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In the Matter of AMERICAN TELEPHONE & TELEGRAPH COMPANY, AND THE ASSOCIATED BELL SYSTEM COMPANIES Charges for Interstate Telephone Service, Transmittal Nos. 10989 and 11027

 

Docket No. 19129

 

FEDERAL COMMUNICATIONS COMMISSION

 

38 F.C.C.2d 213

 

RELEASE-NUMBER: FCC 72-1059

 

November 22, 1972 Released

 

 Adopted November 22, 1972

 


COUNSEL:

APPEARANCES

On behalf of American Telephone & Telegraph Company and Associated Bell System Companies (AT&T), Messrs. John F. Preston, Jr., Howard Trienens, Harold Cohen, Thomas M. Eichenberger, and Jules Perlberg; on behalf of GTE Service Corporation (for General Telephone and Electronics Corp.), Messrs. John Robert Jones and William H. Schneider (of Power, Jones, Bell & Schneider, Esqs., Columbus, Ohio), Theodore F. Brophy and George E. Shertzer (of New York, New York), and William Malone, Washington, D.C.; on behalf of United Utilities, Inc. and United Telephone System Companies, Messrs. Lloyd D. Young and Warren E. Baker (of Chadbourne, Parke, Whiteside & Wolff, Esqs., Washington, D.C.); on behalf of Microwave Communications, Inc. (MCI), Messrs. Kenneth A. Cox, Michael H. Bader and William J. Byrnes (of Haley, Bader & Potts, Esqs., Washington, D.C.); on behalf of Telephone Users Association, Inc., Messrs. Arthur S. Curtis and Mel Laney; on behalf of the City of Chicago, Messrs. Bernard Rane and Mark Goldstein, Assistant Corporation Counsel for Mr. Richard L. Curry, Corporation Counsel, City of Chicago; on behalf of the Trial Staff, Common Carrier Bureau, Federal Communications Commission, Messrs. Asher H. Ende, Peter M. Andersen, William L. Fishman and A. Michael Cappelletti; on behalf of National Telephone Cooperative Association (NTCA), Mr. Robert J. Leigh; on behalf of the Secretary of Defense and all Executive Agencies of the United States Government, Messrs. Curtis L. Wagner, Jr.  (Chief, Regulatory Law Division, Office of the Judge Advocate General, Department of the Army) and Wolfgang Drescher (of the Regulatory Law Division, Office od the Judge Advocate General, Department of the Army); on behalf of Data Transmission Company (DATRAN), Messrs. John M. Scorce (General Counsel), Michael L. Glaser, and Francis E. Fletcher, Jr.; on behalf of United States Independent Telephone Association (USITA), Mr. Thomas J. O'Reilly; on behalf of the Western Union Telegraph Company, Messrs. Jack Werner, Robert N. Green and David H. Lubetsky; on behalf of American Broadcasting Company, Inc. (ABC), Mr. Robert J. Kaufman; on behalf of Columbia Broadcasting System, Inc. (CBS), Mr. Joseph DeFranco; on behalf of National Broadcasting Company, Inc. (NBC), Mr. Howard Monderer; on behalf of all three networks (ABC, CBS and NBC), Messrs. Joseph M. Kittner, John L. Tierney and Norman P. Leventhatl (of McKenna & Wilkinson, Esqs., Washington, D.C.); on behalf of Atlantic Richfield Company, Messrs. Alan Y. Naftalin and George V. Wheeler (Koteen & Burt, Esq., Washington, (D.C.); on behalf of National Retail Merchants Association, Inc. (NRMA), Messrs. David L. Hill and William H. Borghesani, Jr. (of Keller & Heckman, Esqs., Washington, D.C.); on behalf of the City of New York, Mr. J. Lee Rankin, Corporation Counsel by Mr. Francis I. Howley, Assistant Corporation Counsel; on behalf of Air Transport Association of America (ATA), Messrs. James E. Landry (General Counsel) and William E. Miller and Herbert E. Forrest (of Steptoe & Johnson, Washington, D.C.); on behalf of Aeronautical Radio, Inc., Messrs. Donald C. Beelar, John L. Bartlett and Charles R. Cutler; on behalf of American Telephone Consumers Council, Mr. George Levine and Mrs. Eleanor Martell; on behalf of Communications Workers of America, Mr.  Charles McDonald; on behalf of The Public Service Commission of the State of West Virginia, Mr. John E. Lee, Chief Counsel; on behalf of Grass Roots Action, Inc., Messrs. Richard Ottinger and Terry Lenzner; on behalf of the State of New Jersey, Messrs. Kenneth F. Yates, Deputy Attorney General, William E. McGlynn and Jack B. Kirsten (Newark, New Jersey); on behalf of the Commonwealth of Pennsylvania, Mr. Gordon P. MacDougall, Special Assistant Attorney General, Washington, D.C.; and Anthony R. Martin-Trigona, for himself.


JUDGES:

BY THE COMMISSION: COMMISSIONER ROBERT E. LEE ISSUING ADDITIONAL VIEWS; COMMISSIONERS JOHNSON AND H. REX LEE DISSENTING AND ISSUING STATEMENTS; COMMISSIONER REID CONCURRING IN THE RESULT; COMMISSIONER HOOKS CONCURRING AND ISSUING A STATEMENT.


OPINION:

 [*213]  Table of Contents

 

 

Paragraph

Page

 

No.

No.

I.  INTRODUCTION

 

Nature of the Proceeding

1-5

3-4

Issues and Relationship to Other Dockets

6-8

4-5

Parties

9-12

5-7

Initial Decision and Exceptions

13

7

New Economic Program

14-16

7-8

Oral Re-Argument

17

8

Official Notice of Additional Data

18-19

9

Special Tariff Application

20

9

II.  SUMMARY OF POSITIONS

 

The Bell System Position

21-25

10-11

The Trial Staff Position

26-28

11-12

Position of Carriers Other than Bell

29

12

Position of Users and User Groups

30-32

12-13

Other Parties

33

13

Re-Argument

35-39

14-15

III.  DISCUSSION

 

Introduction

40-43

16-17

Cost of Equity Findings in Docket 16258

44-50

17-18

Economic Changes

51-53

19

Cost of Embedded Debt

54

19

Current Cost of New Debt

55-57

20-21

Current Cost of Equity

58-78

21-27

Conclusions on Current Cost of Equity

70-84

27-29

Conclusions on Capital Structure

85-89

29-31

Overll Rate of Return

90-103

31-36

Conclusions on Rate of Return

104-107

36-37

MCI Petition for Reconsideration

108-109

38

Price Commission Regulations

110-113

39-40

Exceptions to Initial Decision

114

40

IV.  OPERATING RESULTS

 

AND REVENUE REQUIRE-

 

lMENTS

115-121

41-44

V.  ORDER

122-125

45

Appendix A -- Bell System's Testimony and Data

 

B - Trial Staff's Testimony and Data

 

C -- Other Parties' Testimony and Data

 

D -- Rulings on Exceptions

 

 

 

I.  INTRODUCTION

Nature of the Proceeding

1.  This proceeding is an investigation pursuant to Sections 201(b), 202(a), 204, 205, and 403 of the Communications Act of 1934, as amended, 47 U.S.C. 201(b) et seq., into the lawfulness of certain charges that are presently in effect subject to accounting and refund provisions and charges that are proposed for the future applicable to interstate message toll telephone service (MTS).  This service is furnished throughout the United States by American Telephone and Telegraph Company (AT&T) and its Associated Bell System telephone companies and interconnecting non-Bell System telephone companies over the nationwide switched telephone network.  The specific tariff in issue is Tariff F.C.C. No. 263 of the American Telephone and Telegraph Company.  AT&T files this tariff for itself and for all the other interconnecting companies, both Bell System and non-Bell System companies, that participate in furnishing interstate MTS.

2.  On November 20, 1970, AT&T filed revisions to the aforementioned tariff (Transmittal No. 10989) proposing to increase the charges for interstate MTS by some $760 million a year on the basis of the then current traffic volumes and usage.  The changes were designed to increase Bell's overall interstate and foreign communications service rate of return to 9.5% by increasing earnings of Bell by an estimated $546 million a year before Federal income taxes (FIT) and after taking usage shifts, shrinkage and cost adjustments into account.  By letter adopted January 12, 1971, we requested AT&T to postpone the effective date of these tariff changes and granted permission to the company to file revised tariffs in lieu thereof which would increase the Bell System's net earnings before FIT by not more than $250 million a year pending the outcome of an expedited hearing on the lawfulness of both the November 20, 1970 proposal and the new revisions. AT&T complied with our request and filed revised tariffs (Transmittal No. 11027) on January 14, 1971 designed to have this effect after the aforementioned adjustments, to be effective January 21, 1971.

3.  On January 20, 1971, we adopted a brief order, 27 F.C.C. 2d 149 initiating the proceeding herein and suspending the effectiveness of the new rate schedule until January 26, 1971.  This order also required all carriers collecting the increased charges to keep detailed records of all interstate calls other than sent-paid coin box and hotel guest-initiated calls so that if the rates were found excessive, the refunds, with interest could be ordered.  The following day, on January  [*216]  21, 1971, we issued a Memorandum Opinion and Order, in which we discussed in detail the various questions presented by the new and proposed rate schedules and formulated the issues that were to be considered in this proceeding.  27 F.C.C. 2d 151

4.  In our Order of January 21, 1971, we specified that the trial staff of the Common Carrier Bureau (hereafter Trial Staff) was to be separated from the decision making process as recommended by the Administrative Conference of the U.S. We also specified that the burden of proof, as well as the burden of going forward with the evidence, was to be on AT&T and the Associated Bell System companies who were named as party Respondents.  We ordered a hearing before a Hearing Examiner who was directed to issue an expedited Initial Decision on the rate of return or Phase I issue, hereafter described.

5.  On January 29, 1971, the Trial Staff filed a Petition for Reconsideration in which it requested that the Commission suspend for three months the revised rates with respect to sent-paid coin box and hotel guest-initiated calls.  We denied this Petition in our Memorandum Opinion and Order released March 3, 1971, F.C.C. 71-185.  27 F.C.C. 2d 914.

 

Issues and Relationship to Other Docket Cases

6.  In our Memorandum Opinion and Order of January 21, 1971, 27 F.C.C. 2d 151, we designated various issues of broad scope to be considered in the proceeding.  However, we directed that the issues be heard and determined in two phases.  We stated that the 9.5% overall rate of return objective of the Bell System for its interstate operations was substantially higher than the range of 7.0% to 7.5% we found reasonable in our decision in Docket 16258.  9 F.C.C. 2d 30. Accordingly, we designated this rate of return question as a prime issue to be resolved in the first phase of this proceeding.  (Hereafter referred to as Phase I).  The other issues which we designated for consideration in the second phase (hereafter Phase II), called for examination of those matters that could affect the revenue requirements of AT&T and the Associated Bell System operating companies including the reasonableness of the prices of the Bell System's manufacturing and supply affiliate, Western Electric Company, Inc. and the amounts claimed by the Bell System for investment and operating expenses and for examination of the interstate rate structure of MTS.  With respect to these Phase II issues, we also retained jurisdiction in the proceeding until we reach a determination in Docket No. 19143, in the matter of the Petitions filed by the Equal Employment Opportunity Commission, concerning the effect, if any, of alleged discriminatory practices of the Bell System companies on their revenue requirements.

7.  We made clear in our Order of January 21, 1971, that with respect to the Phase I overall rate of return issue, there was a concurrent proceeding under way in Docket 18128 that involves questions relating to the implementation of our findings in Phase I on rate of return.  Thus, the issues in Docket 18128 concern, inter alia, the principles that should govern in the assignment of the Bell System's revenue requirement among its principal classes of interstate and foreign services.   [*217]  Accordingly, our January 21, 1971 Order provided that implementation of our findings in Phase I will be subject to the determinations to be made in Docket 18128 insofar as they relate to the assignment of revenue requirements to MTS that we may find herein in Docket 19129.

8.  In connection with the aforementioned relationship of Docket 18128 to the issue herein, the Trial Staff filed a Petition for Clarification on April 15, 1971 in which it raised the question of whether the Bell System was required to prove that any additional revenue requirements it may have should be loaded exclusively on MTS during the interim period until a decision is reached in Docket No. 18128 and whether, alternatively, we should specify that, in the event of a failure of such proof, any interim earnings increase must be effectuated by increasing charges for all interstate services proportionately.  By Memorandum Opinion and Order of June 29, 1971, we noted that the Bell System had undertaken to consider increases on non-MTV services and to propose such increases for each service as appeared to be consistent with sound rate making principles, and we stated that we expected AT&T to propose appropriate rate adjustments.  We concluded that neither the Examiner nor the Commission need deal with rate relationships in Phase I. 30 F.C.C. 2d 503. n1 On December 23, 1971, we issued an order dismissing the proceeding herein as to the issues in Phase II. 32 F.C.C. 2d 691. By a further Memorandum Opinion and Order released January 28, 1972, we reversed that action and reinstituted the proceedings herein as to the Phase II issues.  33 F.C.C. 2d 269. However, the Phase I issue on the fair rate of return for the Bell System's interstate and foreign communications service is the sole issue to be resolved in our decision herein with the implementation thereof to be related appropriately to the proceedings in Docket 18128. 

 

n1 A petition for reconsideration of our June 29, 1971 action, filed by Microwave Communications, Inc. is discussed hereinafter.

 

Parties

9.  As heretofore stated, AT&T and the Associated Bell System companies were named party Respondents herein.  Thus, in addition to AT&T, the parent company, the parties respondent are: New England Telephone and Telegraph Company; New York Telephone Company; New Jersey Bell Telephone Company; Bell Telephone Company of Pennsylvania; Diamond State Telephone Company; C & P Telephone Company; C & P Telephone Company of Maryland; C & P Telephone Company of Virginia; C & P Telephone Company of West Virginia; Southern Bell Telephone & Telegraph Company; South Central Bell Telephone Company; Ohio Bell Telephone Company; Michigan Bell Telephone Company; Wisconsin Telephone Company; Illinois Bell Telephone Company, Inc.; Northwestern Bell Telephone Company; Southwestern Bell Telephone Company; Mountain States Telephone & Telegraph Company; Pacific Northwest Bell Telephone Company; Pacific Tel. & Tel. Co.; Bell Tel. Co. of Nevada; Southern New England Tel. Co.; and Cincinnati Bell, Inc.

10.  All of the forenamed companies (referred to herein collectively as "Bell", "Bell System" or "Respondents") participate in providing  [*218]  interstate and foreign communications services including MTS.  Such services are, in general, offered jointly, under a nationwide uniform schedule of rates, by the Bell System and about 1800 non-Bell, or independent companies, over a nationwide network of interconnected exchange and toll telephone facilities.  Under the Bell System's division of revenue arrangements and practices, each operating telephone company in the Bell System obtains the same rate of return on its investment allocated to interstate and foreign communications services.  (See 9 F.C.C. 2d at page 38).  Accordingly, the Bell System made a unified presentation herein on the rate of return issue.

11.  In addition to the Bell System, the other parties herein were the Trial Staff, federal, state and city government representatives, non-Bell independent telephone companies, competitors, user groups, and labor representatives.  The parties presenting or proffering testimony and evidence for the record were: The Bell System; the Trial Staff; the Secretary of Defense on his own behalf and that of all executive agencies of the Federal government; the United States Independent Telephone Association; Microwave Communications, Inc.; and the Telephone Users Association (TUA).

12.  Following the closing of the record on June 3, 1971, Proposed Findings of Fact were filed by the Trial Staff; Bell; United Telephone System; Telephone Users Association; Microwave Communications, Inc.; The Secretary of Defense on his behalf and in behalf of all Executive Agencies of the United States; The American Telephone Consumers' Council, on its own behalf and on behalf of Mrs. Florence Rice, Director, Harlem Telephone Audit Bureau and Miss Florence R. Kennedy, Director Consumer Information Service; United States Independent Telephone Association; GTE Service Corporation; and Grassroots Actions, Inc.  An amendment to its Proposed Findings of Fact was filed by Grassroots Action, Inc. and by Reuben B. Robertson and Ralph Nader, requesting that the named individuals be included as parties filing jointly with Grassroots Action, Inc. on its original Proposed Findings of Fact.  In addition, separate briefs were filed by: Air Transport Association of America; American Broadcasting Company; Columbia Broadcasting System and National Broadcasting Company; GTE Service Corporation; The Commonwealth of Pennsylvania; The State of New Jersey; The City of Chicago; Aeronautical Radio, Inc.; United States Independent Telephone Association.  A Statement in lieu of Proposed Findings was filed by Data Transmission Company and Western Union Telegraph Company.  A Memorandum on Rate of Return was filed by the Utility Users League.

