Download Case No. 8731phii - Maryland Public Service Commission

Case No. 8731
Q.
Please state your full name and occupation.
A.
My name is Bradford Cornell.
I am a professor of finance at
the Anderson Graduate School of Management at the University
of California at Los Angeles and the founder and President
of FinEcon, a consulting firm that specializes in financial
economics issues and the cost of capital.
Q.
Are you the same Bradford Cornell who previously submitted
prepared direct testimony on behalf of AT&T Communications
of Maryland, Inc. and MCI Telecommunications Corporation in
this proceeding?
A.
Yes, I am.
Q.
What is the purpose of your rebuttal testimony?
A.
The purpose of my rebuttal testimony is to respond to
certain arguments that have been raised elsewhere and are
likely to be raised by Bell Atlantic Maryland (“BA-MD”) in
the rebuttal testimony of its cost of capital expert, Dr.
James H. Vander Weide.
Q.
Dr. Vander Weide has testified in several proceedings that
the DCF model cannot be applied to telephone companies
because of the dramatic regulatory and technological changes
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which currently affect the telecommunications industry.
Therefore, he calculates a DCF cost of equity on a sample of
S&P Industrial companies as a proxy.
Do you agree with his
premise and approach?
A.
No.
First, he has provided no evidence that these “dramatic
changes” impacting the telecommunications industry are in
fact biasing the DCF model.
Second, he has provided no
analysis on the S&P Industrial sample to determine if any of
the component companies are themselves subject to “dramatic
change” occurring in their respective industries.
It is
incongruous that Dr. Vander Weide dismisses the companies
most comparable to Bell Atlantic but is willing to accept a
broad sample of proxy companies about which he has no
knowledge, other than his assertion that they represent
companies in competitive industries.
Ironically, Dr. Vander
Weide includes Bell Atlantic itself and other regional
telephone holding companies in his sample, contrary to his
argument and emphasizing the fact that no analysis was done
on the companies included in his sample.
Q.
Dr. Vander Weide has also suggested that your choice of
comparable companies includes companies in the process of
merging, downwardly biasing the DCF cost of equity estimate
because analysts do not account for merger benefits in their
growth forecasts.
Do you agree?
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R.
No.
Again, Dr. Vander Weide provides no evidence that this
is the case.
The impact of anticipated mergers on stock
prices is complex.
Stock prices can fluctuate up and down
over time in anticipation of merger benefits, merger
detriments and the probability that the merger will be
consummated.
Empirical finance research indicates that the
acquiring company in an acquisition or merger sometimes
overpays, which causes the price of the acquiring company to
fall.
This could cause cost of equity estimates to be too
high for acquiring companies according to Dr. Vander Weide’s
premise, which would have an offsetting impact.
In his
sample, Dr. Vander Weide again has not provided an analysis
of which, if any, of these companies were going through, or
perhaps affected by the anticipation of, a merger.
When all
these implications are considered, I do not believe that Dr.
Vander Weide has offered a plausible reason for abandoning
the appropriate proxy group.
Q.
Bell Atlantic has suggested that Dr. Vander Weide's
perpetual growth assumption is appropriate, and that no
prominent economists use the multiple-stage DCF model.
Is
this true?
A.
No.
Quite to the contrary.
Dr. Vander Weide's approach
systematically guarantees an inappropriately high rate of
return estimate.
All prominent economists familiar with
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current cost of capital research have recognized that the
simple perpetual growth DCF model using short-run forecasts
is inappropriate to use if a company’s short-run growth rate
is expected to exceed the long-run growth rate of the
economy, or the cost of equity will be overestimated.
