite significantly really over the past year. I track the rates, but I probably don't track them every day and it seems like every time I look it's like, really? They're up to this now? I think look at it in the context of they have moved so far, so fast and for this whole general conversation, I've talked to few customers and they're definitely paying more attention to it, for sure.

Certainly, it's a pain point, but at least at this point in time I don't think we're really seeing any pullback from capex spending, which as you know from because you know and all the other podcasts you've done is broadband buildouts are really what's going on now. There's a great need to bridge the digital divide.

Lot of players doing this from infrastructure funds, private equity, traditional LEC’s, startups, fiber companies, ISPs and WISPs. And really it's everyone is working to bridge the digital divide and quite frankly when you take the rural part of it out, it's the replacement of the copper network to fiber. We can talk about all the other mediums that provide broadband, but I think the general consensus is fiber is the best option in most future proof. 

M&A deals are still getting done and a lot of people are still expanding their broadband networks and building broadband networks out. So to sum it up, I think at this point we really haven't seen any impact, but that's not that we may not in the near term or medium future.

Jeff: Actually, I want to drill down on that a little bit more because I think that's an important point. It's like, it's been such a parabolic move in rates that, maybe it's caught people flat-footed and they're not sure how this is all going to play out but-- If I think about building a network or overlaying an existing network with fiber, whatever it is, that's a long process. There's a lot of planning that goes into that. Given the lead times with equipment, and the planning upfront, all the things you got to go through with the zoning and things like that. There's just a lot of upfront work that needs to happen here. With those long lead times, how does that play a role into interest rates impacting builds? Does that make sense?

Andy: Yes. Absolutely it does. My answer to that question, in that it depends on who's doing it. When you got an experienced operator that has their machine in place can navigate the zoning, and the supply procurement, and things of that nature. They can generally get it done a little bit quicker. Look, generally, depending on the company, and the life cycle of the company, and how much debt capacity they have, the early cost you're generally footed by equity before revenues and cashflows come on.

Now, if it's an existing company, they obviously have revenues and cashflows that they can leverage if there's-- If it's more of a start-up, obviously the equities got to go in first to build out to general infrastructure before you start having homes pass, and drops, and revenues, and cashflows. Certainly, I think the cost, the interest cost are going to cause a bit more pain.

Obviously, there has to be enough cash to service debt, depending on if it's a start-up, a pre-cashflow positive deal or an existing deal. If more capital is going to service debt, potentially, that could slow or scale back plans a little bit.

Look, I think the motivation for everybody is one, to get there first because two, if you can get some customer concentration and you're generating revenues and cashflow, the investments you make and you can add interest to the cost of the overall investment given where the multiples are, I think your return on investment is so high that, yeah, if you are paying 3.5% today or last year, now you're paying 7%. That's not eating into my overall return, any projected return anyway enough for me for it to be a big concern at this point. Obviously, if you're highly leveraged, there becomes an ability to service debt when interest rates go up. Generally, many of the companies have a lot of equity behind them or would have access to equity behind them.

At this point, we haven't seen really any weakness in credit facilities, at least due to higher interest rates. Again, I would table that to maybe this discussion's a little bit different a year from now.

Jeff: That make sense. I guess given that we're in a bit of land grab. There's so many markets that are underserved or unserved that operators are anxious to build out. If you have to borrow today at a higher rate, you can always refinance the debt I would imagine if you've got the capabilities to do it a year or two from now, and rates come down. I heard the CEO of Redfin yesterday in an interview he said, as relates to mortgages it's like, "Date the rate, marry the house." So, get the house, it’s what you can afford, and then refinance in a year or two from now and you'll be okay. I feel that applies here too.

Andy: Yes, absolutely. Absolutely. That's a great analogy.

Jeff: Yeah, so to what extent are you seeing borrowers hedge these risks on interest rate with swaps and things like that? Is that something that you're seeing more of? It would feel like if you're sophisticated enough, that might be something you want to do?

Andy: In some credit facilities there's a hedging requirement, it used to be a little more prevalent, but isn't now? But I think and these are for the larger syndicated deals, but kind of going back to my last comment, are we at the top? It would've been great to set a hedge a year ago. Then it goes, okay are you trying to time the top of where the market is?

That being said, I think if borrowers want certainty, they're definitely going to hedge. I think any, I don't know the exact number, but many are hedging. Even if you're only putting on a one or two-year swap, I think your downside -and downside being if rates come down- is limited there. I would think if I'm sitting in the CFO position, I want some sort of certainty on my floating rate debt for sure.