 

Initial Decision and Exceptions

13.  On August 31, 1971, the Hearing Examiner issued his Initial Decision (I.D.), appended hereto, in which he set forth his findings and conclusions as to the fair overall rate of return for the Bell System Respondents for their total interstate and foreign communications services.  As more fully discussed hereinafter, the I.D. concluded that a fair and reasonable rate of return ranged from 7.9 percent to 8.8 percent with current economic conditions justifying a rate of return of 8.25 percent within that range.  Exceptions were filed to the I.D. by the Bell System; Trial Staff; Telephone Users Association;  [*219]  American Broadcasting Company; Columbia Broadcasting System and National Broadcasting Company; GT&E Service Corporation; City of Chicago; Department of Defense; USITA; Commonwealth of Pennsylvania; United Telephone System; MCI; Utility Users League; and Communications Workers of America.  Reply briefs to exceptions were filed by the Bell System, Trial Staff, USITA, MCI, Commonwealth of Pennsylvania and American Telephone Consumers' Council.  The Commission held oral argument en banc on the exceptions on October 26 and 27, 1971.

New Economic Program

14.  Following the close of the record, the President instituted a new economic program to combat inflation.  On August 15, 1971 he ordered a 90-day freeze on prices and wages, and on October 7, 1971 he announced that a wage and price control program would be put in force when the freeze expired on November 13, 1971.  A Price Commission was established under the provisions of Section 215 of the Economic Stabilization Act of 1970, as amended.  On November 11, 1971 the Price Commission released a tentative set of guidelines and rules governing price increases for regulated public utilities, including telephone carriers.  On January 12, 1972, the Price Commission revised its tentative rules (Sections 300.16 and 300.51) and set forth a detailed set of guidelines it expected to follow in reviewing price increases to such public utilities.

15.  Following hearings in February, 1972, the Price Commission issued new regulations, effective June 1, 1972, applicable to "interim" rate increases by Public Utilities.  Under these rules an "interim rate" was defined as "an increased rate allowed to go into effect by operation of law, or by action or inaction of a regulatory agency, pending a final determination by that agency on the requested increase" 6 C.F.R. 300.16(a)(1), and before an "interim rate" could go into effect, the regulatory agency was required to suspend the rate for the maximum period authorized by law.  In addition, the utility was required to certify in writing to the regulatory agency (copy to the Price Commission) that (i) the increase is cost-justified and does not reflect future inflationary expectations; (ii) the increase is the minimum required to assure continued, adequate and safe service or to provide for necessary expansion to meet future requirements; (iii) the increase will achieve the minimum rate of return needed to attract capital at reasonable costs and not to impair credit; (iv) the increase does not reflect labor costs in excess of that allowed by Price Commission policies; and (v) the increase takes into account expected and obtainable productivity gains, as determined under Price Commission policies.  Further, the utility was required to furnish the Price Commission proof of newspaper publication of notices of such interim rate requests and of procedures for public requests for proceedings thereon 6 C.F.R. 300.16(a)(c).

16.  Effective September 18, 1972 the Price Commission issued a remodification and clarification of its rules relating to Public Utilities (37 F.C. 18893). The new Section 300.307 governing interim rates (6 CFR 300.307) applies whether or not the regulatory agency has been certified by the Price Commission as having adopted rules in compliance  [*220]  with the Price Commission regulations.  With certain exceptions (noted below) the rules require suspension of interim rates for the maximum period authorized by law and the running of the suspension period before an interim rate may go into effect.  The rules also require a certificate by the utility that the increase complies with the five criteria set forth above, and proof of public notice.  A substantive change in the revision, however, is that, in addition to the previous exemptions to the suspension requirement -- emergency and previous suspensions -- the regulatory agency is not require to suspend an interim increase if it finds, in an order, that such suspension would create "undue hardship or gross inequity" (6 CFR 300.307(c)(1)).

Oral Re-argument

17.  On July 24, 1972, we issued our Memorandum Opinion and Order in which we noted the New Price Commission regulations applicable to "interim" rates, and positions of the Trial Staff, Respondents and the Hearing Examiner, that it would be appropriate for us, in reaching our decision herein, to take account of relevant financial data applicable to the period subsequent to the close of the record.  Accordingly, we specified certain data concerning Bell's long term debt costs and operating results since the close of the record which we intended to notice and we ordered a limited re-argument on the rate of return issue herein in the context of both the changes reflected by such financial and operating data and the Price Commission's regulations applicable to any "interim" rates which may be authorized by our decision herein.  FCC 72-662, July 24, 1972;     FCC 2d    .  Re-argument was held before us on September 19, 1972, and we summarize hereinafter the positions of the parties at the re-argument.

Official Notice of Additional Data

18.  In preparation for the oral re-argument, the Trial Staff, on August 3, 1972, requested Bell to provide certain new, revised, and updated data relating to the earlier record testimony of Mr. Scanlon (Bell's Exhibits 7 and 45).  This information was submitted by Bell on August 18, 1972 and included, among other things, more current information concerning the consumer price index, Bell's preferred stock, Bell's intermediate and short-term debt, Bell's interest coverage, AT&T shareowners' statistics, maturing dates of Bell's debt, Bell's construction program, market data on AT&T warrants; and the capital structure, interest coverage and expenditures of electric utilities.  In addition to the data set forth in our Memorandum Opinion and Order released July 24, 1972, we take notice of this information submitted by Bell which is more specifically identified in Appendix A hereof as part of Bell's testimony and data (Paragraph 41, Appendix A).

19.  At the re-argument, the Trial Staff requested us to take notice of additional data and information which was not included in our Memorandum Opinion and Order of July 24, 1972 and we shall grant this request.  Such additional data and information are described more fully in Appendix B hereof as part of the testimony and data of the Trial Staff (Paragraphs 14-15 of Appendix B).

 [*221]  Special Tariff Application

20.  On September 1, 1972, AT&T filed a special tariff application requesting permission to re-file the $545 million rate increase tariffs that were originally filed on November 20, 1970, with the intent that such tariffs would then be suspended by us for the 3-month period specified in Section 204 of the Act.  The stated objective of this application was to obviate any claim that we had not suspended these rate increases for the maximum period authorized by law within the meaning of the Price Commission's rules.  On October 26, 1972, we released our Memorandum Opinion and Order denying this application.  We held, inter alia, that we had already suspended the tariffs pending our decision herein and that the Price Commission rules did not require any further suspension by us of any "interim" rate increases that we might allow herein.  FCC 72-942, October 26, 1972;     FCC 2d    .

II.  SUMMARY OF POSITIONS

 

The Bell System Position

21.  Pursuant to the requirements of Section 61.38 of our Rules, 47 C.F.R. 61.38, the Bell System submitted its case-in-chief in writing on November 20, 1970 at the time of the filing of the original rate increases in issue.  The claims made at that time by the Bell System are summarized in the following paragraph.

22.  The Bell System needed more than $7 billion annually to fund its construction program, and the bulk of this, well over $4 billion a year, must come from external financing.  Because the market price of AT&T stock was at about book value, new equity could not be floated without unfairly injuring existing stockholders.  Further, additions to Bell System debt were not advisable because the capital structure was already about 45% debt, which was as high as it should be.  Changes in economic conditions since the 1966-1967 period covered by the Commission's Decision in Docket No. 16258 had increased the embedded cost of debt from 4% to about 6% and the cost of equity capital had risen to at least 12.5%.  Aside from the need to raise additional capital, Respondents claimed that, under then existing conditions, stockholders were entitled to these increased equity earnings.  Respondents requested an increase in their allowed rate of return from the range of 7.0-7.5%, which we had fixed in Docket 16258, to 9.5%.  This return of 9.5% would properly compensate existing stockholders and, in addition, would result in a sufficient elevation of the market price above book value to permit the successful sale of new equity needed to finance the construction of facilities required to provide high grade service to the public.  Respondents claimed that their overall rate of return for interstate and foreign communications service was about 7.5% for the year 1970 and that, without the proposed rate increases filed on November 20, 1970, the return for 1971 would be 7.4%; and that, with a net investment of about $13.6 billion for 1971, Respondents required a total increase in earnings before Federal Income Texas of $546 million a year in order to increase their return from 7.4% to 9.5%.

23.  In the proceedings before the Hearing Examiner, Respondents presented the testimony of 12 witnesses and written evidence to support  [*222]  essentially the same position as was set forth in its original case-in-chief, except as to the amount of the increase in rates necessary to provide the needed earnings.  Respondents contended before the Examiner that their projected earnings for 1971 would be 7.2% rather than the earlier estimated 7.4% and that, in addition to the $250 million increase which went into effect on January 26, 1971, the Bell System would need a further increase of $350 million a year or a total of $600 million annually in order to improve the Bell System's return to the requested 9.5% level.

24.  The Bell System's exceptions to the Examiner's Initial Decision can be summarized as follows: Although the Examiner correctly found that the embedded cost of debt is 6.0% and that the cost of equity has increased since our Decision in Docket No. 16258, the conclusion of an 8.25% overall return based upon a 10.3% return on equity, a debt cost of 6.0% and a debt ratio of 48% provides no increase whatsoever in the cost of equity since our Decision in Docket No. 16258.  Respondents claim that 8.25% is grossly inadequate under current conditions and that the Initial Decision seriously understates the fair return on equity capital (a) by not recognizing the significant rise in the cost of equity since the Decision in Docket No. 16258; (b) by rejecting any comparison with the earnings on equity of electric utilities; (c) by not recognizing the need of the Bell System to raise new equity capital and to be able to do so on reasonable terms, particularly at prices in excess of book value; (d) by dismissing as unpersuasive the contentions of the Bell System that its credit cannot be maintained unless it can arrest the decline in interest coverage and maintain it at a level comparable to the interest coverage of the highest rated electric utilities (Aaa); (e) by undue reliance on the testimony of witnesses for the Trial Staff on the return on book equity; and (f) by concluding that the Bell System should work toward a 50% debt ratio.

25.  The Bell System concurred in the Examiner's conclusion that the upper end of the range of the Bell System's fair rate of return should be set 0.55 percentage point above the level at which rates are adjusted.  However, Respondents claim that the Examiner's recommendation that there be "conscious use of 'regulatory lag'" would be ineffective under today's conditions.

The Trial Staff Position

26.  The Trial Staff provided two witnesses.  Briefly summarized, its Proposed Findings and Conclusions submitted to the Hearing Examiner, were to the effect that the Bell System had failed to meet its burden of showing (a) that the heavy construction program expenditures made by the Bell System have been made prudently and economically, or (b) that 45% is the maximum amount of debt it can safely and prudently carry, or (c) that the cost to Bell of equity capital is in the range of 11-13%.  On the contrary, the Trial Staff contended that it is now safe, prudent and economical for the Bell System to follow a policy of a 50% debt ratio in its capital structure, and that its unduly conservative past and present financial policies have unreasonably increased the present capital cost burden; that the current cost of equity capital to the Bell System is in the area of 9.75% to 10.25%  [*223]  using an embedded cost of debt of 5.94% and a debt ratio of 45.3%; and that taking into account (a) the errors of management in the past in the construction and financing program of the Bell System, (b) the quality of service, and (c) the economic uncertainties at this time, the Bell System should be allowed to earn in the range of 7.75% of 8.25% and that rates for their interstate services should be adjusted so as to permit is to earn at the mid-point of this range, or 8.0%.

27.  The Trial Staff further contended in its Proposed Findings that, since the Bell System realizes earnings from its investment in Western Electric (WE) in excess of its earnings from communications services, the Bell System's allowable earnings on interstate communications services, as distinguished from its WE investment, should be at about 7.8%.  Finally, the Trial Staff estimated the interstate earnings of the Bell System for 1971 to be 8.29% and proposed that this should be reduced to 7.8% by a reduction in MTS rates by $133,000,000 a year with appropriate refunds.

28.  With respect to the Examiner's I.D., the Trial Staff, in its exceptions, contends that the Examiner was too generous in fixing the fair rate of return at 8.25% within a range of 7.9 to 8.8%, in finding that the cost of equity capital is 10.3%, and in finding that the cost of new debt will be 7.8%.  In summary, the exceptions of the Trial Staff assert that the Examiner arrived at his erroneous conclusions for the reasons, inter alia, that he (a) failed to take into account the President's New Economic Policy that will benefit Bell System by lowering the cost of money and the required return, by providing investment tax credit allowances, and by increasing the level of interstate revenues; (b) he failed to adjust the overall fair return of the Bell System by the amount of the excess WE earnings; (c) he erroneously refused to give appropriate weight to the effect of past management of the construction and financing programs on cost of capital, and (d) he incorrectly blamed government regulation in part for such past bad management.  The Trial Staff contends in its exceptions that the New Economic Program strengthens and re-affirms the hearing record basis for the Trial Staff's proposed 7.75-8.25% fair rate of return based on a debt ratio of 45%, a current cost of debt of 7.5%, and an embedded debt cost of 5.94%.

Position of Carriers Other Than Bell

29.  USITA presented two witnesses to support its position, concurred in by the GTE Service Corporation, and United Telephone System, that the Bell System requires a 9.5% return on its interstate and foreign communication services.  Western Union, MCI and Datran took no position on the rate of return required by Bell.  Their interest was limited to whether, and to what extent, any permitted increases, should be loaded on MTS.  Thus, MCI, at oral argument, took the position that, even if we find that Bell System is entitled to a higher rate of return, we cannot implement such a decision until we decide the rate-making issues in Docket No. 18128.  Otherwise, it is argued, MCI's competitive position will be undermined by undue increases in MTS which would enable Bell to underprice its competitive services.

 

 [*224]  Position of Users and User Groups

30.  The Secretary of Defense, for the Department of Defense and other Federal agency users, presented one witness and took the position that the Bell System has not proven the need for any increase in its allowable rate of return and should be denied any rate increase.  The Commonwealth of Pennsylvania urges us to make no change in the allowable rate of return for the Bell System from the 7-7 1/2% permitted in Docket No. 16258.  It requests us to reopen the record for further proceedings to consider the impact of the New Economic Policy on the cost of capital, and to refund increased charges collected by the carriers since January 26, 1971, to the extent that the return exceeded 8.0%.  The City of Chicago contends that a rate of return of 8.2% would be proper for the Bell System based upon a 45-55 debt/equity ratio, an embedded cost of debt of 6.0%, and a return on equity of 10.0%.

31.  The American Telephone Consumer's Council submitted proposed findings to the effect that we should deny completely any increase in rates on the grounds that the Bell System has not proven the need for the claimed 9.5% return.  However the interest of that party appears to be primarily in the internal rate structure of MTS.  The Telephone Users Association (Mr. Arthur Curtis) presented one witness in rebuttal to certain portions of rate of return testimony of the Bell System.  We assume that this party is also opposed to any increase in allowable return for the Bell System.  Utility Users League also objects to the findings and conclusions of the I.D. and takes the position that the Bell System should not be allowed any increases in rates and should refund all increases collected since January 26, 1971.  Grassroots takes no position on the rate of return issue but objects to certain procedures herein.

32.  The remainder of the parties; namely, ARINC, ATA, and the broadcast networks (ABC, CBS, and NBC) take no position on the issue of overall rate of return.  Their interest is limited to the question of whether, and to what extent, any increases in rates necessary to achieve any allowable higher rate of return may be loaded on classes of service other than MTS.  The aforementioned networks, at oral argument, asked for an opportunity to a hearing before any decision is made as to how any allowable rate increases would be apportioned among the various classes of Bell System services.

Other Parties

33.  The Communications Workers of American (CWA) took no position on the rate of return issue.  It objects to that part of the I.D. that purports to foreclose CWA from participating in the issues in Phase II.