For example, Stewart Myers and Lynda Borucki state
that:
“[f]orecasted growth rates are obviously not
constant forever. Variable-growth DCF models,
which distinguish short- and long-term growth
rates, should give more accurate estimates of
the cost of equity. Use of such models guards
against naïve projection of short-run earnings
changes into the indefinite future.” 1
Ibbotson Associates state that:
“[t]he reason it is difficult to estimate the
perpetual growth rate of dividends, earnings, or
cash flows is that these quantities do not in
fact grow at stable rates forever. Typically it
is easier to forecast a company-specific or
project-specific growth rate over the short run
than over the long run. To produce a better
estimate of the equity cost of capital, one can
use a two stage DCF model. … For the resulting
cost of capital estimate to be useful, the
growth rate over the latter period should be
sustainable indefinitely. An example of an
indefinitely sustainable growth rate is the
expected long-run growth rate of the economy.”2
Stewart C. Myers and Lynda S. Borucki, Discounted Cash Flow Estimates of the
Cost of Equity Capital—A Case Study, Financial Markets, Institutions &
Instruments, vol. 3, no. 3, New York University Salomon Center, 1994.
1
Ibbotson Associates, Stock, Bonds, Bills and Inflation, 1996 Yearbook,
Chicago, pp. 158-159
2
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Sharpe, Alexander and Bailey state that:
“Over the last 30 years, dividend discount
models (DDMs) have achieved broad acceptance
among professional common stock investors. …
Valuing common stock with a DDM technically
requires an estimate of future dividends over an
infinite time horizon. Given that accurately
forecasting dividends three years from today,
let alone 20 years in the future, is a difficult
proposition, how do investment firms actually go
about implementing DDMs?
One approach is to use constant or two-stage
dividend growth, models, as described in the
text. However, although such models are
relatively easy to apply, institutional
investors typically view the assumed dividend
growth assumptions as overly simplistic.
Instead, these investors generally prefer threestage models, believing that they provide the
best combination of realism and ease of
application.
…[M]ost three-stage DDMs make standard
assumptions that all companies in the maturity
stage have the same growth rates, payout ratios
and return on equity.”3
Damodaran states that:
“While the Gordon growth model is a simple and
powerful approach to valuing equity, its use is
limited to firms that are growing at a stable
growth rate…
The second issue relates to what growth rate is
reasonable as a stable growth rate. Again, the
assumption in the model that this growth rate
will last forever establishes rigorous
constraints on reasonableness. A firm cannot in
the long term grow at a rate significantly
greater than the growth rate in the economy in
which it operates. Thus, a firm that grows at
Sharpe, William F., Gordon J. Alexander and Jeffery V. Bailey, Investments,
Fifth Edition, Prentice Hall, Englewood Cliffs, New Jersey, 1995, pp. 590-591
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12% forever in an economy growing at 6% will
eventually become larger than the economy. In
practical terms, the stable growth rate cannot
be larger than the nominal (real) growth rate in
the economy in which the firm operates, if the
valuation is done in nominal (real) terms…
…If a firm is likely to maintain a few years of
above-stable growth rates, an approximate value
for the firm can be obtained by adding a premium
to the stable growth rate, to reflect the aboveaverage growth in the initial years. Even in
this case, the flexibility that the analyst has
is limited. The sensitivity of the model to
growth implies that the stable growth rate
cannot be more than 1% or 2% above the growth
rate in the economy. If the deviation becomes
larger, the analyst will be better served by
using a two-stage or a three-stage model to
capture the supernormal or above-average growth
and restricting the use of the Gordon growth
model to when the firm becomes truly stable.”4
Copeland, Koller and Murrin echo these observations,
stating that “[f]ew companies can be expected to grow faster
than the economy for long periods of time.”5
In contrast, the only support that Dr. Vander Weide
cites for the naïve application of the perpetual growth DCF
model using short-run growth forecasts is the fact that Dr.
Vander Weide himself has used this method for twenty years
in traditional rate regulation hearings, when the telephone
business was highly regulated and stable.
Dr. Vander Weide
is conspicuously silent on this issue when quoting the
Damodaran, Aswath, Damodaran on Valuation Security Analysis for Investment
and Corporate Finance, John Wiley & Sons, New York, 1994, pp. 99-101
4
Copeland, Tom, Tim Koller, and Jack Murrin, Valuation Measuring and
Managing the Value of Companies, John Wiley & Sons, New York, 1994, pg. 295
5
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academic literature because there is no current work by
prominent economists which support his position.
