Mike Harder: I think the debt markets are continuing to evolve. New structures and facilities will continue to come online and continue to press the market to think differently about how to finance these structures.
Jeff Johnston: That was Mike Harder, credit supervisor, Digital Infrastructure Banking Group at CoBank, regarding the changing dynamics in the broadband lending environment.
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.
Competition, growth opportunities and the race to provide broadband service unserved and underserved markets is forcing some broadband operators to think more creatively about how to fund their capital budgets. In some cases, they are taking on more risk, which is requiring banks to rethink how they are going to support these new lending structures.
Mike sits at the center of this business for CoBank, and has worked in the credit markets for two decades. His experience and bird’s eye view of current market conditions make him an ideal guest to talk about how the rural broadband lending environment is evolving at a rapid pace.
So, without any further ado, pitter patter, let’s see what Mike has to say.
Mike Harder, welcome to the podcast. It's a pleasure to have you with us here today.
Harder: I appreciate it, Jeff. Good to be with you as always, and good to see your smiling face.
Johnston: Super excited to have you on the podcast today. You've got a lot of experience and a lot of knowledge in the broadband industry and the credit markets and how all those work together in rural America. I'm really interested in picking your brain today to get into some of the details because I think all of this is pretty topical.
Hey, let's kick it off here, Mike, for listeners, and maybe you can just give listeners a high-level overview of the rural broadband industry. I'm thinking of what's going on as it relates to underserved and unserved markets, where companies are trying to move in to plant their fiber flag and all of the things that are going on associated with that. If you can just give us a high-level overview to set the stage, that would be great.
Harder: Absolutely. Again, thanks for having me on, Jeff. I guess you're saying that I'm old since I've been around the block for a little bit. I guess I have some knowledge in the space here, but it's just when you think you understand what's going on, the market's been changing.
I quantify the industry, it really is the tale of two cities right now within the rural space, which you have the small rural providers, the local exchange guys, which are the old mom and pop bell organizations that are providing internet and old telecom voice services who are desperately trying to convert over their networks to avoid obsolescence.
That's an interesting area. These are very remote areas, which typically aren't growing at huge rapid rates. The cost to deploy internet service to these more remote rural areas is extremely expensive. To be honest, the financial resources of these smaller LECs are not substantial. They don't have access to the capital markets, to the equity markets, to private equity.
There's ongoing funding, and that's done a lot with – what we do here at CoBank is that's a big, huge part of our missional endeavors, is to provide financing to those smaller providers out there. It's go-time for them in terms of they need to build that fiber out, to overcome the declining network access, which is basically the network access as well as the government support revenues are all been in a decline given that people are moving away from voice landlines.
Here at CoBank, that's a huge part, and really a very rewarding part for that matter to build out a higher-speed broadband network to these more rural areas. That's typically done more on the bilateral lending basis where it's true relationship banking, it's old school style banking where you're providing revolvers, term loans.
On the flip side is the rapidly deploying fiber overbuilders that are typically well-funded, potentially private equity owned or infrastructure fund owned. These guys are trying to double or triple their home passings each and every year. They have substantial equity resources behind them. We are very fortunate to be in the middle of all these from a CoBank lending perspective.
In both cases, this tale of two cities, if you will, they are really trying to get to that first network, first mover advantage in networks. If you aren't, it's going to provide quite a bit of difficulty in terms of getting your penetration rates there.
In these rural areas, it is very much a viable strategy when there's literally maybe potentially some satellite providers, some lower speed thresholds, fixed wireless providers. These rural LECs that are able to build fiber, get the subscriber there, it's really an advantage to them because those are very sticky, high-margin pieces of recurring revenue business for them.
The flip side is the more aggressive competitive fiber overbuilders. There could be potentially another provider of high-speed internet, maybe a cable provider or another fiber provider for that matter. It tends to be a bit more competitive I think in some rural areas where it's just the couple copper LEC that is providing the new fiber, you can see them getting penetration rates north of 40%, 50%.
Now in these more competitive situations where there's a cable provider or another fiber provider, penetration rates may not be that high. First-mover advantage, very important, especially if it's an underserved, unserved area. Obviously, within the LEC and the underserved rural areas, the conversion and the opportunity for growth from these fiber overbuilds is driving huge increases in multiples out there in terms of what these networks could be bought and sold for.