Appendices

34.  The immediately preceding paragraphs 21-33 summarize the basic positions of the parties.  In appendices A, B and C hereof we set forth in greater detail the testimony and data presented by the Bell System (App. A), the Trial Staff (App. B) and the Other Parties (App. C).

 [*225]  35.  The position of the Bell System at the time of re-argument was unchanged from its earlier position.  Thus, it summarized its own position by stating that there was an "increasingly urgent need for a level of earnings to permit the raising of common equity capital required to finance construction programs"; that "current financial data reinforce Bell's showing that 9.5 percent is the minimum rate of return required to attract capital at reasonable costs"; that "current interstate operating results confirm the need for adjustment in the interstate rate level"; and that "applicable Price Commission regulations recognize the need for, and permit, the interim rate adjustment which should be authorized" herein:

36.  The position of the Trial Staff at re-argument was also unchanged from its original position.  n2 Its re-argument may be summarized as follows: a return of 8% to respondents (before the Western Electric adjustment) would be just and reasonable and would meet all of the statutory criteria; the events occurring after the close of the record indicate that 8% overall return for interstate services is on the generous side; there has been an easing of both inflationary pressures and interest rates; the economy, which was faltering a year ago, is now surging forward; increases in productivity will offset inflationary trends in the next 2-3 years; the Commission should deny inflationary price increases and hold Bell to a reasonable profit level; Bell is seeking a 6.6% increase in prices over current tariff rates for interstate services to meet its 9.5% earnings objective; if the 9.5% objective were to be accepted system-wide, an average increase of over 9% above the charges in effect at the end of May 1972 would be required; and that these increases are over and above all of the increases thus far allowed Bell both by the Commission and the various state Commissions. 

 

n2 The Trial Staff originally recommended a reduction in Bell's rates to achieve its recommended rate of return, because of a higher estimated level of earnings.  At re-argument the Trial Staff recognized that Bell now should be allowed to increase its rates in view of the lower actual earnings experienced thus far in 1972.

37.  The Trial Staff further contended, at re-argument, that since the end of October 1972, 33 separate orders have been issued by state Commissions authorizing increases estimated by AT&T as allowing the system over $1,200,000,000 in rate increases on an annual basis; to reach Bell's goal additional increases totaling well over a billion dollars would be required; and that price increases of these magnitudes on top of previous price increases are unthinkable at a time when strenuous efforts to control inflation are beginning to take hold.

38.  Further, the Staff asserted that even under the conditions found to exist when Bell's case was originally prepared the requested rate of return was by far too high; that the changes which took place in the economy between the original filing and the first oral argument demonstrated clearly that the rate being sought was exorbitant; that the current relative stabilization of the prices, the control of inflation, the growth in production, the expansion of the economy, the experienced interstate return of Bell and the future prospects for continued growth all indicate that the Staff's recommendations are, if anything, on the high side.  Finally, the Staff contended that Bell's unchanged requests  [*226]  are clearly beyond the pale and should be rejected promptly, forcefully and unequivocally.

39.  GTE, USITA, MCI, DOD, Pennsylvania, Chicago, ATCC and TUA essentially reiterated their original positions at re-argument, and these positions have been adequately summarized in the preceding paragraphs.  Anthony R. Martin-Trigona argued, among other things, that the present rate of return of Bell is adequate; that a rate increase at this time would add inflationary pressure on the economy; and that a rate increase is not in the public interest.  The State of New Jersey asserted that the events occurring after the closing of the record reduce the necessity for increased rates for Bell; and that Bell could reduce its capital needs if it gave users the option of buying subscriber equipment, such as PBX's and telephones.

III.  DISCUSSION

 

Introduction

40.  In our 1967 Decision in Docket 16258 we set forth the basic principles to guide us in determining the fair rate of return for carriers subject to our jurisdiction.  We stated that, in simplest terms, rate of return is a percentage expression of the cost of capital; that this cost is as real as any other costs necessary to conduct the business of the carrier; and that we must determine what this cost is and whether it has been prudently incurred and is otherwise reasonable, and, if not, whether some other cost should be used for rate-making purposes in accordance with established legal standards (9 F.C.C. 2d 51-52).

41.  We further stated in our 1967 Decision that the Bell System has historically raised capital by the issuance of both debt and equity securities, the rate of return to which it is entitled is the weighted average of the cost of debt (interest) and the earnings or profit it requires on the invested equity capital.  We held that, since the rate of return is affected by the proportion of debt and equity to the total capitalization (i.e., capital structure), Respondents have the duty to fix this proportion in such a way as to raise the required capital "at the lowest possible cost consistent with their overall responsibility to provide modern, efficient service at reasonable rates and to maintain the financial integrity of the enterprise" (9 F.C.C. 2d 52).

42.  We found in 1967 that, on the basis of the hearing record then before us in Docket 16258, and our considered judgment, the fair rate of return to the Bell System at that time for their interstate operations was in the range of 7-7 1/2% (9 FCC 2d 88). With this conclusion, we ordered substantial reductions in rates (which became fully effective in 1968) in order to reduce the earnings of Respondents to the level found reasonable.  However, we stated in our 1967 Decision that the 7-7 1/2% range was to be applicable only so long as the conditions that obtained during the test period used in that proceeding (i.e., 1966) continued and that these figures did not represent either an absolute floor or ceiling, but were subject to revision as circumstances changed (9 FCC 2d 964). In 1969 we negotiated a $150 million a year reduction in rates and re-examined the operating results of the Respondents in the context of our 1967 Decision.  With due regard to the aforesaid $150 million rate reduction, we decided that "interstate rates producing an earnings level which exceeds the upper limit of the 1967 range  [*227]  (7.5 percent) are not unreasonable." We made this decision because we recognized that, by 1969, substantial changes had taken place in the economic, financial and other conditions which prevailed at the time of our 1967 Decision.  We particularly noted the sharp increase in the interest rates on borrowed capital the increase in the embedded cost of debt, and the much higher rate of inflation, and the need of Respondents to raise substantial amounts of new capital under such changed conditions (21 FCC 2d 654). When we issued our Order of January 21, 1971, designating this matter for hearing we reiterated our recognition "that changes had taken place in the various elements which make up the cost of capital since the Commission's 1967 Decision in Docket 16258" (paragraph 8).

43.  It is therefore clear that a part of our task in this case is to evaluate the testimony, data and contentions of the parties herein with respect to the nature and scope of the changes that have occurred since our 1967 Decision.  However, we reject the apparent contention of Bell that we can take the amounts that we found as the cost of capital at that time and add on certain increments to reflect such changes.  We must determine, on the basis of the entire record herein, what rate of return is warranted under current and immediately foreseeable economic and financial circumstances for Bell's interstate and foreign communications services.

 

Cost of Equity Findings in Docket 16258

44.  We address ourselves first to what appears to be a prime contention of the Bell System that, in our 1967 Decision in Docket 16258, we concluded, in effect, that the cost to it of equity capital under 1966 conditions was 10.3% or 10.4%; that this was the allowable return on equity; and that neither the Examiner, in his I.D. nor the Trial Staff in their proposal would allow for any increase therein.

45.  This contention first emerges in Bell's Proposed Findings.  In its brief, at page 7, it says "Under a 45 percent debt ratio, the allowable overall rate of return of 7 1/2 percent found by the Commission for 1966 conditions would produce a rate of return on equity of 10.4% * * * calculated as follows:

 

45% debt at 4.0%

1.8

55% equity at 10.4%

5.7

Total

7.5%"

 

The contention is repeated again in Bell's brief on exceptions at page 3, where the claim is made that the 10.3% return on equity allowed by the Examiner does not reflect "The admitted increase in the cost of equity capital since Docket 16258," and that the "one dominant error" in the I.D. is that the Examiner's finding of 10.3% on equity fails to provide any increase in the return on equity since our Decision in Docket 16258 (Page 1).

46.  Finally, in its reply brief on exceptions, page 2, Bell contends that the "basic deficiency" in the I.D. is that it recommended a return on equity no higher than our 1967 Decision "would have produced at the same debt ratio" and that "the 8.0% overall rate of return proposed by the Trial Staff reflects its computation using a rate of return on equity of 9.75 percent * * * as contrasted with the 10.3% percent  [*228]  adopted in the Initial Decision and implicit in the Commission's Decision in Docket No. 16258, based upon very different economic conditions" (our italic).

47.  We must reject at the outset Bell's contentions that we determined in our 1967 Decision, implicitly or otherwise, the Bell System was entitled at that time or in the immediately foreseeable future to a 10.3% or 10.4% return on equity.

48.  Although we made no quantitative findings as to Bell's allowable equity return, we made it quite clear that we were not approving a return on equity as high as 10%.  Thus, we stated unequivocally in our 1967 Decision that "The fact that Respondents were able to raise successfully billions of dollars at average returns on equity ranging from 7 to 8.4 percent, especially when equity in most of the period was being diluted, does not support Respondents' claim that they now need a 10 percent return on equity.  On the contrary, such experience does strongly suggest that an equity return of less than 10 percent would provide adequate capital protection and maintain Respondents' ability to attract new capital"; and that "we find that regardless of the opinion testimony offered, the record demonstrates that Respondents have in the past, and can in the future, raise the capital they require at returns on equity below 10 percent" (9 FCC 2d 74) (our italic).  Finally, we stated that we could not accept Mr. Scanlon's testimony on comparable earnings "as valid support for their claim for a return of 10 percent on equity;" and that we were "unable to accept the conclusions of Respondents' witnesses Scanlon, Morton and Friend that AT&T requires a return on equity of approximately 10 percent" (9 FCC 2d 86) (our italic).

49.  In view of the clear and unambiguous findings quoted above from our 1967 Decision, Bell's contention that we approved at that time a return on equity of 10.3% or 10.4% is untenable and contrary to the explicit findings and conclusions in that case on the cost of capital.  Moreover, the actual operating results for the Bell System during the years 1966-1970 demonstrate the fallacy of the aforementioned basic argument of Bell.  In the 1966 test period, Bell's average return on equity was 9.9% (with a debt ratio of 32.9%).  In 1967, when we made our Decision in Docket 16258, the average return on equity was 9.7% (with a debt ratio of 35.4%).  After we rendered our Decision in Docket 16258 and ordered substantial reduction in rates effective early in 1968 to reduce the overall interstate and foreign earnings, the return on equity went down in 1968 to 9.3% (with a debt ratio of 36.4%).  Thereafter, in 1969 the return on equity was 9.5% (debt ratio of 39.5%) and in 1970, it was 9.2% (debt ratio of 44.9%).  Accordingly, the actual results of our 1967 Decision were to reduce the equity return from about 9.7% in 1967 to about 9.3% in 1968.  Moreover, in 1969, when we negotiated a rate reduction, the interstate and foreign earnings of Bell were in excess of the top of the 7-7.5% range and the return on equity was 9.5%, somewhat below the 10.3% or 10.4% Bell contends that we had implicitly approved.

50.  In view of the foregoing, we conclude that the Examiner's recommendation of a 10.3% return on equity is in excess of the return on equity we found reasonable or allowed in our Decision in 1967 and any finding or conclusion we may make herein that Bell's return on  [*229]  equity should be equal to or in excess of 10% is higher than what we considered to be appropriate in our 1967 Decision.

Economic Changes

51.  All of the parties herein, who addressed themselves to the question, appear to be in general agreement that the extensive evidence of record herein confirms conclusively that there have been significant economic, financial and other changes since our Decision in 1967 and that these changes have had an effect on the cost of capital of the Bell System.

52.  No party, for example, disagrees with the finding of the Examiner that the embedded cost of long term debt has increased significantly from the 4% we found in our 1967 Decision; that the current cost of debt is significantly higher than the range of 5 1/2 to 6% we found in 1967; that Bell's debt ratio has increased from about 32% in 1966 to 45% in 1970; and that its interest coverage declined during the period 1966-1970.  Indeed, all parties who addressed themselves to the question agree that these and other changes that have occurred since 1966 have necessarily caused Bell's cost of equity capital to increase since our Decision in 1967.  The Examiner found that this was so (see I.D. paragraphs 17, 18, 43 and 103) and the Trial Staff takes no exception to these particular findings.  Both of the Trial Staff witnesses testified that the cost of equity capital for Bell had increased since the record in Docket 16258 although Mr. Kosh's position was that we allowed a return in 1967 that was too high.  The differences among the parties, which we discuss later, lie in whether and to what extent these changed conditions warrant any revision in the allowable rate of return.

53.  We conclude therefore that there have been significant changes in the circumstances since our 1967 Decision that increased the cost of Bell's debt and equity capital.  However, as theretofore stated, we must determine whether, and to what extent, such increases, considered with all other relevant considerations developed on the record herein, require or warrant any change in the allowable rate of return of the Bell System for the present and immediate future and if so, what those changes should be.

Cost of Embedded Debt

54.  Respondents estimated that by the end of 1971 the total embedded cost of its debt would be about 6%, which figure the Examiner accepted in computing an overall rate of return.  The Trial Staff estimated that total embedded debt cost in 1971 would be about 5.94%.  The Trial Staff's estimate is lower because it predicted rates for short and long term debt in the last seven months of 1971 that were lower than those predicted by Bell.  However, the Trial Staff does not except to the finding of the Examiner that 6% is the embedded debt cost of the Bell System that should be used herein for the determination of the allowable rate of return, and we believe that the evidence supports that finding.  Thus we conclude that the embedded debt cost for the Bell System has increased from 4% to 6% in 1971 and that we shall use 6% in our determination of Bell's cost of capital.

 

 [*230]  Current Cost of New Debt

55.  Ordinarily, the current cost to a carrier of new debt is an important factor in determining for the immediate future both the embedded cost of debt and the current cost of common equity.  However, in the case of Bell, the amount of new debt which Bell may reasonably be expected to issue in the immediately foreseeable future at rates higher than the aforementioned embedded debt cost of 6% would not significantly increase Bell's embedded debt cost because of the large amount of long-term debt already outstanding and the limited amount of refunding required for maturing low cost debt.  Thus, in Bell's case, the importance of the higher costs of new debt is in its impact upon Bell's current and immediate future costs of equity.  Bell correctly claims that a significant rise in the cost of debt capital necessarily results in a rise in the cost of equity capital although, as Bell concedes, "the relationship between equity costs and current debt costs is not precise or linear."

56.  Bell claims that the current cost to it of long-term debt is 7.5% to 8.5% and that the trend is upward.  Bell relies upon the testimony of its witnesses to the effect that there is "widespread" expectation of a "continuing high level of inflation" that "economic conditions in 1972 are apt to produce a sharper increase in interest rates" and that there is "continuing powerful expectation of a high rate of price level increase" (Bell's P.F. paragraph 17).  The Trial Staff contends that the current outlook is for a debt cost of 7.5% with the trend being toward lower interest rates.  The Hearing Examiner generally accepted Bell's views and found that the current cost of debt will be 7.5% to 8.0% with the expectation of slowly increasing rates.  However, the Examiner also indicated that Bell should be able to reduce the impact of higher long-term debt costs by taking timely advantage of lower cost short-term and intermediate term debt.

57.  The hearing record shows that Bell's actual cost of long-term debt ranged from a high of 9.4% in June, 1970, to a low of 6.9% in January, 1971, and back to a lesser high of 8.3% in May, 1971.  On this performance, we can find some rational basis for Bell's claim.  However, recent developments do not support those claims.  We take official notice that the actual average cost of Bell's new long-term debt in 1971 and 7.60% and that the actual cost of long-term debt issues by Bell through October, 1972 averaged 7.51% and ranged from 7.27% to 7.53%.  The average cost of intermediate term (5 to 7 year notes) through October, 1972 was 6.68% and ranged from 6.48% to 7.01%.  In view of the foregoing, we agree with the Trial Staff that the claims of the Bell System and the findings of the Hearing Examiner, on current cost of new debt, are unsupported and were based upon expectations of inflation which do not take into account the impact of the new national economic policies and programs to curb inflation upon the present and future costs of debt.  We appreciate that the parties and the Hearing Examiner did not have before them at the time of the hearings and decision the aforementioned officially noted facts as to the average debt costs for the year 1971 and the costs of the 1972 debt issues.  It appears from the record that in most of the testimony as to the relationship between the current cost of equity and current cost of debt the cost of debt or current interest rates referred to cost of long term  [*231]  debt.  Accordingly, we find and conclude that, for the purposes of comparing current cost of equity to current interest rates in this case, the cost to Bell of long-term debt for the present and in the immediately foreseeable future, is and will be in the range of 7 1/4 to 7 1/2%.