Q.
In several proceedings, Dr. Vander Weide has claimed in
defense of his single stage DCF analysis that Value Line
forecasts support his assumption that the 5-year I/B/E/S
growth rates for his group of "comparable" companies will
persist indefinitely in the future.
How do you respond to
this assertion?
A.
Among other things, Dr. Vander Weide has claimed that Value
Line provides long-term projections for a number of
telephone companies which purportedly confirm that
relatively high growth rates can be sustained for long
periods. However, it is clear from the Value Line reports
that forecasts are provided for up to 5 years only.
Indeed,
the Value Line reports cited by Dr. Vander Weide provide no
forecast beyond the year 2001.
We confirmed with Value Line
that they do not intend to make such long-term forecasts
implied by Dr. Vander Weide.
What Dr. Vander Weide is really saying is that, by
using the traditional book “b X r” method (where “b”
represents book earnings that are retained by the company,
and “r” represents the book return on book equity), he can
infer a long-run perpetual growth rate by looking at
historical book retained earnings growth and assuming it
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will persist into the future.
It is important to emphasize
that Value Line is not making any type of forecast.
Dr.
Vander Weide is simply taking data from Value Line reports
and using a method often used in traditional regulatory
hearings for stable, regulated industries which are not
expected to experience significant variance from their
historical growth rates.
Q.
Is this traditional book “b x r” method forward looking?
A.
No.
Q.
Is the use of a method which is based on the return on book
It relies solely on historical data.
equity consistent with Dr. Vander Weide’s testimony
regarding the appropriate capital structure to be used in
estimating the cost of capital?
A.
No.
Dr. Vander Weide has vociferously argued that a market-
value capital structure is the only one that can be used
because a book capital structure is based on embedded costs
and is backward looking.
Consequently, his argument that a
book value method is appropriate for estimating growth, a
critical input in estimating the forward-looking cost of
equity, is fatally discrepant.
Q.
Have you seen other instances where Dr. Vander Weide has
inconsistently used book value capital structures?
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A.
Yes.
In an affidavit recently filed with the FCC on behalf
of the United States Telephone Association regarding network
access charges, Dr. Vander Weide used average regulatory
book value capital structure weights for estimating the
economic returns earned by price cap local exchange
companies.
A copy of this affidavit is attached hereto as
Exhibit BC-2.
This again is wholly inconsistent with his
arguments in the TELRIC hearings.
Q.
Are you aware that Dr. Vander Weide has testified elsewhere
about the significance of the Bell Atlantic-Nynex
prospectus/proxy statement?
A.
Yes, I have seen Dr. Vander Weide's testimony before the New
Jersey, Delaware, Pennsylvania and West Virginia Commissions
that the 8-10 percent DCF discount rates disclosed in the
prospectus/proxy statement for valuing the telephone
operations of the company were not probative because, among
other things, they were intended merely to provide relative
values of the companies for purposes of evaluating the
fairness of the exchange ratio.
Dr. Vander Weide has also
suggested that the DCF analysis in the prospectus is not
material due to certain disclaimers made by Bell Atlantic’s
financial advisor, Merrill Lynch.
Q.
How do you respond to such statements in Dr.Vander Weide's
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testimony regarding the prospectus?
A.
I find Dr. Vander Weide's testimony nothing less than
astonishing.
In the first place, Dr. Vander Weide's
suggestion that there was no need to change the rate of
return estimate because it applied equally to both companies
is wrong.
The investment advisors to the transaction relied
on those estimates as part of their valuation of the two
companies, which in turn was intended to ensure that
shareholders receive proper compensation as a result of the
proposed merger of the two companies.
As agents of the
management of the respective merger partner, the investment
advisors were obligated to modify their advice in response
to material changes.
shareholders.
Management owed the same duty to
To suggest that this duty was somehow
suspended by boilerplate exculpatory disclaimers, because
the rates of return applied to both companies, is as absurd
as saying that it did not matter what the rates of return
were in the first place.