Jeff: You're right. The timing is an important point. Had you had a crystal ball and positioned yourself accordingly a year ago, you'd look like a rock star. Unfortunately, none of us can see the future, so makes it a little more difficult. I just want to talk a little bit about the private market, the capital in the private market. There's been obviously a lot of capital raised, I believe, from infrastructure funds and private equity sponsors to invest in rural broadband.

I'm hearing that getting access to private capital in this environment has gotten more difficult maybe for some of the more speculative type of investments, just given the uncertainty around the economy next year and where interest rates are and so forth. I mean, what are you seeing in the private markets from a capital raise standpoint in rural broadband? Is it tightening a little bit there, or is there still more money chasing fewer opportunities?

Andy: I would say it's probably more the latter. There's still a great deal of money out there that either would like to start a company or buy a decent platform. It just depends on what it is. There's been at least three or four announcements of brand-new greenfield buildouts. A couple of them private-equity funded. A couple I know some of the players involved where they are starting from scratch and going to buy in. Additionally, there's still the M&A where someone is looking at platforms, whether they're an existing company that doesn't have say, a fiber to the premise platform already, but they'd like to get into that business and they're looking of maybe the targets are not all that substantial.

I think some of these things are not necessarily going through processes, so we may not see them. I would say we're still in the era where there are people that want to put dollars to work. It goes back to my value comment and are looking for acquisition opportunities. They can't find anything to acquire, maybe the multiples, the juice isn't worth the squeeze from what you have to pay. I think some folks are just saying, "Let's just go build our own. Let's start from scratch." That's happening in a few cases around the country. Look, I think, again, it really goes back to the copper network needs to be replaced, whether it's urban or rural. Fiber is the medium. There's a lot of opportunity but you're going to realize the greatest value creation if you're the first in, especially with a strand of fiber and there's still a lot of that opportunity pockets everywhere, rural and urban to do that and it's just the replacement of the copper network.

I still think there's a great bit of opportunity, there's a great bit of interest and there's a great bit of capital that's going into these things and I foresee that barring really significant supply chain issues, things like that continuing.

Jeff: I don't want to put words in your mouth but it sounds like from an M&A standpoint, I don't know if we would use the word robust but it seems pretty healthy still. It was red hot not long ago. It still feels like it's pretty robust. Is that a fair characterization?

Andy: I think that's fair. I think that's fair.

Jeff: How about valuations then? With interest rates going up, how has that impacted valuations for M&A and just mark-to-market stuff? How is that looking?

Andy: Yes. Again, I think it may be still too early to tell. I think valuations have probably held pretty good. Obviously, it depends on what segment of the telecommunications market the company is in with fiber being the belle of the ball and those valuations which is gone in the high teens and up into the 20s, and maybe even a little higher than that in some instances.

Again, I would say that's probably a question maybe better table to next year as other processes come online. I'm not aware of what is obviously, we find out after deals are launched, but not seeing anything getting pulled that I'm aware of and they are getting done and the multiples are pretty healthy. Depending on where interest rates are a year from now or two years from now there may be some impact there.

Jeff: It's nice to hear because there's so much carnage out there. You look at what's happening in the semiconductor industry, these companies are getting absolutely destroyed. PC demand is really weak because a lot of stuff got pulled in with COVID and now enterprises are cutting back because of recessionary concerns and you look at some of the apparel companies like Nike and others, they've got huge inventory and no one wants to buy appliances anymore so Whirlpool is a mess. And so there's just all this carnage in the market right now, but it feels like if you're a rural or communications provider, things are pretty good.

Andy: Look, broadband is a necessity these days. All those other things you mentioned consumers can put off that purchase and everybody at these days businesses want to be competitive. Parents want kids to have good educations, access to commerce, entertainment, what have you, it's going over a broadband pipe so much like energy and water, broadband, it's a critical service that has people are going to pay for. They may forego other things I think at this point but for the most part they're going to keep their broadband connection on.

Jeff: The nice thing too is that we haven't seen inflation drive the price of broadband up so not like food, commodities and of course, energy costs all that sort of stuff is going through the roof, but when it comes to broadband, I don't think those bills are going up, right?

Andy: Not that I've seen. There are competitive factors that also come into play on what you can raise your rates to. A lot of times if a fiber to the home over builders, over building a cable company which may not provide as good a broadband service, however, if it costs twice as much, maybe the consumer's just going to stay with the old cable thing and just deal with the inferior service. So, there is a competitive governor that keeps that from happening.

Jeff: That makes sense. Hey, let's switch gears and talk about the BEAD Program. This is of course the $42.5 billion, I believe it is, that's carved out of the recent infrastructure bill or, I guess, now it's the Infrastructure Investment and Jobs Act, so we got to $42 billion, call it, that's going into underserved and unserved areas which is great. It's unprecedented.