 

Current Cost of Equity

58.  Having found Bell's embedded debt cost, we must proceed to determine Bell's current cost of equity and the proper capital structure in order to resolve the question of Bell's allowable rate of return for interstate and foreign communications services.  As we stated in our 1967 Decision in Docket 16258, our objective in fixing Bell's allowable rate of return is to meet the requirements of the public interest in just and reasonable rates consistent with the judicial precedents holding that the allowable return must be such as to sustain the financial integrity of the operating companies and to enable them to attract capital (9 FCC 2d 52-53).

59.  To summarize our conclusions up to this point, we have denied Bell's claim that we ruled in 1967 that Bell was then entitled to a return on equity as high as 10%; we have found that there has been an increase in the current cost of Bell's long-term debt from 5 1/2-6% in 1967 to a present range of 7 1/4-7 1/2%; that Bell's embedded debt cost has risen from 4% in 1967 to 6% today; and that the increase in debt costs has also been accompanied by an increase in Bell's equity costs since 1967 which we have not quantified.  We shall discuss Bell's nine basic contentions to support its claim that its current cost of equity is 12 1/2%.

60.  First, Bell's claim for a 12 1/2% equity return is based upon the same alleged trends in economic and financial conditions upon which Bell relies to support its claim of a current cost of debt of 7 1/2-8 1/2%.  It is of course true that equity costs generally increase as debt costs increase since debt is senior in claim on assets and income and the equity holder bears most of the risk of the business and requires a higher return to compensate for such risk.  However, for reasons set forth in preceding paragraphs 43-45, we have rejected Bell's claim that the economic and financial trends referred to by Bell warrant a conclusion that the cost of debt has increased as much as Bell claims.  It necessarily follows that, for the same reason, we cannot accept Bell's claim that equity costs have increased as much as Bell claims.  We have found that the current cost of debt has risen from a range of 5 1/2-6% in 1967 to 7 1/4-7 1/2% currently rather than to 7 1/2-8 1/2% claimed by Bell.  There is no reasonable basis to conclude that Bell's equity return should be increased from 9.3% in 1968 to 12.5%, for a net increase of more than 3 percentage points, whereas the debt costs have increased by only 1 1/4 to 2 percentage points.  Mr. Scanlon testified that, as interest rates have gone up the spread between such rates and equity costs has becomes narrower rather than wider.  Accordingly, although we recognize that equity costs have increased since 1967 and that Bell is entitled to higher equity earnings, we reject Bell's aforementioned first ground as supporting an increase to 12 1/2%.

61.  Second, Bell claims that a 12 1/2% equity return is justified by the results reached by Bell in allegedly updating the Gordon model.  In the proceedings in Docket No. 16258, Dr. Myron J. Gordon, an independent  [*232]  consultant engaged by the Commission, presented an econometric model designed to determine the required rate of return in proceedings involving regulated entities.  At that time Dr. Gordon's result with respect to Bell's interstate operations indicated a rate of return of 7% to 7.25%.  In the current proceeding Bell presented testimony by Dr. Martin B. Wilk on what Bell described as its own updating of the Gordon model, allegedly reflecting current economic conditions.  Dr. Wilk stated that Bell's updating produced an overall rate of return of 10.7% and that, using a debt ratio of 45% and an embedded debt cost of 6%, the return on equity would be 14 1/2%.  Thus, Bell's updating of the Gordon model allegedly supports a 14 1/2% return on equity although Bell is not seeking such a high return.  Moreover, Bell does not accept the validity of the Gordon model and it did not produce Dr. Gordon as a witness to qualify the updating.  In addition, Bell claims that a 10.7% overall return accompanied by a 14 1/2% return on equity is consistent with the Examiner's conclusion (I.D. paragraph 103) that there has been an increase of 3% to 3 1/2% "in the cost of money since 1966." Bell arrives at this conclusion by stating that if you add the Examiner's 3 to 3 1/2 to the 7 to 7 1/2% overall return we found in 1967, the result is an overall return of 10 to 11%.

62.  The examiner concludes that no weight should be given to Bell's testimony on the alleged up-dated Gordon model (I.D. para. 62).  We concur in the Examiner's conclusion for the reasons that he gives.  In addition, we reject Bell's contention that we can or should add the 3% to 3 1/2% increase the Examiner found since 1966 in "the cost of money" to the 7 to 7 1/2% overall rate of return we found reasonable in 1967.  It is clear from the context of his decision that the Examiner's 3-3 1/2% findings of increased "cost of money" refer to the increase in interest rates and not overall cost of capital.  Moreover, we have found that the increase in interest rates since our Decision in 1967 is not of the magnitude of 3 to 3 1/2% found by the Examiner but in the range of 1 1/4% to 2%.  Accordingly, we must reject Bell's contentions that the allegedly updated Gordon model supports either a 14 1/2 or 12 1/2% return on equity capital.

63.  Third, Bell claims that a 12 1/2% return on equity is required to maintain Bell's credit standing.  Bell's point is that its long-term debt is generally rated at the highest rating of triple A (Aaa) and that it has been able to retain such highest rating in the past by an adequate interest coverage during the period when its debt ratio was substantially lower than the current 45%.  However, Bell claims that the combination of an increased debt ratio from (33% in 1966 to 45% today), a current high level of interest rate (7 1/2-8 1/2%), and a low level of earnings has caused a precipitous decline in the interest coverage from 6.3 times in 1966 to 2.9 times by the end of 1970 (on an after-tax basis) and that such a decline must be arrested in order to avoid a substantial degrading of its bonds.  Such a degrading, Bell argues, would not only increase its debt costs for both embedded and new debt, but would also restrict the market for Bell bonds and make it difficult for Bell to sell now debt in the volume it requires to finance needed construction.  Bell states that a 12 1/2% return on equity is needed to "avert the decline" in coverage and to maintain its coverage "at a level approximating that of the Aaa electrics."

 [*233]  64.  The Examiner makes detailed findings on this contention of Bell in paragraphs 30-40 of the I.D. and concluded that Bell has not shown that there is any peril of such a downrating for the Bell System as a whole and that even if this were to happen, "the result would scarcely be dire"(I.D. paragraph 40).  We believe that the conclusions of the Examiner should be amplified or modified to make clear that, based upon current and immediately foreseeable financial conditions, it is desirable to arrest the decline in Bell's interest coverage.  Although there are factors other than interest coverage that are considered by the rating agencies in grading Bell's bonds, it is clear from the record that any further significant decline in interest coverage could jeopardize the present rating of Bell's long term debt.  We are of the opinion that it is desirable for Bell to be able to prevent any substantial downgrading of its bonds.  However, the record will not permit a positive finding as to what interest coverage is required to prevent such downgrading.  It appears that the required coverage would vary under differing financial and economic conditions.  Accordingly, we should make clear that we are making no findings or conclusions as to the magnitude of interest coverage that is required for this purpose.

65.  We want to emphasize that we concur with Bell to the extent that it claims that the decline in its interest coverage should be arrested.  We believe that it is desirable for Bell to maintain a high rating for its bonds.  However, we have difficulty with Bell's claim that it should have the same or greater interest coverage that the Aaa electrics or that an equity return of 12 1/2% is necessary to sustain adequate interest coverage for the Bell System.  Bell's claim for a 12 1/2% equity return in this respect is based upon certain calculations it made using an alleged current debt cost of 7 1/2% to 8 1/2%, which we have found to be too high.  Under these calculations of Bell a return of the magnitude of 12 1/2% is required to provide an interest coverage of 3.2 to 3.3 which Bell claims is comparable to the coverage of the Aaa electrics.  However, for the reasons stated by the Examiner, we are not persuaded that Bell's coverage must be pegged to that of the Aaa electrics.  Bell's equity return, in our judgment should be increased to enable Bell, under efficient and economic management, to arrest the coverage decline.  We believe that the return we are allowing on equity will be adequate to halt the coverage decline and to prevent any significant degrading to Bell's bonds.  Although Bell is entitled to an increased equity earning, Bell has not shown that a 12 1/2% equity return is required to provide adequate interest coverage.

66.  Fourth, Bell contends that a 12 1/2% return of its equity is justified by the fact that equity earnings of regulated electric utilities was in the range of 12.5% during the period 1966-1969; that many of these electrics are currently seeking even higher equity earnings; that under present conditions the relative risks of Bell's equity are no less than the risks of the electrics on their equity; and that in Docket 16258 we stated that we would give particular attention to the earnings of electric utilities in reviewing Bell's earnings in the future.

67.  The Examiner discussed this claim of Bell in paragraphs 48-52 and 64-65 of the I.D.  The 45% debt ratio of Bell continues to be significantly lower than the debt ratio of the electrics.  Moreover, Bell contends that it should keep its debt ratio at 45 1/2% and should not be  [*234]  forced to push its debt ratio as high as the electrics.  As we set forth hereinafter in our discussion of the appropriate capital structure, we agree with Bell that it should not be forced to push its debt ratio above 45% at the present time.  Accordingly, inasmuch as Bell appears to concede that the higher the debt ratio the higher the risk to equity holders, it would appear from this factor alone that at the present time and for the foreseeable future Bell's equity holders are and will be subject to less risk than the equity holders of electrics.  We do not believe that, at Bell's debt ratio of 45%, it would be fair or equitable to the rate payers of Bell to require them to pay the additional sums required to enable Bell to earn the same as do the electrics on equity in view of the differences in the percentage of debt.  We are not holding that Bell should not have overall earnings comparable to regulated electrics.  We shall continue to look to such overall earnings and overall rates of return allowed the electrics as a fruitful basis for our review of Bell's overall earnings in the future.  However, for the reasons stated above and by the Examiner, we reject Bell's claim that its equity earnings should be geared at 12 1/2% to match the earnings of electrics on their equity.

68.  Fifth, Bell contends that in order to attract new equity capital, it must offer investors a return in dividend and market appreciation at least equal to the current dividend of 5% plus an annual growth rate in earnings per share of 6%, for a total of 11% on market value; and that, according to simulation runs by Mr. Scanlon, a 12 1/2% return on book equity is required to satisfy such investor expectations.  We concur in the Examiner's findings and conclusions on this claim of Bell as set forth in paragraphs 65-66 of the I.D. Moreover, we take note that the simulation runs were based upon new debt costs ranging from 7-8%, the upper range of which we have found to be too high.  We agree with the contention of Bell that Bell's current earnings per share growth, of little more than 2 percent a year, is probably inadequate to enable Bell to attract equity capital on reasonable terms.  However, we conclude that Bell has not met its burden of showing that a 12 1/2% return on equity is required to provide an annual growth rate in earnings per share necessary to attract investors.

69.  Sixth, Bell contends that, since Bell's stock is now selling at close to book value, Bell is not now in a position to raise the large and continuing volume of new common equity capital required by Bell without dilution and confiscation of existing investment; that this situation prevents Bell from maintaining its financial integrity; that a return on equity needed to produce a market price/book value ratio that will not result in dilution is an equity return comparable to the electrics, i.e., 12 1/2%, that in view of the similar price-earnings ratios and alleged similar risks as between the common stock of Bell and the electrics, a return on Bell's book equity of 12 1/2% is required to enable Bell to attract capital.

70.  In paragraphs 58-61 of the I.D., the Examiner treats this claim of Bell.  He rejects the claim largely because of the alleged failure of Bell to take into account the value of existing stockholders' subscription rights in defining "dilution of equity." However, both the Examiner (I.D. 87) and the Trial Staff make it clear that it is desirable for Bell stock to be marketed at a price above book value and that Bell  [*235]  has maintained its burden of proof by showing that the present equity earnings of Bell are inadequate to attract capital on fair terms because of the poor market price/book value ratio.  We are in agreement with these general conclusions and believe that the increased return on equity stock we are allowing herein would enable Bell to issue stock on terms fair to existing stockholders.  However, since Bell's claim for a 12 1/2% return is based upon its contentions, heretofore rejected by us, that the equity holders of Bell and the equity holders of electrics have similar risks, we cannot agree that Bell has proven the need for a 12 1/2% return on equity.

71.  Seventh, Bell claims that it cannot attract equity capital unless the spread between the cost of current debt and return on equity is maintained at about 5 percentage points; and that, assuming a current debt cost of 7.5%, a 12 1/2% return on equity is required to provide the needed spread to attract investors to Bell's common equity.

72.  The Examiner makes findings on this claim, in paragraphs 31 and 73 of the I.D., and concludes that investors consider the risks in equity as justifying a spread of "a minimum of 2 percentage points." Bell attacks this conclusion and contends that a spread as low as 2 percentage points is unsupported by any evidence of record.

73.  It is our opinion that the record does not support a positive finding as to what the minimum spread should be.  We begin with Bell's admission that in general the relationship between equity costs and current debt costs is not precise or linear and that as debts costs rise, the spread between current interest costs and equity costs narrows rather than widens.  Moreover, Bell relies upon its earlier contention, which we have rejected, that we found in our 1967 Decision that Bell was entitled to a 10.4% return on equity and that, on the basis of a cost of debt of 5.4%, we must have concluded that there should be a 5-point spread.  This was not our finding.  Also, we disagree with Bell's implication that a precise percentage point spread can be used as proof in support of a specific equity return.  Although we believe that the current debt cost/equity cost spread is pertinent in reaching an overall judgment as to the current cost of equity, we do not believe that a precise relationship can be defined because of the multitude of volatile factors which affect this relationship.  We believe that, under the increased equity return we are allowing, Bell can maintain the spread needed to attract equity capital.  Accordingly, we reject Bell's claim that it should have a 12 1/2% return on equity to achieve a 5-point current debt-equity return spread.

74.  Eighth, Bell contends that the evidence presented by the Trial Staff, upon which the Examiner relied heavily, does not justify an equity return of less than 12 1/2%.  The Examiner discusses the testimony of witnesses presented by the Trial Staff in paragraph 67-86 of the I.D. and gives substantial weight thereto in reaching his ultimate conclusion on the cost of Bell's equity.

75.  Bell contends that we should not give any weight whatsoever to the testimony of Dr. Myers and Mr. Kosh because, as Bell argues, the return on equity found by these witnesses "clearly contravenes the standards of the Commission's Decision in Docket No. 16258." Thus, Bell states that the 10.5% equity return found by Dr. Myers was approximately the same as the 10.4% which Bell says we allowed in  [*236]  our 1967 Decision.  We disagree with Bell on this point.  As we have stated elsewhere herein, we did not make any findings in our Decision in 1967 that the allowable equity return for Bell was 10.4%.  To the contrary, we held unequivocally that Bell had not proven its claim at that time that a 10% return on equity should be allowed or would be just and reasonable.  Thus, the recommendation by Dr. Mayers of a 10.5% return on equity is substantially in excess of the equity return we said would be reasonable and the return actually earned by Bell under our Decision.  Similarly, the recommended equity return of 9.75% made by Mr. Kosh cannot be said to be contrary to our Decision in 1967 in that it represents an increase in the actual return on equity from 9.3%, 9.5% and 9.2% realized by Bell in 1968, 1969 and 1970.

76.  Bell also argues that the discounted cash flow (DCF) method used by both Dr. Myers and Mr. Kosh underestimates the fair return on book equity.  This is because DCF is a method that, by definition, produces a capitalization rate which, if applied directly to book equity, will produce a market price equal to book equity.  We agree with this characterization of the definition of the DCF method.  However, as both Dr. Myers and Mr. Kosh made clear, the DCF method must be used in conjunction with additional factors for safety, market pressure and other allowances that are essentially matters of judgment.  Proper use of these added factors makes the DCF method a useful tool or guide for the Commission to use in the context of the entire record and in applying its informed judgment in determining the fair return for Bell on equity.  Accordingly, we reject Bell's contention that we should not consider the testimony and conclusions of Dr. Myers and Mr. Kosh.

77.  Ninth, Bell claims that the 9.75% return on equity recommended by Mr. Kosh is too low not only because of the use of the DCF method but also because he understated the factors used in calculating the DCF rate and used a hypothetical capital structure of 50% debt.  For example, Mr. Kosh used a current debt cost of 7.00% for 1971 and 6.51% in 1972 which we have concluded are too low.  Bell also points out that Mr. Kosh conceded that a 9.75% return on equity and a debt ratio of 50% would provide interest coverage of only 2.6 times.