Indeed, the rate of return
estimate involved the Telco portions of the business, which
could have differing effects on the valuation of each
company.
Moreover, and in any event, investors are entitled
to rely on the disclosures in the prospectus/proxy statement
(including discount rate estimates) quite apart from their
impact on the relative valuation of both companies.
For
management to have thrown up their hands and say "it will
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all even out in the end," would have constituted a breach of
fiduciary responsibility, by the investment advisors to
management and by management to shareholders.
Q.
Unlike your analysis, Dr. Vander Weide fails to distinguish
the differences in risk between the wholesale, network
element leasing business and the retail local exchange
business.
Assuming that more competition arises at the
retail level, is there evidence that increased retail
competition would make the wholesale business of leasing
unbundled network elements less risky?
A.
Yes.
Bell Atlantic's own management has expressed this
view.
In Bell Atlantic's annual report issued in February
1996 for the calendar year 1995, management characterized
the "recent passage of the telecommunications reform
legislation" as "good news" for Bell Atlantic's investors.
Bell Atlantic's management explained (emphasis added):
"While telecom reform accelerates the opening of
our local markets, it also removes artificial
barriers that have kept us out of lucrative
markets like long distance. The new
opportunities far outstrip the prospect of
increased competition: the bill expands the
attractive markets we can address from our
current investment base by as much as 40
percent, according to industry analysts."
Bell Atlantic has also indicated in a Strategic
Overview published on its Internet web site (attached as
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Appendix 1 to my direct testimony) that the business of
leasing network elements, in and of itself, represents an
opportunity for the company, since retail competition will
increase utilization of its network at the wholesale level
without the need to make any additional investment.
Q.
Are you saying that the prospect of increased competition in
the retail phone service is irrelevant for purposes of
determining a TELRIC rate of return in this proceeding?
A.
Absolutely. The Commission in its August 8 Order explicitly
defined the relevant risk as the risk incurred in the
business of leasing unbundled network elements at wholesale
[August 8 Order at ¶702]. (That the FCC has indicated that
"the risk adjusted cost of capital need not be uniform for
all elements," further indicates that the relevant risks are
those inherent in the business of leasing elements itself,
not the risks entailed with retail phone service.
[Id. at
¶702.])
Such an interpretation is only logical.
Whether
competition in the local exchange service business will
increase depends in the first instance on the unbundled
element price to be charged to the new entrants by the
incumbent LECs, which is determined by (among other things)
the cost of capital.
Setting the cost of capital too high
due to expectations regarding intense competition down the
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road (based on Dr. Vander Weide’s incorrect interpretation
of the FCC Order) could foreclose that competition from ever
arising by increasing the price of network elements above
forward looking levels. Conversely, setting the cost of
capital too low (on the assumption that little or no
competition will develop) would attract unexpectedly high
levels of competitive entry by decreasing the price of
unbundled network elements below forward looking levels.
If
one instead focuses on the risks attendant to the business
of selling access to retailers at wholesale cost, one can
derive a cost of capital that is not biased by
unsubstantiated speculation about downstream effects in the
retail market.
This is one of the reasons I believe that the
Commission did not intend for the TELRIC rate of return to
reflect emerging competition at the local retail phone
service level as opposed to the level of leasing unbundled
network elements at wholesale.
Q.
How can you be certain that the FCC did not intend to adjust
the rate of return to reflect an increase in competition in
the local retail telephone business, or for a hypothetical
assumption of a highly competitive market?
A.
The FCC Order states that the forward looking economic cost
methodology will be based on the most efficient technology
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deployed in the incumbent LEC’s current wire center
locations, and that this benchmark most closely represents
the incremental costs that incumbents actually expect to
incur in making network elements available to new entrants
(August 8 Order at ¶685).
The FCC Order states further that
the 1996 Act will allow new entrants to enter local markets
by leasing the incumbent LEC’s facilities at prices which
reflect the incumbents’ economies of scale and scope (August
8 Order at ¶232).
These provisions make it clear that new
entrants get the benefits of efficient costs existing today,
which would include the cost of capital as of today.
