What to Make of a CFO’s Musings on Regulatory Hypotheticals?

In recent days, the net neutrality crowd has seized on select, abbreviated versions of comments by certain executives of Internet service providers (ISPs) as evidence that ISPs are in fact supportive of the public-utility-style regulations being considered by the FCC for internet access service. Even the Chairman of the FCC made hay with the comments to advance his regulatory agenda.

As it turns out, the “gotcha” quotes were amplified in the media, while statements consistent with the “regulation-can-be-harmful” thesis were neglected. Even if we ignore what else those executives said, corporate financial officers (CFOs), or any executive for that matter, don’t have complete say over their firm’s investment decisions. That’s because external investors who lend money to ISPs are equally if not more important, particularly over the long run.

A small helping of investment theory is in order. Tim Karr at Free Press is fond of characterizing the ISP investment decision as an all-or-nothing affair, but in reality, investments (like any decision in economics) are made at the margin. Each project has a different expected return. And even within a project—say, fiber to the home (FTTH)—the expected return will vary depending on the city in which the investment would be made.

As any CFO knows, basic investment theory teaches that a firm invests in a project so long as the internal rate of return (IRR) on a project is greater than the minimum required rate of return, as measured by the firm’s the cost of capital. This is simple, folks: Line up your projects from highest to lowest IRR, and fund the ones that exceed your cost of capital.

So to believe that public-utility-style regulation would undermine investment at the margin, one needs only to believe that reclassification would either (1) increase an ISP’s cost of capital or (2) reduce the expected return of a set of ISP investment opportunities. Projects with an IRR above the pre-reclassification cost of capital but below the post-reclassification cost of capital are called the “marginal” investments—that’s a kind way of saying the forgone investment caused by reclassification.

Let’s start with the first mechanism–raising the cost of capital–and leave the returns constant. By one estimate, Verizon’s weighted average cost of capital was slightly below 6 percent in April 2014, right before the FCC’s light-touch approach was abandoned for political reasons and Title II gained traction. Because Verizon has largely stopped its FiOS investment, one can infer by the investment rule that the IRR associated with expanding FiOS into other cities within Verizon’s footprint is south of 6 percent.

As bullish as Verizon CFO Francis Shammo is about investment, Verizon’s investment decisions involve participants—namely, the investor community—not entirely under Verizon’s employ. (Notice that Mr. Shammo referred to the light-touch approach of section 706 as “section 765” in the “gotcha” quote that appeared in the Washington Post, which suggests that he isn’t following the net neutrality debate too closely.) More on Mr. Shammo in a bit.

External investors could demand a risk premium (over and above what they otherwise would demand) to compensate for the added risk associated with the new rules. An investor may ask: Why should I lend an ISP money for a new project if there is a heightened chance under reclassification that the ISP would be subject to rate regulation or mandatory sharing rules? Through the haggling between Verizon and investors, the new risk could manifest itself in the form of a higher cost of capital. While the CFO needs to allay investor fears related to regulation, no amount of corporate cheerleading can compensate for a perceived increase in risk.

Turning to the second mechanism, holding constant the cost of capital, reclassification could reduce the expected return of an array of investment projects by a certain percentage. This would not mean that all such projects would be abandoned. But if Project A’s IRR was reduced from 10 to 9 percent, while Project B’s IRR was reduced from 6 to 5.4 percent, and if the ISP’s cost of capital were 6 percent, then Project B would be abandoned.

In a seminal application of this theory, in 2002, Cambridge Strategic Management Group (CSMG) examined the potential effects of mandated unbundling on FTTH deployments by incumbent and competitive providers. CSMG projected that if unbundling were required, all-fiber deployments would pass only 5 percent of U.S. households in a ten-year period. In contrast, if unbundling of fiber loops was not mandated, CSMG estimated that by 2013 FTTH could be economically deployed in 31 percent of households. In 2003, the FCC relied in part on these findings to decide not to mandate unbundled access to FTTH loops, concluding, “We expect that this decision to refrain from unbundling incumbent LEC next-generation networks…will stimulate facilities-based deployment.”

When sifting between the disparate messages coming out of ISP executives, tech reporter Brian Fung pointed out that the musings of ISP executives should be credited because SEC rule 10b-5 compels executives to tell the truth—kinda like Wonder Woman’s lasso of truth. (Free from these restraints, ISP lobbyists take “extreme rhetorical positions.”) But publicly traded firms have an equal fiduciary obligation to shareholders not to lose money. Applied here, that means not to invest in projects whose net present value is negative.

Once you understand a bit of investment theory, it is not much of a stretch to see how heightened risk associated with reclassification could reduce investment at the margin. And that would be a terrible thing.

The whole episode of selectively quoting CFOs could introduce a new word into the lexicon: “Shammoed.” As in, you’ve been Shammoed for purportedly making an admission against your interest. To clarify his thinking, Mr. Shammo posted further comments to the Verizon Policy Blog:

“But as we and other observers of the net neutrality debate have made abundantly clear, experience in other countries shows that over-regulation decreases network investment. If the U.S. ends up with permanent regulations inflicting Title II’s 1930s-era rules on broadband Internet access, the same thing will happen in the U.S. and investment in broadband networks will go down.”

Per the SEC requirements cited above, one should give equal weight to these statements as the ones flagged in the media. Taken together, any balanced reading leads to the same conclusion as economic theory: Regulations that reduce the expected rate of return on a given class of capital investments or raise the cost of capital will cause such investments to fall at the margin.

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