78.  To the extent that Mr. Kosh relied upon an assumed current debt cost of less than the 7.25-7.50% we have found herein, particularly in context of the imputed 50% debt ratio urged upon us by Mr. Kosh, his recommended 9.75% return on equity falls short of the current cost of Bell equity.  Also to the extent that a 9.75% return on equity will not halt the decline of the interest coverage of Bell from the 2.9 experienced at the end of 1970 we believe that 9.75% is inadequate to maintain the credit of Bell.  Accordingly, although we agree with Bell that the 9.75% return recommended by Mr. Kosh is inadequate, the studies and analyses made by Mr. Kosh and his testimony in this case fortify our conclusions that Bell has not supported its case for a 12 1/2% return on equity.

Conclusions on Current Cost of Equity

79.  In the preceding paragraphs we have made it clear that, although it is our judgment that Bell has proven the need for a higher return on equity, it has fallen short in demonstrating that the return should be as high as 12 1/2%.  None of the contentions by Bell individually or collectively,  [*237]  support such a return.  In arriving at our conclusion as to the allowable return on Bell's common equity, we have given careful consideration to the Examiner's recommendations, all testimony and other evidence of record, proposed findings, briefs, exceptions and en banc oral arguments herein.

80.  The Examiner relies substantially on the testimony of Mr. Kosh and Dr. Myers and recommends an allowable return on equity ranging from 10% to 10.5%, with 10.3% being used for computation purposes; the Trial Staff, also relying largely upon the same testimony, recommends an equity return ranging from 9.75% to 10.25%; USITA recommends the 12.5% equity return as requested by Bell; and the Secretary of Defense recommends no change whatsoever in Bell's allowable overall rate or return and thus, in effect, urges a reduction in Bell's return on equity.

81.  We agree with the Examiner and the Trial Staff that the studies made by Mr. Kosh and Dr. Myers, their analyses on the record herein and their recommendations offer the most fruitful basis for us to use in applying our informed judgment in arriving at the proper equity return for Bell.  Although we find Mr. Kosh's studies and testimony to be helpful in our evaluation of Bell's claims and in arriving at our conclusions herein, we agree with the Trial Staff that the ultimate recommendation by Mr. Kosh for a 9.75% equity return is too low.  We discuss the reasons for our rejection of Mr. Kosh's recommendation in preceding paragraphs 65-66.

82.  On the other hand we do not find the same shortcomings in Dr. Myers' recommendation that we have found with respect to Mr. Kosh. Dr. Myers made a study of the past performance of Bell common stock in comparison with the market as a whole.  He contrasted the volatility of AT&T's price changes with the market as a whole and concluded that Bell's stock has significantly lower market sensitivity (.7 as against 1.0) than the market as a whole.  He also studied the total yield on a large number of stocks during different intervals of time and concluded that investors are today expecting a return of 10-12% from an "average" equity security.  He further concluded that, inasmuch as Bell's equity is less risky than the average, Bell should be allowed an equity return in the lower part of this 10-12% range which, in his judgment, should be fixed at 10.5%.  In arriving at his recommended 10.5% return on equity, it is significant that, unlike Mr. Kosh, Dr. Myers assumed a current debt cost of 7.25% which prevailed at the time he prepared his testimony.  Although this cost had risen to 7.625% by the time Dr. Myers was cross-examined on the record, the 7.25% is at the lower end of the range of 7.25-7.50% current debt costs which we have found based upon actual costs in 1971 and 1972 to date.  Therefore, we believe that Dr. Mayers' recommendation of 10.5% return on Bell's equity is entitled to substantial weight.

83.  The Examiner does not indicate any specific basis for his conclusion that the lower figure of 10.3% should be used by him for computational purposes unless it is in recognition of the arguments made by the Trial Staff that Dr. Myers overstated Bell's cost of equity.  However, the Trial Staff does not provide any factual basis for questioning Dr. Myers' recommendation of 10.5%.  In its proposed findings of fact (page 96), the only statement made by the Staff is that "it is the staff's  [*238]  considered judgment that Dr. Myers' recommended return of 10.5% for book equity is too high and should not be used as a basis for computing the respondents' overall rate of return." This statement constitutes the Trial Staff's complete finding of fact upon which it relies for rejecting the 10.5% return recommended by Dr. Myers.  There is no record citation to support this "judgment." This is an inadequate proposed finding of fact and offers no basis for us to use in rejecting the recommendation of Dr. Myers. Later, in its proposed "conclusions" (page 162) the Trial Staff again states "we believe that Dr. Myers overestimated and overstated the cost of equity, primarily by failing to give enough weight to the stability of respondents' earnings and the reduced risk factor resulting there from..." However, the Trial Staff makes no factual showing that Dr. Myers did not give enough weight to such earnings stability and reduced risk factor in arriving at his market sensitivity index of.7 for Bell or in making his judgment that Bell's equity return should be at the lower end of the 10-12% range of return expected by investors.  No questions appear to have been raised on the record with Dr. Myers by the Trial Staff or others to lay any foundation for arguing that Dr. Myers did not give enough weight to these matters.

84.  There are many techniques for producing useful factual information as a basis for determining the equity return which should be allowed in the computation of the overall fair rate of return.  We have discussed in the preceding paragraphs the evidence of record in this proceeding regarding most of the specific measurements that are normally used in attempting to quantify the return required for equity capital and have stated our views with regard thereto.  However, in the final analysis, large areas of judgment must be applied to each of the measurements used.  Therefore, while not attempting to make specific finding with regard to each measurement, we find that it is reasonable to conclude that, on the basis of the evidence in that record and the subsequent factual information of which we have taken official notice, 10.5% is the minimum return on equity required by Bell.  We shall discuss later the composition of costs of preferred and common equity which comprise this 10.5%.  (Para. 90)

 

Conclusions on Capital Structure

85.  We turn next to the question of whether we should make our overall rate of return determination herein on the basis of Bell's actual current or reasonably foreseeable future capital structure or on the basis of some theoretical or hypothetical structure.  We have heretofore held that, since the overall rate of return is affected by the proportion of debt and equity, Bell has "the obligation to fix this proportion in such a way as to raise the required capital at the lowest possible cost consistent with overall responsibility to provide modern, efficient service at reasonable rates and to maintain the financial integrity of the enterprise" and that a balance must be struck which, "on the one hand, obviates the risks inherent in too much debt, and on the other hand avoids the unduly high charges to the public and adverse effects upon stockholders from too little debt" (9 FCC 2d, page 52). Thus, if we should find on the basis of the record herein that the  [*239]  present or immediately foreseeable capital structure of Bell is or will be unsound and so out of balance as to impose unduly high charges upon the rate payers, we could act to correct such imbalance by computing the cost of capital herein on the basis of a theoretical or hypothetical capital structure which we would determine to be sound and in proper balance as related to rate payers and investors.

86.  None of the parties herein take the position that we should determine the cost of capital on any capital structure other than Bell's long term debt ratio of 45%.  It is true that the Trial Staff urges that, at some indefinite time in the future, Bell should move to a 50% debt ratio.  However, the Staff uses the actual debt ratio of 45% rather that 50% in making its cost of capital computation and we therefore assume that the Trial Staff recommends that we do likewise.

87.  The Hearing Examiner takes a different tack.  After concluding that it would be safe and reasonable for Bell to maintain a debt ratio in the range of 48% to 52%, the Examiner utilizes a hypothetical debt ratio of 48% in his computation of Bell's overall cost of capital.  He justifies this by concluding that Bell should not have sold $1.38 billion of preferred stock in June, 1971, at a cost of 8%, but instead should have sold debt at a cost presumably lower than 8% and that, if this had been done, Bell's actual debt ratio would have been 48% rather than 45% and the rate payers would not have been required to bear the additional burden of the higher preferred stock cost.

88.  We believe that the Examiner erred in using a theoretical 48% debt ratio in his computation.  First, he erroneously assumed in his calculation that the $1.38 billion of theoretical debt could have been sold at the embedded debt cost of 6% rather than at some higher figure consistent with our findings that the actual debt cost to Bell in 1971 averaged 7.49%.  Second, we think that Bell's reasons for selling $1.38 billion of preferred stock rather than debt in June, 1971, were plausible, namely, that Bell believed that the issuance of additional debt would have caused a further decline in Bell's interest coverage and that the issuance of common stock at that time would have been unreasonable in view of the then prevailing unfavorable market price to book value ratio.

89.  Bell has done that which we urged it to do in our 1967 Decision by increasing its debt ratio substantially from 33% to 45%.  Bell sets forth plausible reasons to support its judgment that the debt ratio should not go above 45% (see App. A, pages 6-7).  Since 1966 Bell has not only increased its debt ratio but has made substantial use of short term debt, commercial paper and intermediate-term debt; it has issued convertible preferred stock in lieu of more expensive common stock, and it has issued warrants for common stock for future expansion of equity capital.  We believe that these actions demonstrate a careful and responsible effort on the part of Bell to explore all rational modes of financing and reflect reasonable efforts to "strike a balance" between the risks inherent in too much debt and the adverse effects on the rate payers and stockholders of too little debt.  Accordingly, we find no sound basis for us to conclude that we should use a debt ratio other than the debt ratio of 45% in our determination of the fair rate of return herein.  This is not to say that we disagree with the Trial  [*240]  Staff or the Examiner that it would be safe, prudent or perhaps more economical for Bell to go to a 50% debt ratio or more at some time in the future.  Nor do we necessarily agree with Bell that a range of 40-45% debt is appropriate.  The Trial Staff and the Examiner may be correct in their views as to a 50% debt ratio.  However, the initial determination of such financial planning rests with Bell subject to our review and we expect Bell to Carry out its financing program in the future by fixing the proportions of debt, both long-term and short-term, and equity, including preferred stock, in such a way as to avoid unduly high charges to the public.  All that we are deciding herein is that we agree with all of the parties that expressed a position therein that we should use Bell's actual debt ratio of 45% for determining Bell's cost of capital rather than a hypothetical structure such as that used by the Examiner.

 

Overall Rate of Return

90.  We have found that for the purpose of determining Bell's overall rate of return, the embedded debt cost is 6%; that the minimum cost of Bell's equity for the present and immediately foreseeable future is 10.5%; and that the appropriate capital structure to use in determining Bell's overall cost of capital includes debt at a ratio of 45% to the total capital.  We have not specified as yet our findings as to the effect of the inclusion of preferred stock in the capital structure on the cost of common equity and on the total cost of capital.  Bell contends that if preferred stock is considered as a separate layer of capital at a cost lower than the overall cost of equity, then an upward adjustment should be made in the cost of common in recognition of the additional fixed charges ahead of common equity.  We do not disagree with this contention in principle and we have taken this into account in arriving at 10.5%, as the allowable return on total (preferred and common) equity.  Giving consideration to the 8% cost of convertible preferred issued in June, 1971, we conclude that with the inclusion of this preferred in the capital structure, 10.7% is appropriate as the minimum return we should allow for common equity.  We should stress, however, that we do not believe the record in this case supports the conclusion that the total cost of equity capital remains unchanged regardless of the proportions of preferred and common.  We believe that Bell has the opportunity to increase the earnings on common by judicious use of preferred financing and at the same time provide a beneficial effect on its overall revenue requirements and thus to the rate paying public.  It is our view that there may be combinations of preferred and common which will provide some increase in earnings on common with a lower total cost of equity.  We believe Bell should explore this possibility although as we stated in paragraph 89 the initial determination of financial planning rests with Bell.

91.  Consistent with our findings on the cost of capital to Bell, the indicated minimum overall return on Bell's interstate and foreign service would be as follows:  [*241] 

 

 

Proportion of

Cost rate

Proportion of

Item

capital

(percent)

total cost

 

(percent)

 

(percent)

Debt

45

6.0

2.70

Total equity

55

10.5

5.78

Total cost (including convertible preferred)

 

 

8.48

Use

 

 

8.5

 

This minimum 8.50% overall return contrasts with the minimum of 7.75% return recommended by the Trial Staff (using a 45% debt ratio and a range of 7.75-8.25%) and the minimum of 7.9% return recommended by the Examiner (using a 48% debt ratio and a range of 7.9-8.8%).

92.  We are aware of Bell's contention that the 8% cost of the convertible preferred does not include the costs of financing.  However, the record does not show what these added costs are and we do not believe that the amount thereof, if added, would significantly affect the required rate of return.  In any event, we are allowing a sufficient margin in the rate of return to cover a reasonable amount for costs of financing this issue.  Bell also contends that this stock is transitory, in that it will be replaced by common equity and that, therefore, the cost should be considered the same as the cost of common.  Bel submitted no studies or factual data as to whether, or to what extent, this conversion may take place in the near future.  We assume there will be some conversion and we have taken that possibility into account in our determination of the allowable rate of return.  Furthermore, in view of our finding as to the cost of preferred and common equity, we do not believe the total rate of return required by Bell will be materially affected by any such conversions.

93.  The Trial Staff contends that the overall return allowed in this case should reflect downward adjustments based upon alleged "unwarranted and unjustified current costs resulting from the improper capital structure and errors in the construction program for 1966 through 1970." Thus, the Trial Staff first determined that Bell's indicated rate of return should be 8-8.25% and then concluded that the lower end of the range of the allowable overall return for Bell should be reduced at least 1/4 of one percentage point because of the alleged "inefficiencies, mistakes and ultra-conservatism."

94.  With respect first to Bell's alleged "ultra-conservatism" concerning its capital structure, the Trial Staff centers its criticism on Bell's past financial policy which led to the reduction of its debt ratio from 51% in 1948 to 35% in 1954 and in maintaining the debt ratio at approximately that low level until our Decision in 1967 in Docket 16258.  Thus, the Staff makes the point that Bell, unlike the electrics, maintained low debt ratios when interest rates were low and when it should have increased its debt component at low cost and thereby benefit both the rate payers and the equity holders.  We do not disagree that, as the result of its historical financial policies, Bell's present actual cost of both debt and equity is greater than it might otherwise have been.  However, this particular past policy of Bell and its effect on Bell's cost of capital was given careful consideration in  [*242]  our Decision in 1967 in Docket 16258.  We concluded at that time that continuation of such policy would unduly increase the cost of service to the users.  In fixing the rate of return to be allowed (7-7 1/2%) we gave appropriate weight to the extraordinary amount of risk insurance that such low debt ratio policy had given to AT&T's stockholders.  We also found in 1967 that Bell should go to a debt ratio above 40% in the interest of rate payers, investors and Bell (see 9 FCC 2d, pages 62-63; 83-85).  Bell has acted in conformance with our Decision and has increased its debt ratio to 45%.  Under these circumstances, we would not be warranted in going beyond our 1967 Decision by making downward adjustments in the otherwise required rate of return so as to penalize Bell for the conservative financial policies it followed over the years with Commission acquiescence.

95.  With respect to the allegations of "inefficiencies," "mistakes" and "errors in the construction program for 1966 through 1970," the criticism of the Staff centers around its contention that Bell did not time its expenditures properly; that Bell should have spent about $1 billion more on construction in the period 1966-68 when interest rates were low (about 6%) and $1 billion less in 1970, when interest rates were high (about 8.73%).  The rationale of the Trial Staff is that Bell's actual construction expenditures in 1966-68 were too low because of a deliberate policy on Bell's part during this period to cut down on the margin of operating capacity and to decrease the relative amounts expended in the service improvement category.  According to the Staff, the consequences of this policy were twofold.  First, by cutting construction in 1966-68 below the relative level prevailing prior thereto, the Staff contends that Bell in effect invited the service difficulties that began to emerge in 1968 in such locations as New York, Miami and Boston, and that Bell should have foreseen that such slow-down in construction in 1966-68 would result in such service problems.  Second, in order to overcome these difficulties, Bell embarked upon a hurriedly planned and disproportionately greater construction program in 1969-70 that had adverse cost consequences.