Johnston: That's great, Mike. That's a wonderful overview. I just want to ask a couple of follow-up questions here on all of this. That first cohort, when I think about first-mover advantage in building out fiber in those markets, I would assume that there really isn't much competition in those markets. It sounds like those are fairly remote, high-cost markets that may not attract competition and therefore rely more on government support[JJ1] . So the race to build fiber in those markets may not be as urgent, I guess, as it would be in the second cohort. Is that a fair characterization?
Harder: Yes, I absolutely agree. I think the rollout that we've seen from the conversion of government support being rolled out in terms of the CAF 2 RDOF as well as A-CAM into the new Enhanced A-CAM programs has really spurred that growth in those really rural areas. Based on our analysis and just observation, they very much depend on these government support mechanisms to make it economically viable for these providers.
Otherwise, it's almost a non-starter from an economic return on capital deployed perspective, you need some sort of government or grant support, which I think is the challenge that a lot of our rural broadband providers are facing right now.
Johnston: Look, Mike, that was super helpful and makes a lot of sense. I guess what I wanted to do now was talk about the second cohort. By no means am I trying to discount the first cohort because they're obviously critical to rural America and ensuring people are connected in those remote parts of the country.
But the second cohort I think is interesting from the standpoint that it feels like there's more growth opportunity. It feels like there's more competition. It feels like there's more money being thrown at those markets. I wanted to talk about the evolving credit dynamics in those markets.
What are you seeing from a borrowing standpoint, from a credit standpoint, that maybe you weren't seeing, I don't know, 18 months ago or two years ago in terms of, the aggressiveness, if you will, on the part of borrowers to maybe take on a little bit more risk or take on a little bit more debt? Because again, getting back to this racing to plant the fiber flag, it feels like in some of these markets in the second cohort, there's more urgency around building fiber in these markets. If you can help us understand what's going on there, that would be great.
Harder: Absolutely. As you know, we had this little thing called a pandemic sometime in the-- [laughs] going on almost four years ago. This little thing called the pandemic certainly spurred additional demand for internet bandwidth, both from a download and upload standpoint, the ability to have high-quality video conferencing, video chats, all the applications have really driven a strong demand within the space, which obviously more people need these high-quality fiber-based networks built and deployed to them.
The demand for capital has boomed, I would say, since 2020. We all thought the world was coming to an end. We were all going to be sitting on our couches doing nothing during this, but no, not us here in the digital infrastructure lending world. It has literally been full speed ahead, gangbusters, trying to keep up with demand.
The structure is originally, from a lending perspective, were your typical revolving credit facilities coupled with some sort of term loan, term financing to help bridge the next several years' worth of capital expenditures. That was the vanilla style prior to the pandemic. Ever since then, really, companies have been seeking to have debt capacity available to them for future builds.
So what we began to see quite a bit in this space was more delayed draw term loans, which means you're given a commitment, and these delayed draw term loans can be available for a year or two. You're subject to certain leverage metrics for utilization. This has been the evolution within our space, especially for those who are rapidly deploying fiber home passings.
That's been the norm ever since the pandemic. However, talking about shortages in labor, inflation in terms of materials and equipment and fiber costs, everything involved with that has really increased further the demand for capital. It's piling on, if you will. We've seen borrowers really max out traditional leverage metrics and seek to potentially go into more alternative lending arrangements, if you will, alternative lending markets. I think you've talked about in previous episodes, where we've seen the likes of a Frontier enter the securitization market. That's been a new phenomenon here in the telecommunications lending world.
We've seen that change the narrative a bit where ultimately borrowers are able to obtain higher leverage than the traditional banking markets would allow them to. We've also seen some asset-based structures where borrowers are looking to deploy fiber and not necessarily have enough existing EBITDA, which is your cash flow-based earnings, to leverage. They're looking more on a project finance style loan-to-cost structure where you're actually borrowing a percentage of the actual cost needed to build and then equity comes in on a certain percentage as well.
We're also seeing borrowers seeking to add a lot of additional adjustments to their EBITDA covenant definitions, which gives them more flexibility for when they're entering into new markets.
