Due Diligence: Risk Factors in the Frontline Proposal
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EXECUTIVE SUMMARY
Frontline Wireless proposes to construct and operate a $15-$20 billion national broadband network utilizing 20 MHz of spectrum in the 700 MHz band, which it would share with public safety users. As described in filings before the Federal Communications Commission (FCC), in Congressional testimony, and elsewhere, the network ultimately would cover 99 percent of the U.S. population. Frontline would provide unconditionally preemptible wholesale services to commercial users, while giving public safety users priority access to 10 MHz of spectrum and use of the other 10 MHz during emergencies. Neither the U.S. government nor public safety agencies would pay anything to fund construction of the network, but public safety agencies would pay negotiated user fees for access, and be responsible for purchasing handsets and other user equipment. The rest would be funded by private investors and by Frontline’s commercial customers.
The two keys to Frontline’s proposal are the willingness of (1) public safety agencies to contribute 10 MHz of spectrum they have been allocated for broadband services and (2) the FCC to impose service rules that would encumber an additional 10 MHz of spectrum (the “E-Block”) with both public safety and business model restrictions, substantially reducing the value of the spectrum at auction. In effect, Frontline is asking public safety agencies and the U.S. government to be its first investors, by capitalizing the firm with several billion dollars worth of “beachfront” spectrum.
While Frontline’s early-stage financial investors will be able to exit through the usual means (typically an IPO), the multi-billion dollar government investment would hardly be “liquid.” Once the plan is approved and Frontline is awarded a license to the spectrum,* (*Under the Frontline proposal, other bidders could bid for the spectrum. For purposes of this analysis, I assume Frontline is the winning bidder.) it is difficult to imagine how it could be unwound. The FCC’s history of recovering spectrum from private licensees who fail to meet build-out requirements is discouraging, as evidenced by the infamous NextWave episode. As for public safety, it will invest additional billions in handsets and other unrecoverable costs, and in any case will be dependent on the network for essential services.
For the past decade, the FCC has allowed market forces to evaluate the financial viability of prospective licensees’ business models. In an open auction, where the risk of failure is borne virtually entirely by the private bidder, there is no need for the government to conduct a detailed financial analysis: Its investors have all the incentives to do so, and are in the best position to evaluate the risks and rewards involved. The Frontline proposal is a different matter: Frontline asks both U.S. taxpayers and public safety agencies to become its business partners, its first and
largest investors.
Given the magnitude and permanence of the commitment involved, one would expect that the prospective investors—public safety agencies and the U.S. government—would conduct a certain level of due diligence. What will be the nature of the network constructed? What technologies will it use? How many towers will be required, and what will they cost? How will the build-out of the network—which must take place long before any revenues begin to flow—be financed? How many commercial customers does the firm expect to have, who will they be, and how much will they pay? And, what will Frontline need to charge public safety users to make up the difference between commercial revenues and what is required?
Yet, with the date for an FCC decision to either approve or disapprove the Frontline proposal rapidly approaching, none of these questions (or dozens more like them) has been systematically asked, let alone answered. Frontline has not provided even a rudimentary business plan, let alone the extensive financial projections, technological validation, marketing plans and other backup materials private investors (including the very successful venture capitalists who are among the firms’ financial backers) would require before making even a modest investment, let alone billions of dollars. Either Frontline doesn’t have a fully formed business plan, or it has decided not to tell its prospective initial investors what it is.
In this paper, I outline some of the questions a proper due diligence exercise would seek to answer. I do so in part by constructing a rudimentary business model, based on the elements of the Frontline proposal that have been publicly unveiled and on reasonable assumptions regarding revenues, costs, financing and so forth. The model raises serious questions about Frontline’s ability to accomplish its objectives. Specifically, using very favorable assumptions about everything from deployment schedules to penetration rates, the model projects that public safety would be required to pay over $9 billion in access fees alone over the first six years the network is in operation (2013-2018) in order for Frontline to pay down its debt and begin returning dividends to its equity investors. To put the $9 billion figure in perspective, it amounts to about a third of public safety’s total projected spending on communications for firstresponders. And, it does not include the cost of handsets and other equipment, which would be billions more.
The exercise here should not be viewed as taking the place of a proper due diligence process, or even reasonably approximating one. Properly conducted, the due diligence process for an investment of this size and scope would examine every aspect of the proposed business in grueling detail. It would include developing and validating pro forma income statements and balance sheets, conducting interviews with prospective customers, critically evaluating the capabilities of key personnel, validating key technological and market assumptions, and preparing a detailed plan for obtaining the financing necessary to get the business from start-up to (hoped for) profitability. A proper due diligence process would also look critically at the risks facing the business, and the probability that it can overcome those risks.
Ultimately, it is the responsibility of the business owners to come forward with answers to all of these questions, and properly so: It is their business, and they are the only ones in a position to explain how it will work and why, at the end of the day, they believe it will succeed.
This paper is designed to illustrate what, at the most basic level, a due diligence exercise would look like, and to identify some of the issues it would address. I conclude that the Frontline plan is unlikely to succeed financially, and that its first-round investors—the public safety agencies and the U.S. government—are likely to end up bearing the costs of that failure. If Frontline’s Silicon Valley backers have conducted serious due diligence that shows otherwise, they should produce it and allow it to be subjected to independent analysis. If not, or if they are not prepared to subject their plans to public scrutiny, the FCC should walk away from this particular “business opportunity.”