96.  The Staff elaborates on the foregoing by contending that Bell's failure to plan properly resulted in costs being incurred in 1969 and 1970 that were excessive; that the rate base was correspondingly inflated; and that the rate payers should not be required to pay for such inflated rate base.  However, instead of recommending a reduction in Bell's rate base, the Staff recommends that this inflated rate base be considered as a factor in fixing Bell's allowed rate of return.  Furthermore, the Staff contends that in addition to inflating the rate base unnecessarily, this alleged improper planning meant that if Bell had obtained $1 billion additional debt capital to finance the needed additional construction in the 1966-68 period when interest rates were low, there would have been no need for Bell to sell $1 billion in debt in 1970 at 8.73% to finance the catch-up construction.  Thus, the Staff asserts that the current embedded debt cost of Bell was unnecessarily increased; that the rate payers should not be required to pay these unnecessarily increased costs of embedded debt and that an additional downward adjustment should be made in the overall rate of return allowed Bell to compensate for this unnecessary cost of capital.

 [*243]  97.  The Hearing Examiner treated these contentions of the Staff in paragraphs 86, 89-98 and 105-06 of the I.D.  He concluded that the proposal of the Staff to reduce the allowable rate of return of Bell would, in effect, constitute a penalty that would be self-defeating since decreasing the allowable rate of return in his view would impair Bell's ability to attract needed capital for the provision of adequate service to the public.

98.  We are in agreement with the Examiner's ultimate conclusion that no downward adjustment should be made in the allowable rate of return to compensate for the alleged inflated rate base.  It is our opinion that, notwithstanding that the record herein may support findings that Bell's management underestimated Bell's future construction requirements and miscalculated future service demands as proven by later events, we would not be warranted on this record in reducing the otherwise required rate of return in order to compensate for such alleged inflated rate base.  The Staff has not quantified the extent that it claims that the rate base has been inflated.  Moreover, Bell argues that its rate base is not inflated; that Bell would have had to incur these 1969-1970 costs in any event; that such costs were not the result of under-construction in 1966-68; that Bell did not need a higher level of construction in 1966-68 because it was meeting growth needs through technological improvements, such as increases in capacity of the TD-2 radio relay system; and that the Trial Staff is attempting to penalize Bell for its efficiencies and technological improvement in 1966-68.  We agree with the Examiner that the evidence of record on this subject is incomplete and inadequate for us to make findings that there are excessive costs in Bell's rate base.  We believe that this question should be pursued in Phase II.  Our action herein is without prejudice to the making of any adjustments in Phase II in the rate base as may be justified on the record at that time.  We hold only that we will not make any adjustment at this time in the allowable rate of return because of the alleged inflated rate base.

99.  With respect to the other claim of the Trial Staff we do not think that it necessarily follows that Bell's current cost of capital would be less today if Bell had spent $1 billion more on construction in 1966-68 and $1 billion less in 1969-70.  The Staff bases its claim on the assumption that Bell would have raised $1 billion in debt in the earlier period at a cost of 6% and that this would have obviated the necessity to sell $1 billion debt in 1970 at a cost of 8.73%.  However, the Staff overlooks the fact that Bell would have had the option of raising the additional $1 billion in 1966-68 by the issuance of common equity at a cost in excess of 8.73% which would have made the current cost of capital greater than it is today because of the higher cost of equity in 1966-68 compared to debt in 1969-70.  Such action by Bell would have been consistent with the proposed findings by the Staff that, if Bell had sold more equity in the 1966-69 period Bell's interest coverage would not have declined as rapidly as it did and that Bell could have moved more slowly toward a 45% debt ratio and issued common equity during this period when the market price/book value was favorable.  Accordingly, we reject the Staff's further contention that the overall rate of return should be adjusted downward because of the alleged unnecessary increase in the current cost of capital.

 [*244]  100.  We are aware of the magnitude of the effect on the carrier's cost which can result from overestimating or underestimating facility requirements and the plant construction needed to meet those requirements.  The Bell System's construction program is of major concern to this Commission from the standpoint of its effect on cost of service as well as its effect on quality of service.  We wish to make clear, therefore, that since the management of the construction program can have a direct effect on rate base and operating expense it will not only be considered further in Phase Ii/ of this docket, but will continue to be the subject of our continuing program of analysis and review of Bell's operations.

101.  The Trial Staff recommends a further downward adjustment in Bell's rate of return on its interstate and foreign communications services to compensate for AT&T's earnings from Western Electric.  AT&T owns all the equity of Western Electric.  It return on its investment in Western Electric was 11.59% in 1970; 10.07% in 1971; and 9.83% for the first nine months (annualized) of 1972.  The Staff asserts that we should take into account the actual return received by AT&T from its investment in Western Electric in determining how much in the way of earnings must be contributed by interstate and foreign communications to meet the total earnings requirement of AT&T.  In the simplest terms, the Staff states that if a utility with two lines of business has a total earnings requirements of $100 and earnings of $5 from one line of business, then the earnings contribution of the other line of business has to b $95.  Thus, the Staff contends that an overall rate of return of 8.00% for AT&T is satisfied by the 11.59% return of AT&T's investment in Western Electric (based on 1970 figures) and a 7.8% return on investment to furnish interstate communications services.

102.  Bell does not deny the validity of the Trial Staff's position.  However, Bell contends in its Reply Brief that "... issues relating to Western Electric prices and earnings are clearly Phase II issues and it would not be proper to make the basic economic decision in the form requested by the Trial Staff on the basis of a fragment of cross-examination in Phase I in which the subject of Western Electric prices and earnings is not in issue."

103.  We agree with the Staff that it would be appropriate for the Commission to take into account the return received by AT&T from its investment in Western Electric in determining the rate of return for interstate and foreign communication service.  However, we are not prepared on the basis of the limited record in this case to make the specific adjustment recommended by the Staff.  We believe that this question warrants a thorough examination in Phase II which deals, among other things, with all ramifications of the relationship of Western Electric to the Bell System and its effect upon telephone rates and revenue requirements.  Accordingly, we conclude that it is not appropriate for us to make any adjustments in Bell's rate of return with respect to Western Electric's earnings in this proceeding.

Conclusions on Rate of Return

104.  We have carefully considered the testimony of all witnesses, all evidence of record and facts officially noticed herein, all briefs  [*245]  and arguments of all parties and the Examiner's I.D.  We have agreed with the parties and have concluded that, for purposes of determining the rate of return herein, the embedded cost of debt for Bell is 6% and that the appropriate capital structure for us to use is a structure with debt at 45%.  As heretofore stated, we have found that Bell's current cost of equity capital is higher than that found by the Examiner and the Trial Staff and lower than that claimed by Bell.  Thus, after thorough review of the evidence and arguments of the parties, we find that Bell's common equity cost for the present and immediately foreseeable future is 10.5%.  Based upon our findings on these conventional factors, the indicated rate of return for Bell is 8.50%.  However, we further considered carefully and rejected the contentions of the Trial Staff that the indicated return for Bell should be reduced to take into account Western Electric's earnings and certain alleged errors, mistakes and imprudent planning by Bell in its financing and construction programs.

105.  In view of all of the foregoing, we are of the opinion and so conclude that the fair rate of return to Bell on its interstate and foreign communication services is 8.5%.  We consider that this return is the minimum required by Bell to enable it to attract capital at a reasonable cost and to maintain the credit of Bell; and to assure continued, adequate and safe interstate and foreign communications service to the public and to provide for necessary expansion to meet future requirements.

106.  The Examiner places considerable emphasis upon his recommendation that the Commission adopt the "conscious use of regulatory lag" in conjunction with his recommended wide range of overall fair rate of return (7.9%-8.8%).  The Trial Staff, although objecting to the "conscious use of regulatory lag," proposes a narrower range (from 7.75% and 8.25%).

107.  We believe that we should adopt an appropriate range of return by which to measure the reasonableness of Bell's future earnings and revenue requirements.  Inasmuch as we have found that the minimum rate of return that Bell should be permitted to earn on its interstate operations at this time is 8.5%, we are allowing Bell to file rates designed to produce such return.  However, it is our view that if Bell is able, through improved efficiency or productivity gains, for example, to increase its earnings under such rates within a reasonable range above 8.5%, we should consider such increased earnings to be acceptable without regulatory action on our part.  As to what this reasonable range should be, we agree with the Trial Staff that the range of.9 of one percentage point recommended by the Hearing Examiner is too broad.  The.5 of a percent range recommended by the Trial Staff is in keepting with the.5 percent range we adopted in our 1967 Decision in Docket 16258.  Accordingly, with due regard for all of the factors heretofore discussed, we shall specify a range of 8.5-9.0% as the range of reasonableness for the earnings of Bell on its interstate operations at the tariff rates we are allowing Bell to file herein.  This is done with the understanding that an earned rate of return within this 8.5-9.0% range at these tariff rates would be considered by us to be reasonable.  We believe that this is in keeping with the objectives of the  [*246]  economic policies of the Administration and the rules of the Price Commission to limit price increases on utility services to the absolute minimum and to encourage improved operating efficiency and productivity as an appropriate means of increasing earnings.

 

MCI Petition for Reconsideration

108.  As we have noted (see paragraphs 7 and 8), MCI requested reconsideration of our action released herein on June 29, 1971, (31 F.C.C. 2d 503). In that action we partially granted a clarification petition by the Trial Staff and ruled that, after we made our Phase I decision herein on rate of return, we expected AT&T to prepare an appropriate specific rate adjustment for its interstate services and that such rate proposal would be subject to review and further action by the Commission.  We pointed out that, since the parallel proceedings in Docket 18128 were concerned with the principles that should govern in the assignment of the Bell System's revenue requirements among its principal classes of services, any rate adjustments made on the basis of our rate of return ruling would be interim in nature and subject to final decision in Docket 18128.  Accordingly, we further ruled that any such rate proposal by AT&T will be subject to an accounting order by the Commission with possible refunds pending the outcome of Docket 18128.

109.  MCI objected to the action we took and urged us to reconsider and hold that irrespective of what we may decide herein on rate of return, AT&T may not submit any rate proposal until Docket 18128 is decided or, alternatively, that any rate increase proposal submitted by AT&T on the basis of our rate of return allowance shall be effectuated only by increasing charges for all interstate services proportionately, subject to an accounting order.  MCI's petition presents no new questions that were not carefully considered by the Commission at the time of its Decision.  As we have concluded herein, Bell is entitled to a higher rate of return on its interstate and foreign communication services.  We believe that it should be permitted to submit a rate proposal that would enable Bell to increase its earnings to the level hereinafter set forth.  In view of the demonstrated need of Bell for increased earnings to attract capital on reasonable terms and to maintain its credit, we see no sound reason to defer any increased rates until after we decide Docket 18128.  Moreover, we do not believe that we should make it mandatory that AT&T's interim rate proposal shall increase charges for all services proportionately.  Bell must make the initial decision as to the proposal it will submit.  However, as heretofore stated, we expect Bell to submit an interim rate proposal that will be consistent with sound rate-making principles and Bell will be expected to support its proposal.  MCI and other parties herein will have an opportunity to submit written comments on whatever interim rate proposal is submitted.  n3 Accordingly we shall deny MCI's petition. 

 

n3 We anticipate that such interim rate proposals will apply to those services particularly affected by increased costs, such as operator assisted calls.

 

Price Commission Regulations

110.  On May 26, 1972, the Price Commission issued new regulations, effective June 1, 1972, applicable to "interim" rate increases by Public Utilities.  These rules define as "interim rate" as "an increased rate allowed  [*247]  to go into effect by operation of law, or by action or inaction of a regulatory agency, pending a final determination by that agency on the requested increase" 6 C.F.R. 300.16a(a)(1).  The question arises as to the applicability of these rules to the rate increases that we are allowing herein.

111.  In much as the currently effective MTS rates went into effect January 26, 1971, substantially prior to the August 15, 1971 freeze date under the new economic program, it appears that none of the Price Commission rules apply to such rates.  However, with respect to our decision herein to permit Bell to propose further increases in rates, it appears that any such increased rate proposal by Bell could not be put into effect except upon compliance with the Price Commission rules.  This is because we propose to allow such increased rates to go into effect pending a final determination of the lawfulness thereof in Phase II hereof and in Docket 18128.

112.  The pertinent rules of the Price Commission specify that, before an interim rate may go into effect, the regulatory agency must suspend the rate for the maximum period authorized by law.  In addition, the utility must certify in writing to the regulatory agency (copy to the Price Commission) that (i) the increase is cost-justified and does not reflect future inflationary expectations; (ii) the increase is the minimum required to assure continued, adequate and safe service or to provide for necessary expansion to meet future requirements; (iii) the increase will achieve the minimum rate of return needed to attract capital at reasonable costs and not to impair credit; (iv) the increase does not reflect labor costs in excess of that allowed by Price Commission policies; and (v) the increase takes into account expected and obtainable productivity gains, as determined under Price Commission policies.  Further, the utility must furnish the Price Commission proof of newspaper publication of notices of such interim rate requests and of procedures for public requests for proceedings thereon 6 C.F.R. 300.16(a)(c).

113.  In view of our action herein permitting interim rate increases that are below the level of those that were filed with us in November, 1970 and deferred by AT&T until now at our request, we believe that the Price Commission's general requirement of maximum suspension of interim rate increase proposals has been met in the case.  Moreover, our decision herein constitutes sufficient basis for AT&T to submit the written certification required as to criteria (i), (ii) and (iii) above.  It appears that Bell can certify with respect to criteria (iv) and (v) from factual information furnished by Bell even though this decision does not contain specific findings with respect thereto since these criteria concern matters more closely related to Phase II of our investigations. Bell's counsel at the September 19, 1972 Oral Argument stated that the Price Commission policy with respect to wage increases was satisfied because the increased costs represented by wage increases were required by contracts which were ratified before the date specified by the Price Commission policy; and that the Price Commission's policies with respect to productivity do not come into play because Bell's support for the rate increase is based on actual results for a past period and do not include any additional costs for the future.  It is our view, therefore, that the Price Commission's regulations applicable to the  [*248]  rate increase we are authorizing Bell to file will have been complied with when Bell files the appropriate certification.

 

Exceptions to Initial Decision

114.  Numerous exceptions to the Initial Decision of the Nearing Examiner have been filed by the parties.  We have clearly indicated herein the basis for our decision and the extent to which we are in agreement or disagreement with the findings and conclusions of the Examiner.  In arriving at our decision we have given careful consideration to all exceptions and briefs in support thereof and to argument and re-argument thereon.  Thus, to the extent that the exceptions to the Initial Decision are in accord with our findings and conclusions herein, they are granted and otherwise denied.  Further, we shall issue in the very near future a supplement to our order herein in which we shall indicate our disposition of each individual exception that has been properly made by the parties.

IV.  OPERATING RESULTS AND REVENUE REQUIREMENTS

115.  To determine the dollar amount of any rate adjustments required to effectuate the rate of return found herein to be reasonable; we must find the going level of Respondents' interstate earnings.  Respondents submitted for the record certain interstate operating data for the years 1969 and 1970 based on actual operations and their projected view for the year 1971 as shown below:

Bell System Interstate Data

[Millions except for items (2) and (6)]

 

 

1969

1970

1971 view

(1) Messages

2,473

2,714

3,020

(2) Average revenue per message

$1.87

$1.81

$1.85

(3) Total revenues

$5,011

$5,276

$5,931

(4) Total expenses

$4,092

$4,352

$4,886

(5) Average net investment

$11,285

$12,296

$13,605

(6) Earnings ratio (percent)

8.1

7.5

7.7

 

The above 1971 projection data do not include the effect of the Ozark Separations Plan adopted by the Commission in Docket No. 18866 and which became effective January 1, 1971 nor the increased MTS rates which became effective January 26, 1971.  The net effect on the earnings ratio of these two actions (0.5% decrease for Ozark and 0.95% increase for the rate revision) would be to increase the earnings ratio to 8.15% for the 1971 projection.  Respondents stated that their 1971 view was based on a forecasted upturn in business over that experienced in 1970 and that if the upturn did not materialize and expenses increased in 1971 as much or more than revenues, the 8.15% projected earnings ratio would not be realized.  We note also that the 1971 view was based upon projected wage increases using the average wage increases for the prior three years, whereas the actual wage increases which became effective in mid-1971 were substantially in excess of that average.  However, during the hearings and in their proposed findings and briefs, Respondents maintained their view that an earnings level of 8.15%  [*249]  was appropriate to use for the year 1971 and in the Oral Argument before the Commission in October 1971, Respondents' spokesman expressed their view that the interstate earnings level would be 8.1% for 1972 assuming the economy responded as they hoped it would.