But the devil is in the details from a financial perspective on this stuff, and I want to just drill down on that a little bit with you because I don't know that it's fully appreciated by all that are looking at this program. What I'm specifically referring to is the letter of credit requirement that operators need to have in order to participate in this program. Maybe you could talk a little bit about how--

You've been through this before with different government programs where letters of credit are required, maybe you can just opine a little bit on that and lessons learned from previous programs that operator should be aware of going into this thing.

Andy: A lot could be said about the BEAD program coming down. I would refer the listeners to either NTCA or WTA who are totally on top of the BEAD program. What, on these programs, I am close to is, to a certain extent, the financing end of these things.

The letter of credit requirements really started in, I believe, it was CAF-1 or CAF-2 where NTIA, the FCC required a backstop in case they doled out a bunch of money and the projects weren't finished or they weren't used for their intended use. They had a way to claw back by calling a letter of credit. Now to my knowledge that is never happened.

What we have run into, and again, a letter of credit is an obligation by whoever the issuer is, generally, a bank, CoBank is one of the bank, that if it's a face amount, let's just say it's $1 million that if the beneficiary, which would be NTIA or potentially would be the states, wanted to call their money, the bank is 100% obligated to pay that money back to them if they call it for any reason. It's not like the bank gets involved in the whys.

The bank has to fund that funding, so to speak. We have to put in a credit facility to back the letter of credit when letters of credit. When letters of credit increase over time, obviously that's borrowing capacity that we have to hold in case the letter of credit is called.

People engage engineers and consultants, they do engineering studies, they put together the applications, they win either modest or very significant amount of funds, and then at the end of the day, at least with RDOF and CAF-2 they get awarded the funds and then they go looking for a letter of credit. In some cases, that's not a problem.

If the entity has strong enough balance sheet to back the requirement, but in several cases that may be a problem. Then potentially you get stuck with an award, but you can't meet the requirements because you can't get a letter of credit. Not that that's the only requirement. I would recommend to anyone that's going to be applying for BEAD or any sort of program that's going to require a letter of credit that along with your early due diligence as far as engineering and feasibility studies and things like that you're talking with your financial institution or a financial institution that can provide a letter of credit because that can govern how much funds that you want to apply for.

Now with the BEAD program, as I understand it, those funds are going to be allocated to the state's broadband offices.

I'm not 100% sure on this, but I'm pretty sure the case is that you will need to provide, not necessarily a letter of credit, but a letter from a financial institution stating that they will provide a letter of credit should you win the award. Adds another wrinkle to the whole thing.

If you got everything together and then a week before you have to submit an application, you need a letter, even just a letter from a bank stating that they will provide the letter of credit, the financial institution or bank is going to have to go through their due diligence to make sure that they have a great deal of comfort that they'll be able to put that letter of credit in place if the applicant wins. It's not necessarily going through putting a credit agreement in place, but 's pretty close to it.

Jeff: It's like shopping for a house where you have absolutely no idea how big a mortgage you can get or want or can handle. I'm using that house analogy again.

Andy: You're killing it with the house analogies.

Jeff: [laughs] Exactly. The message is really do your due diligence and your planning up front, not only as it relates to your engineering, evaluations, and network planning, but make sure that you do it on the financial side as well.

Andy: Absolutely. You can do all that. We've seen it happen and there's a lot that goes into those applications, so there's a lot of time and money spent and in some cases it seems like the letter of credit is the last thing people have thought of when it should be one of the first things thought of.

Jeff: Great. Andy, it's been a pleasure having you here on the podcast today. Very insightful. Definitely didn't disappoint. So again, thanks so much for your participation.

Andy: Happy to be here, Jeff. Thanks for asking me.

Jeff: A special thanks goes out to Andy for taking time out of his schedule to be with us here today. I found the conversation with Andy rather encouraging. In a world where there all sorts of companies struggling with things like depressed margins, excess inventory and revenue headwinds, to hear that the rural communications market is still robust is a great sign. Of course, as Andy mentioned, things might look different 6-12 months from now depending on what happens in the economy. But the resilience we’re seeing today speaks to how critical broadband has become to consumers and businesses, and the insatiable appetite investors have for broadband investments.

Hey thank for joining me today and watch out for the next episode of the All Day Digital podcast.

Disclaimer: The information provided in this podcast is not intended to be investment, tax, or legal advice and should not be relied upon by listeners for such purposes. The information contained in this podcast has been compiled from what CoBank regards as reliable sources. However, CoBank does not make any representation or warranty regarding the content, and disclaims any responsibility for the information, materials, third-party opinions, and data included in this podcast. In no event will CoBank be liable for any decision made or actions taken by any person or persons relying on the information contained in this podcast.

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