Q.
Does Dr. Vander Weide claim that competition in the retail
phone business may adversely affect Bell Atlantic’s entire
stream of income?
Yes, however, that is merely another way of saying that
Bell Atlantic will not recover its embedded costs.
The
Commission ruled in its August 8 order that the LECs would
not be permitted to price network elements on the basis of
embedded costs(¶¶ 704-706). Dr. Vander Weide is attempting
to smuggle embedded cost recovery through the back door when
he testifies that the TELRIC rate of return for the sale of
network elements at wholesale should reflect the risk of
business losses -- i.e., a failure to recover embedded costs
-- in the local exchange market.
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Q.
Has Dr. Vander Weide specifically addressed in any other
proceedings the risk of the business of leasing unbundled
network elements?
A.
Yes, but only in passing.
He has said that the risk
involved in that business is "identical" to the risk of
investing in local exchange service because the same network
elements are involved in providing both services. Dr. Vander
Weide claims further that "recent advances in
telecommunications technology and changes in regulation have
greatly increased competition in the local exchange."
Q.
How do you respond to Dr. Vander Weide on this issue?
A.
Again, I believe that Dr. Vander Weide is confusing
wholesale competition with competition in the retail market.
Simply because the competition may increase in the local
exchange market due to proceedings like this one does not
mean that the business of providing access to unbundled
network elements is subject to the same risks, competitive
or otherwise.
Moreover, it is important to emphasize that risks which
investors can diversify away by holding a broad stock
portfolio should not be considered in estimating the cost of
capital.
For example, Ibbotson Associates state that:
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“…unsystematic risk is that portion of total risk that
can be avoided by diversifying; the CAPM concludes
that unsystematic risk is not rewarded with a risk
premium. For example, the possibility that a firm
will lose market share to a competitor is a source of
unsystematic risk for the stock of a particular
company.”6 [emphasis added]
Q.
Dr. Vander Weide has testified in various proceedings that
one must look at the risk of the assets, not of the business,
and the same assets are used in both the network element
leasing and the retail local exchange businesses.
Is this
correct?
R.
No.
One must look at the risk of the business activity in
question because each business activity is comprised of an
array of assets, which may include physical equipment,
buildings, vehicles, employees, management, software and
various intangible assets.
While there may be some overlap
between businesses as to the assets they use, this doesn’t
lead to a conclusion that such businesses have the same
level of risk.
For example, a company that sells or leases
airplanes to commercial airlines is not necessarily subject
to the same risks that the airlines experience, even though
both use airplanes.
In this case, it is not even clear that the physical
network assets will be precisely the same, since demand for
Ibbotson Associates, Stock, Bonds, Bills and Inflation, 1996 Yearbook,
Chicago, pg. 148
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leased elements may vary from what Bell Atlantic intends to
provide for its retail operations.
It is clear however that
the human assets that will be applied to these operations
will differ markedly.
Retail operations require large
marketing and service field forces in comparison to the
wholesale operations.
In contrast, wholesale operations
require a much smaller staff to serve relatively few clients.
Q.
Dr. Vander Weide has criticized your use of the 5-year beta
and suggests it is not forward-looking.
Would your cost of
capital mid-point estimate increase significantly if you
instead used the 1-year beta that you calculated?
A.
No.
Using my methodology it would increase the midpoint
estimate by 23 basis points to 10.06%.
Q.
Your calculations were performed as of July 31, 1996.
Have
you estimated costs of equity and debt for a more current
date?
A.
Yes.
While I have not yet completed a full cost of capital
analysis, I have prepared estimates of debt and equity costs
as of December 31, 1996, which are presented at Attachment
BC-1.
As the rates have declined from those estimated for
July 31, 1996, it appears that the cost of capital estimate
that I have provided for this proceeding is conservatively
high.
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Q.
Does that conclude your present testimony?
A.
Yes, it does.
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