116.  The Trial Staff recommended the use of a going level of interstate earnings of 8.29% for the computation of any required rate revisions.  This figure was derived by annualizing the first four months (February-May 1971) of actual operating experience following the rate increase, the latest data then available.  Both the Examiner and Respondents have noted serious defects in this method of computing the going level of earnings from interstate operations.  Perhaps the major defects are (1) the failure to reflect any wage increase when it was known that negotiations were under way at that time to provide for increases in wages in mid-1971, and (2) the annualization of a four month period without taking into account seasonal variations and short-term fluctuations in business activities.  However, it is not necessary to review in detail the merits of the projections of either the Trial Staff or the Respondents for the year 1971 since we now have available the actual results of interstate operations for the year 1971 and for the first nine months of 1972, as well as further estimates of operating results for the year 1972 provided by Respondents at the Oral Argument before the Commission.  We will, therefore, take official notice of actual interstate operating results since the close of the record and analyze the trends since January 1971 for the purpose of reaching a determination as to the going level of earnings in order to compute the increase in rates required to enable Bell to reach the rate of return we have allowed.

117.  Annualized earnings ratios for the Bell System's interstate operations since the beginning of 1971 are as follows:

 

 

Percent

1st quarter 1971

8.16

2nd quarter 1971

8.45

3rd quarter 1971

7.29

4th quarter 1971

7.58

Year 1971

7.86

1st quarter 1972

7.56

2nd quarter 1972

7.97

3rd quarter 1972

7.62

9 months ended 9-30-72

7.72

12 months and ended 9-30-72

7.69

 

As indicated heretofore, the actual wage increases which became effective in mid-1971 were substantially higher than the estimates which were used in Bell's projection.  This would account, in part, for the failure, as indicated by the foregoing earnings ratios, to achieve the 8.15% return reflected in Bell's 1971 "view." However, it also appears from an analysis of actual interstate operating results for the year 1971 that the forecasted upturn in business, upon which Respondents relied in making their 1971 projection, did not fully materialize.  For example, the actual 1971 interstate message volume increased 6.8% over the 1970 message volume, compared to the projected message volume increase of about 9.2%.  Likewise, the average revenue per message for 1971 was $1.91 compared to Respondents' "view" of the $1.95 adjusted for the January 26, 1971 rate increase.

 [*250]  118.  Although the foregoing earnings ratios are helpful for analysis purposes, they cannot be used without adjustment as indicative of the present going level of interstate earnings.  The ratio of 7.62% for the third quarter of 1972 does reflect the wage increases which became effective in mid-1972, but as noted by Respondents in their objections to the Trial Staff's annualization of four months of operating data, there are "statistical hazards" in the annualizing process.  Also, while the 7.69% ratio for the 12 months ended 9-30-72 is on an annual basis it encompasses only one quarter of 1972 when the mid-1972 wage increases were in effect.  However, consideration of these earnings ratios with the trends in message volumes and average revenue per message enable us to reach conclusions as to the going level of interstate earnings with a reasonable degree of confidence.  In reaching such conclusions, we have also taken account of the trends in investment and expenses, including the additional wage increases due in mid-1972.

119.  There appears to be some improvement in the growth rate in messages in 1972 as reflected by an increase of 10.3% in the first nine months of this year over the same period of 1972 compared to the 6.8% growth for the year 1971.  The average revenue per message (ARPM) was $1.91 for the year 1971 compared to an ARPM of $1.81 for 1970.  However, the entire increase of 10 cents would be accounted for by the January 1971 rate increase rather than increases in the average distance and average conversation time per message.  Over the past several years increases in these two factors have caused the ARPM to trend upward.  The ARPM for the first nine months of 1972 remained at $1.91, but this represents a one cent increase over the same period in 1971.  Although this improvement in not sufficient to enable us to predict with confidence a resumption of the customary growth rate in the ARPM it does indicate that some growth can be anticipated in the immediately foreseeable future.

120.  The trends in expenses and plant investment are more difficult to analyze because of the effect of the change in separations procedures which became effective January 1, 1971.  The analysis of expenses is further complicated by the effects of wage increases in mid-1971 and mid-1972 and the service problems encountered by Bell in 1970 and 1971.  Without attempting to quantify the specific trends, we are of the view that the operating data do indicate an upward trend in the growth rate in expenses, particularly because of the wage increases, and a slight increase in the growth rate in plant investment.  However, we believe that the improvement in message volumes and ARPM will be sufficient to offset these trends so that there will be some improvement in interstate earnings over the level achieved in the first nine months of this year.

121.  On the basis of our analysis of the recent operating results data, it is our judgment that the earnings level for the immediately foreseeable future will be about 8.0% and we will use this ratio for computing Bell's additional interstate revenue requirements.  Based on Bell's current average net investment devoted to interstate and foreign operations, about $29 million additional net income before Federal income taxes is required to increase Bell's interstate earnings ratio by one-tenth of one percentage point.  Thus, achievement by Bell of the 8.5% rate of return on its interstate operations we have found herein to be  [*251]  appropriate, will require upward rate adjustments which will produce $145 million.  Therefore, we will allow AT&T to submit proposed rate changes designed to produce $145 million in additional net income before Federal income taxes giving due consideration to any anticipated cost savings and adjustments in settlements with the non-Bell telephone companies which will result from the increased rates.  In light of all of the foregoing.  Bell's proposed rates which were filed November 20, 1970 (Transmittal No. 10989) and which were predicated on a rate of return objective of 9.5% will be cancelled.

V. ORDER

122.  Accordingly, IT IS ORDERED, That effective 30 days from the release date of this Order, the tariff revisions to AT&T's Tariff F.C.C. No. 263, filed November 20, 1970 and indefinitely postponed by AT&T pending our decision herein on rate of return, ARE CANCELLED and stricken from the tariff as NULL AND VOID;

123.  IT IS FURTER ORDERED, That within 30 days from the release date of this Order, AT&T may submit for Commission review, a proposed rate schedule or schedules consistent with our foregoing decision which shall be accompanied by the showing required in paragraph 109 and the certificate referred to in paragraph 113 of our decision;

124.  IT IS FURTHER ORDERED, That such rate increase proposal which the Commission may allow to become effective shall be subject without further order of the Commission to the same accounting and refund provisions heretofore applicable to the currently effective MTS rates that were suspended and set for hearing herein in our Order of January 21, 1971, 25 F.C.C. 2d 151 and to such findings as we may make in Phase II hereof and Docket 18128;

125.  IT IS FURTHER ORDERED, That all exceptions to the Initial Decision that are in accord with our findings and conclusions herein are GRANTED and otherwise DENIED.

 

FEDERAL COMMUNICATONS COMMISSION, BEN F. WAPLE, Secretary.


CONCURBY: LEE; HOOKS

 

CONCUR:

ADDITIONAL VIEWS OF COMMISSIONER ROBERT E. LEE

Today's action is designed to meet the needs of the public for continued, adequate and safe interstate and foreign communications service, and to provide for required construction program to meet such needs.

AT&T is permitted to submit a rate proposal that would enable Bell to increase its earnings which will enable it to attract capital on reasonable terms and to maintain its credit rating.

I would hope that AT&T's rate proposal would, to a large extent, apply to weekday business hour calls and to operator assisted calling where presumably higher labor and equipment costs occur.  The business customer using the more expensive service should be expected to pay for it (see footnote 3).  Finally, it should be noted that, the general public can reduce its telephone costs by selective calling during certain days and hours.


CONCURRING STATEMENT OF COMMISSIONER BENJAMIN L. HOOKS

I wish to stress at the outset that, since I arrived in July as the newest member of the Commission, I have constantly pondered the matter of AT&T's requested rate increase and experienced reservations as to whether I (or anyone for that matter) had absorbed sufficient information to vote on the matter at all.  n11 However, upon review of the record -- and a growing conviction that a Commissioner has an affirmative, official duty to participate in major decisions -- I am now confident that I possess sufficient understanding of the economics involved to cast an informed vote. 

 

n11 I made this position clear three months ago when I concurred in designating this matter for limited oral re-argument (FCC 72-662 [Mimeo No. 80035] released July 24, 1972.     FCC 2d     (1972)) so as to afford me an opportunity to gain maximum exposure to the pertinent facts.

That said, I would secondly note the obvious point that the simplest and easiest way would be to pose as the great savior of the people and oppose any rate increase.  Such a posture is obviously a crowd pleaser.  But it is irresponsible government in terms of sound utility regulation.  The law, namely 47 U.S.C.   205(a), requires an infinitely more difficult determination; the prescription of "just, fair and reasonable" rates and practices.

It is clear that denial of a "reasonable" rate of return to AT&T, with a consequent impairment of ability to raise money in the competitive capital market, must lead to a deterioration of service, efficiency, and ultimately higher rates to the subscriber.  As always, this affects most those least able to pay; those dependent on everyday telephone service and without the means to benefit from more costly communications alternatives, those without the affluence to travel.  Insufficient capital must also result in curtailment by the company of recruitment and training programs so essential to the upward mobility of the socially and educationally disadvantaged.  When considered against the scale of a giant employer like AT&T, the effect would be profound.  Construction and research and development (most necessary to bring into being better and cheaper communications methods) likewise suffer financial asphyxiation.  But, I share the view of the Administrative Law Judge, the trial staff, and a number of experts testifying in this proceeding that the 9.5% rate of return urged by AT&T is not necessary to avoid the foregoing results.  n12

 

n12 The authorized rate increase is expected to result in some $290 million less than the $546 million AT&T contends is imperative.

On the other hand, the interim increase hereby permitted is subject to our determination in Phase II of this proceeding and our findings in Docket 18128, with appropriate refunds to subscribers should we deem these rates excessive.  Moreover, should it develop that the permitted rate of return yields undue profits after the closing of the pending proceedings, the Commission is statutorily obliged to seek rate reductions as it has done in the past.  n13

 

n13 See, e.g., the $150 million dollar rate reduction negotiated in 1969, 21 F.C.C. 2d 654.

 [*282]  As a last word, and as acknowledged in the majority opinion, the pricing-out of the tariff rates calculated to produce the authorized rate of return, is in the first instance, at the discretion of AT&T.  n14 But, the latitude provided by the Commission in not requiring symmetrically proportional increases so as to minimize the impact of the rates on the average and below-average income telephone subscribers is of primary concern to me.  Across-the-board increases of the same magnitude, work the greatest hardship on the poor, as all of our progressive tax structures explicitly recognize.  Fifty dents a month represents a great deal more to those at the poverty level than to let us say, a corporate executive.  Hence, I will be looking at AT&T's sensitivity to these patent mathematics when its revised tariff schedule is filed. 

 

n14 Pricing-out is the schedule apportionment of which types of calls (e.g., direct-dial, operator-assisted, day, night, weekend, etc.) will cost most, less, as well as the dollar amount of such changes.


DISSENTBY: JOHNSON; LEE

 

DISSENT:

DISSENTING OPINION OF COMMISSIONER NICHOLAS JOHNSON

You can tell by the time on the press release when the FCC is really putting it to the American consumer.  The items it is most ashamed of always come out on the evening before a holiday -- when the Commission is desperately hoping no one will notice.

So it was last Christmas, when the FCC wanted to present ATT with a little Christmas eve gift and call off its hearing.  See "Why Ma Bell Still Believes in Santa Claus," Saturday Review, March 11, 1972, p. 57.

Now it's Thanksgiving Day, and once again we're celebrating at the FCC -- giving ATT something to be especially thankful for.  For the American ratepayer, however -- already confronted with a natural gas increase the day after the election -- it looks like another load of turkey feathers.

The upshot of today's decision is that (if the state commissions follow our lead) Bell will be able to earn some $1.3 billion per year more -- a 7% increase over its 1971 gross of $18.5 billion.

Almost $500 million of this amount will come from interstate service alone, for today's decision approves a price rise of 15.6% in interstate telephone prices!  (To move from 7.5% to 9.0%, Bell must receive $485 million more; to do so, it must raise prices enough so that, if consumers  [*270]  bought the same amount of telephone service, Bell would receive twice $485 million -- because an increase in rates reduces usage.  n4)

n4 One of the consequences of increasing telephone rates -- especially this much -- is that people stop using the phone so much.

This raises initial questions about the method of revenue raising used by the phone company.  The corporate goal ought to be to increase phone usage, not decrease it.  Assuming the FCC and consumers are quite prepared to let Bell earn a fair return on its efforts, the more phone usage, the higher Bell revenue.  This step in the opposite direction is simply one more example of Bell management's numerous decisions that simultaneously rob shareholder and consumer alike to no one's advantage.  See Bell Disqualification Request, 26 F.C.C. 2d 523, 540 (1970). But that is really another issue for another day.

The point before us now is that, having deliberately cut back on its own business, Bell cannot then be heard to argue that its "price rise" doesn't really count; that what should be examined is only how much more consumers will actually pay (for less service than they otherwise would have obtained).  If a $1.00 call goes to $1.20, that's a 20% increase for the consumer, regardless of how many fewer calls he makes, and how many fewer minutes he talks each time.

In Bell's November 1970 proposal, it hoped to receive $385 million more per year from consumers.  To do so, Bell would have raised prices so that if consumers had bought as much telephone service Bell would have earned $760 million more.  The January 1971 decision permitted Bell to receive $175 million more from consumers, but Bell raised prices so that if consumers had bought as much telephone service.  Bell would have received $390 million -- a price rise of 7.4% based on 1970 Bell interstate revenues.

It is in that sense that I say the rate case before us involves a $500 million increase.  If consumers continued to use the phone as much as they do now, they would pay $290-$310 million more.  Because the higher rates will discourage phone usage, however, that figure is discounted by Bell and the FCC -- in this instance to an estimated $145 million annual increase in Bell revenues.  And the extra 0.5% of the permitted range, up to 9.0%, means consumers will pay at least another $145 million more per year in the future -- all with FCC approval.  Add to this $290 million the $210 million of increases already in effect that are approved here, and the grand total is $500 million per year more paid by the consumer to Bell.

This ruling constitutes the first formal decision by the FCC on Bell's rates since its 1967 order finding a 7.0 to 7.5% range to be the maximum justified rate of return.  Today's decision is an unsupportable outrage -- raising that maximum rate to 9% -- and maybe even more.

The majority today validates a 1971 Bell price rise of some 7.4% on regular long distance service, throws in another $36 million rise for other services, and authorizes a new increase of $290 million.  Moreover, virtually all of this increase will be paid for by regular telephone users -- rather than large corporate users.

The total price to consumers?  This decision alone approves a price rise of about $500 million per year.  If intrastate rates were to reach the same level, the total phone bill for consumers would leap up some $1.3 billion per year -- a 7% increase over Bell's 1971 gross of $18.5 billion.

As explained in some detail below, the majority's decision has the following infirmities:

(1) It ignores cogent recommendations of the Commission's Trial Staff, and the Administrative Law Judge who sat through the hearing.

(2) It is based on an unusually stale record -- even by FCC standards.

(3) Bell's Thanksgiving really begins with the majority's paragraph 107.  While purporting to set a 8.5% rate of return, Bell is told that if it earns 9.0%, that, too, will be approved.  There is no telling how high it can go before the FCC will be concerned.  The difference between 8.5% and 9.0% is worth $145 million per year to Bell in the interstate services alone -- paid for by consumers.

(4) It fails to address who should bear the brunt of these increases -- business, private line users, or homeowners -- or other issues of "cross subsidy." It will be more than one year before the Commission decides whether it is legal and proper for homeowners to bear  [*271]  95% of the burden of these increased rates -- as the current decision allows.

(5) It refuses to resolve other issues necessarily preliminary to a rate of return hearing, namely, the appropriateness of Bell's costs -- operating and capital.  It will likely be at least two years before they are addressed and resolved.

(6) It establishes a rate of return likely to reverberate in other jurisdictions.  Bell has successfully sought $1.6 billion in telephone price hikes in the past three years.  It presently has pending about $1.0 billion in further increases.  If the majority's standard is applied every-where by all regulatory jurisdictions, telephone users will pay an additional $1.3 billion per year above the $20 billion per year they pay now for telephone service.  n5 It is this more than billion-dollar increase that the public should focus upon. 