The lending market is evolving literally as we speak. Definitely a very dynamic space. We have a lot of resources deployed in terms of trying to follow these markets and these evolving structures.
All that to say, when you're looking at all these borrowers, either on an enterprise basis or on a homes-passed basis, there's value in putting fiber in the ground and passing it home. We're early days in terms of what that looks like. As you can see, multiples for fiber providers continue to be very strong out there in the world, and like I said, it's very much an evolving space right now.
Johnston: Just a follow-up question to that. The evolution of the lending environment, it feels like banks and other types of lenders are willing to take on a little bit more risk with the deals that they're entering into because of the evolution of the market.
My first question to you is, A, is that true? Then B, if in fact that is true, why is that? Is that because lenders are looking at this segment and saying, "We realize how critically important digital infrastructure is to people's daily lives and their work and the economy overall," so the segment overall, the complex overall has a lower risk profile? Or is there some other factors that are playing into, again, what I perceive as lenders' willingness to take on more risk?
Harder: I think lenders have certainly been able to identify the value of, as I said, the value of a home passed with fiber. I think the market certainly has a firm grasp on what historical penetration rates, meaning what percent of those homes-passed people are actually subscribing to your internet service.
These businesses tend to be very sticky, especially if you have a strong, high-quality fiber-to-the-home service. These customers tend to stick, they aren't jumping around as much. Like you said, it is very utility-like nowadays. I think that's given lenders more comfort in our space to accept higher leverage profiles.
The recurring revenue nature of this business, I think, has given people quite a bit more comfort. I think the growth in internet traffic over the next-- gosh, I saw a stat the other day, it's going to literally double the amount of internet traffic over the next five, six years. I think that just gives me, as a credit guy or risk guy, it gives me great comfort there in accepting a little bit more risk tolerance.
Johnston: Just taking it a little bit further here from a risk management perspective, when you look at the market and you see what's happening with labor, the labor market's getting better in terms of-- it feels like the tightness is improving, meaning that the supply, demand, imbalance is getting a little bit better in favor of employers, it's still a pretty tight market, an expensive market, we've seen wages continue to go up.
When you look at that and then you also look-- you mentioned earlier about inflation. Clearly, that's been a huge problem for the entire country and certainly for broadband builders as well. So there's that. With inflation, I guess the interesting thing is, too, is that my broadband bill hasn't gone up nearly as much as my grocery bill. Broadband has remained relatively flat, whereas everything else has gone up, including input costs for broadband operators.
When you look at all that and then you overlay on top of that the interest rate environment and there's this ongoing concern about recessionary fears and all that stuff, how does all that foot with you from a risk management perspective as a credit guy?
Harder: Like we talked about, the competition for your subscriber, for the subscriber of home internet is so valuable. They'd be pretty hard-pressed to push through any increase on your monthly internet bill.
Now, of course, if you're a traditional cable, video/broadband, triple play subscriber, we are seeing that increase in monthly bills. That's really more on the video side of the house. The pure fiber broadband-only providers of the world out there, they are very much concerned about keeping your business. They are very much averse to any churn in their business.
We're not seeing a ton of pressure on broadband, monthly ARPUs, which is your average revenue per user per month, in fact, we've actually seen those-- you would think that they would be rising in this inflationary environment, but I think I've seen stats over the past several years that the internet-only component to your monthly bill has been flat, if not on the decline because there's so much value inherent to having a subscriber on your books.
Johnston: Yes, certainly the margins on broadband customers are very attractive.
Harder: They are very attractive. I think, not to throw numbers out there, but I've heard, I've seen EBITDA margins north of 50%, 60% on internet-only type products. It could be even north of there, depending on the cost structure of the individual broadband provider. Those kinds of margins are very strong when you think about it from an economic standpoint.
Johnston: Yes, that's a good point. Yes, pulling out the video component of the network is cost-saving. Yes, those are great margins. Shoot, that's like approaching software margins, which is the envy of everybody.
Harder: Yes, well, I'd say, the margins are necessary. They need to continue to reinvest the cash flows that they're generating. We look at this in our modeling all the time when we're considering new financing structures. They need to continue to push out all that free cash flow to fund future builds. It's very much a key component. Yes, you need to go get your debt financing. You need to consider possibly equity financing if the debt markets can't bear the amount of growth you're handling.
Johnston: Well hey, let's move on to the equity component of financing. These private equity sponsors and infrastructure funds have been very active in the market in terms of acquiring operators and rolling them up and investing in these companies.
I think infrastructure funds see the value in digital infrastructure now more so than ever. I think digital infrastructure assets look perhaps more attractive than investing in an airport or road. That's been wonderful for the industry.
How are these investors approaching all of this as their member companies, their own companies are looking at stepping up their leverage and taking on more debt? Are they coming, they being the investors, are they coming to the table with a sufficient amount of equity support to justify these more aggressive structures?
Harder: Absolutely. I think for the well-versed, well-seasoned infrastructure funds/equity firms that are familiar with our space, who are bullish on our space, yes, for sure. Like we talked about, there was headwinds in terms of labor costs, inflation, post-pandemic that we saw. There was delays and buildouts. Penetration rates didn't necessarily meet the modeling expectations. All that to say is that some of these really rapid-growth fiber providers and overbuilders may have maxed out their debt facilities and their debt capacity earlier than expected, earlier than originally modeled.
We've seen very strong support from the private equity firms/infrastructure funds to bridge that gap while they catch up in terms of their builds. It's been really encouraging to see these guys see the value in the long-term prospects within the broadband fiber space. They've been very willing to bridge the gap in terms of waiting for the EBITDA to catch back up relative to what the previous debt was deployed for the buildouts. So it's been very encouraging.
Now, I think at some point, we continue to ebb and flow with-- the markets continue to ebb and flow with regards to how much debt versus equity, what the right mix there is of that. By and large, the big guys like Searchlight and Apollo and Grain, they've all been very supportive of-- others as well have also been very supportive of these transition periods, while the providers deployed all these passings and they're literally trying to play catch-up at this point.
But the growth stories continue to be very strong. We're seeing double-digit strong growth stories in a lot of these fiber overbuilders at this point. I think, obviously, if you're a private equity firm or structure fund investor, you're loving that. You're loving that growth in terms of subscribers. It takes a minute for the EBITDA and the revenue to catch up.
Johnston: Hey, Mike, before we wrap it up, I just want to give you an opportunity to cover anything or talk about anything that we haven't already discussed that you think is relevant. The stage is yours.
Harder: Again, thanks, Jeff, for having me here on the show. I'd say just in terms of overall strategy, us here at CoBank, we remain extremely bullish within the sector.
There's ongoing, like I said, internet traffic and the need for internet to be deployed into rural areas is a huge motivator for us here at CoBank. I think the debt markets are continuing to evolve. New structures and facilities will continue to come online and continue to press the market to think differently about how to finance these structures. I think being at the forefront has been really exciting. It's exciting to see all the new structures and geek out all that stuff. If you're a credit risk guy, you're totally geeking out on all this stuff.
At some point, I do see there is a potential where the markets may just hit a pause button, but maybe the growth is potentially going to slow down. Being in the right structures and being cautious and judicious in how you're extending your balance sheet is certainly always in the back of our minds. We love the broadband space. We are bullish on it. I think the growth story for the next 5-10 years is going to continue to be strong, and the partnerships that we've enjoyed with investors as well as strategic investors out there in the market has been really encouraging as well.
Johnston: Fantastic. Well, great advice, Mike, and well said. Thank you so much for your time today. It was a pleasure having you on the podcast.
Harder: Awesome, Jeff. Thanks for being you and thanks for all you do for the bank, so we appreciate being here.
Johnston: A special thanks goes out to Mike for being on the podcast today.
It’s an exciting time for the rural broadband market. We’re seeing unprecedented amounts of federal funding, a race to build fiber networks and lots of interest from infrastructure funds and private equity sponsors as they see the value in owning broadband assets. All of this is forcing banks and CFOs to be more creative in how they think about financing their capital budgets to ensure they execute their network build plan.
Hey thanks for joining me today, and a special thanks to my fellow CoBank associates Christina Pope and Tyler Herron who makes this podcast possible. Watch out for the next episode of the All Day Digital podcast.