 

n5 It is, of course, necessary to estimate the total consumer impact of today's decision.  However, I believe the $1.3 billion figure to be conservative and easily supportable.  The states have generally held Bell to rates of return in the 7.0 to 7.5% range during the past five years.  Every percentage point increase in the system-wide average rate of return means that consumers must pay an additional $940 million per year.  The FCC is today moving from a former minimum of 7.0% to a maximum of 9.0% -- and possibly higher.  That is two percentage points, or $1.9 billion.  The FCC has moved its maximum from the system's current 7.6% actual rate of return to an approved maximum of 9.0% for interstate. Should the system-wide average rate of return reach this level, it would be a 1.4 percentage point increase, or $1.3 billion.  If one considers price increases (rather than Bell's increased income), as explained in footnote one above, this amount could easily be doubled, to $2.6 billion or more.  In fact, as mentioned in the text, $2.6 billion in telephone rate increases have been filed or allowed in the last three and one-half years by state commissions -- over 10% of Bell's current $20 billion annual gross (compared to $18.5 billion in 1971).  In short, it does seem fair to me to characterize the impact of today's decision as in the nature of $1.3 billion price rise for consumers.

(7) The majority reveals its decision preferences by deciding this case when no decision is necessary, pressing -- or even appropriate -- while refusing to conclude consideration of long-pending matters of importance: the one-to-a-market rulemaking, the KHJ renewal case, license renewal procedures, children's television regulation, and the proposed establishment of an FCC public counsel to represent the public in FCC proceedings.

(8) The majority fails to apply the appropriate Price Commission criteria in evaluating the rate increase, and scoffs at the Administration's purported interest in reducing inflation.

The Trial Staff recommended a rate of return of 8%.  On this record I believe that recommendation is correct.  The Commission's wisdom in separating its staff, and providing consumer advocacy, was clearly demonstrated in this case.  No doubt more resources and time were required to do the job properly, but it would be a mistake to abandon the Trial Staff concept.  Many of the public interest intervenors, handicapped by the extensive resources needed for common carrier ratemaking, obviously relied on the work of our Trial Staff.  The most knowledgeable, and fair, party to this proceeding -- the Administrative Law Judge -- recommended 7.9% as the minimum return justified by the record.  The majority likewise ignores his recommendation -- despite its relevance to the national economic stabilization policy to keep price increases to a minimum.

The majority picks at the Trial Staff's work, and chooses selectively from Trial Staff evidence to buttress its conclusion; but at least the majority has not adopted wholesale the outrageous demands of Bell -- a $580 million increase to 9.5% rate of return levels.  Apparently unwilling  [*272]  to heed the recommendation of the Administrative Law Judge in this case, and abandon its excessive demands, Bell still endeavors to have this Commission enact them.  No doubt even today's decision, so unjustifiably favorable to Bell's position, will be met with hand-wringing and bad-mouthing by the company.

I do not understand the majority's discussion of Bell's capital structure and construction program.  Both were seriously flawed; consumers paid more (probably $100s of millions more); but Bell is not to be penalized in any way.  As usual, the consumer is simply asked to pick up the tab -- while stock prices and management's salaries go up -- and is expected not to complain.  In paragraph 100 the majority promises ever-vigilant scrutiny, analysis and action.  It does not indicate, however, how long we must wait to witness such a novel approach from this Commission.

It is even more difficult to justify the majority's unwillingness to make an adjustment for Western Electric's excessive earnings.  The majority appears to concede the validity of such an adjustment -- but says it can be considered "later." It is really very simple.  The majority is determining what the cost of capital (rate of return) should be for the entire Bell system.  The majority decides that is 8.5 to 9.0%, I believe this to be too high.  But let's accept it for a moment.  Western Electric is a part of the Bell System.  It contributes to its overall return.  The return for Western Electric, however, was 11.59% in 1970, 10.07% in 1971, and, so far in 1972, 9.83%.  If the required return for the overall Bell System is 8.5 to 9.0% and Western Electric is making significantly more than the System requirement, then the other components of the Bell System -- like interstate service for consumers -- should earn less.  Otherwise the overall Bell System rate is even more than the high 8.5 to 9.0% -- Bell reaps a windfall.  But the majority says it will get around to that problem "later."

So much for the Trial Staff's efforts to add a little reality.  It was a good fight.  They are entitled to consumer's appreciation.  But they've lost.  Now let's examine what we're doing for inflation.

The trial record in this case was closed on June 3, 1971 -- two months before the "New Economic Policy" was announced.  The Commission did hold a little oral argument in this case later on, in October, 1971, but our entire record was built on the premises and experience of the very period of inflation which led directly to the imposition of controls.  The majority's additional oral argument in September, 1972, merely delayed our decision beyond the national election, added little but confusion, and further underscored the need to reopen the record.  Bell came in and hollered for more money when it thought it had the best case.

It is not just that a year and a half has passed since the closing of this record that makes it so stale.  It is that the Administration's economic policy has undergone such revolutionary change during this period, and that none of these changes have been explored on the record.  If the majority is so all-fired eager to increase Bell's profit, one would think the least it could do would be to get a current record before it.  The decision tries manfully to fill in the data about what has happened since June, 1971 -- operating results, interest rates, and so forth -- but it is a mechanical exercise.  I believe any rate increase  [*273]  requires that we simply must remand this case to the Administrative Law Judge to receive evidence on post-June, 1971 issues.

One of Bell's -- and the majority's -- major concerns has been the price of ATT stock.  But recently we have seen a dramatic rise in ATT stock price, from a 1972 low of 41 to a present level above 50 -- a 25% increase.  But this fact has had no impact on the majority's conclusion, reached months ago and announced now.

Not content simply to raise rates, the majority tells Bell that as it continues to earn more and more above the "minimum" of 8.5%, that will be all right with the FCC -- up to 9.0%.  After that, sometime, maybe -- although maybe not -- the FCC might want to ask whether Bell is earning too much.  But, in effect, Bell has a blank check to earn more and more at the expense of the consumer -- and the FCC promises to do nothing about it.  Of course, the majority purports to qualify that by saying the increase should be from improved efficiencies and productivity.  I would be delighted if the majority would enlighten us with its criteria for separating rate of return increases brought about by efficiencies and productivity from those created by improved business conditions, stimulated demand, and rate error or calculated miscalculation.  In fact, I would even settle for a willingness to fail to reward Bell for past inefficiencies, errors in judgment, and excessive conservatism -- which the majority indicates it won't do.  The fact is that Bell has today been handed a blank check by the FCC, drawn on the account of the American consumer.

There is little I need to add to the discussion of the numerous and unwieldy carts that have been harnessed before this balky horse.  It is nothing short of amazing that this agency has been able to conduct two major AT&T rate of return proceedings while being unable to finish either the ten-year-old proceeding to decide whether the average citizen is paying too much for interstate service while special users get a rate subsidy, or the proceeding begun in 1965 to determine the appropriateness of Bell's costs -- which are most of what the ratepayer actually forks over.  My view now is that nothing in this agency affecting AT&T, except national emergencies, should budge one more inch until these moss-covered proceedings are cleaned up and finished off.  To this extent I agree with the views of MCI in this proceeding.  Of some $400 million a year in increases more or less approved by this decision, $175 million are already being paid by small users, $36 million are paid by special users, and the additional $290 million can be allocated in Bell's discretion -- probably to fall, once again, on John Q. Public.  My first choice would be to defer this rate of return proceeding until those two dockets are finally resolved.  My second choice would be merely to remand this case for up-to-date information.

There is little to add on the effect this decision will have on all kinds of utility rate payers.  Bell, and other telephone companies, will try to use the 8.5 to 9.0% result to influence other regulatory bodies.  See the views of the Commonwealth of Pennsylvania at the September 1972 oral argument.  Tr. 5550.  Other utilities will cite the majority's decision as precedent.  Prices and profits are going up again.

I have saved the most complicated for the last.  The ultimate responsibility for controlling price increases -- including telephone price increases -- rests with the Price Commission.  The Price Commission has  [*274]  done a lot of moving around on its regulation of utilities, as I have detailed in another opinion,     F.C.C. 2d    , FCC 72-444 (May 19, 1972), and Price Commission rules were changed again just before the September 1972 oral argument.  37 Fed. Reg. 18893 (September 16, 1972).

The Price Commission provides for two kinds of utility price increases in its rules -- "interim" rates and "final" rates.  Interim rates are those increases allowed while the regulatory agency evaluates issues related to the increase.

I believe this Commission should evaluate its decision in the light of the Price Commission rules and standards.  During the September oral argument I asked, and Bell and the FCC Trial Staff agreed to provide, record citations to the material they believed demonstrated compliance with Price Commission standards -- many of which were established after the close of this record, Tr. 5502.

Bell, in a letter dated November 15, 1972, has now supplied its response.  Bell says it will file the required certificate of compliance once the Commission's decision is issued.  Bell points to the record developed before the Price Commission ever came into existence for evidence of its compliance with Price Commission criteria.  It is apparently Bell's position that the Price Commission criteria add nothing to the traditional standards used by the FCC in judging rate of return cases.  The majority accepts Bell's views in its cursory comments on the Price Commission in paragraphs 110 to 113 of the majority opinion.

Bell also argues that neither the FCC nor the Price Commission is permitted to review this decision under the Price Commission rules.  These are "interim rates" argues Bell, and thus are immune from scrutiny.  Again the majority appears to agree.  Bell's argument raises another interesting question.  This FCC decision is an "interim" decision and the rates are "interim rates" because of an administrative quirk.  That quirk is the Commission's inability to conduct a full hearing on the Bell system -- a hearing that has been underway since 1965 at least.  And since those other issues are encompassed in Phase II of the present proceeding, this FCC decision leaves the rates on an "interim" status.

But it is important to point out how much like "final" rates the profit levels allowed in this decision are.  First, "interim rates" suggest rates that will be in effect for a short period of time -- say, less than a year -- until a final decision is made.  Here there will be no "final rates" for years -- at least two years, probably longer, perhaps never.  There will be no decisions in the cross-subsidy proceedings for at least one year, according to current predictions, and those predictions have been notoriously optimistic in the past.

Secondly, the "interim" profit rate approved here is, in fact, a "final" rate.  The question of rate of return is now settled on this record in a final decision.  That approved profit rate for Bell is now 9.0%.  Other decisions on the remaining issues -- issues that make this an "interim" decision -- may affect which consumers contribute the profits, and what costs Bell can include in its expenses before computation of profits.  But nothing yet to be decided will change the profit rate allowed by the majority here.  The Price Commission should not ignore the fact  [*275]  that, so far as Price Commission rules are concerned, this is the "final" decision of the FCC with respect to the criteria established by the Price Commission for measuring the action of regulatory agencies on the question of rate of return.

Price Commission rules require Bell to submit in writing a statement as to how the increases approved here comport with Price Commission guidelines.  6 CFR   300.307(c)(2) (1972).  The discussion of the Price Commission requirements at the September 1972 oral argument can best be characterized as totally confused -- as any cursory examination of the transcript will demonstrate.  The majority deals with Price Commission questions in a rather offhand way -- understandable since the document issued here is little more than a copy of a July 1972 draft with the numbers inserted.  The July 1972 draft was prepared before the new September 1972 Price Commission rules.

Interim rate increases are reviewed by the Price Commission.  6 CFR   300.307(c)(1) (1972).  Interim increases must be suspended for "the maximum period allowed by law." 6 CFR   300.307(c)(1) (1972).  Except for certain special situations not relevant here, interim increases may not go into effect unless they have been suspended for the period specified by the Price Commission regulations.  Thus it is important to determine the "maximum period allowed by law" under FCC statutory power.  As the FCC has made clear in a series of decisions, the "maximum period" can be much more than the 90 day period specified in section 204 of the Communications Act.  See FCC 72-118; FCC 72-619.

In its last decision, the FCC determined that its January 1971 action was a "suspension" -- which has lasted 22 months.  See     F.C.C. 2d    , FCC 72-942 (1972).  And the FFC's special permission decisions, relying on Sections 4(l), 4(j) and 203(b), affecting aspects of this case, indicate that the "maximum period" is in fact however long it takes for the Commission to consider in good faith the important issues that affect a rate increase of the magnitude under consideration here.  I have already argued that the Commission must decide questions of cross-subsidy and Bell costs before granting a further massive price increase.  I am convinced that the FCC not only can but should continue its present suspension in effect until those issues are decided -- and that the period of time to consider these matters is the "maximum period allowed by law" under Price Commission regulations.  And I am convinced that under Price Commission rules that is what we must do to comply with those rules.

I do not believe the Price Commission legally can permit this FCC decision to become effective -- unless it is willing to violate its own rules, and abdicate its responsibility.  The 8.5 to 9.0% rate of return permitted today is procedurally, and substantively, in violation of Price Commission rules.

On substantive grounds a 8.5 to 9.0% rate of return for Bell violates the Price Commission criteria.  The Price Commission criteria for permissible rate increases are:

(1) The increase is cost-justified and does not reflect future inflationary expectation;

 [*276]  (2) The increase is the minimum required to assure continued adequate and safe service or to provide necessary expansion to meet future requirements;

(3) The increase will achieve the minimum rate of return needed to attract capital at reasonable costs and will not impair the credit of the public utility;

(4) The increase does not reflect labor costs in excess of those allowed by Price Commission policies;

(5) The increase takes into account expected and obtainable productivity gain, as determined under Price Commission policies.  6 CFR   300.303 (1972).

The FCC and Bell may or may not be willing to vow that these criteria have been met.  But the record in this case can only lead to the single conclusion that they have not.

Only a rate of return around 8% can meet the Price Commission criteria.  That is the conclusion of both the Administrative Law Judge and our Trial Staff in this case, which found 7.9 and 7.75%, respectively, to be the appropriate floor.  The majority offers nothing but conclusionary statements to challenge that view in adopting 9.0% as its upper range.  The majority has made no effort to lay the evidence in this case alongside the Price Commission criteria.  This failure in itself demonstrates the majority's willingness to ignore economic stabilization policies.

I also note the majority has already concluded that the rate increases to follow this decision will be permitted to go into effect immediately, without suspension.  The majority has argued that our January 1971 action constituted a suspension of the increases now to be filed.  I need not repeat my arguments as to why the January 1971 action was in fact not a suspension, either under FCC authority or the Price Commission rules,     F.C.C. 2d    , FCC 72-942 (1972), and that therefore any new increases must be suspended for the "maximum period allowed by law."

This case must be decided on the record before us.  I believe that record can sustain no more, at the outside, than 8% at this time.  To the extent exterior standards are consulted, however, they tend to reinforce my conclusions, rather than those of the majority.  Moreover, by torpedoing the efforts of the State Commissions to hold to lower rates of return, we are gratuitously giving a billion-dollar boost to rampant inflation that it scarcely needs.

This is a somewhat lengthy opinion to explain a short conclusion: this agency is not helping the consumer; it is not helping the fight against inflation; it is not keeping price increases to a minimum; it is not applying what I understand to be the applicable principles of public utility law.  It is merely helping a politically powerful corporation -- perhaps the world's largest -- to acquire $1 billion a year more from hard-pressed American consumers.

I dissent.


DISSENTING STATEMENT OF COMMISSIONER H. REX LEE

It is extremely difficult to assess the actual impact of the majority's decision to authorize the highest rate of return on interstate and foreign communications services provided by the American Telephone  [*277]  and Telegraph Company.  To recite that the Bell System is now permitted to return between 8.5 and 9.0 percent in net earnings after federal income taxes on its total investment (rate base) or that AT&T may now file tariff revisions in order to generate $145 million in additional interstate revenues is somehow not a very meaningful way to gauge the economic, social and political implications of the rate of return decision.  It is more than obvious that the Commission's regulatory actions in regard to the telephone industry are of vital importance to every citizen who finds telephonic communications to be a needed, daily utility service.  Because of its impact in terms of sheer scope and size, the decision to fix an increased rate of return for AT&T's interstate and foreign operations is also of extreme importance in the context of the President's current efforts to control inflationary pressures in the American economy.  However, whatever the long-range effects of the majority's decision may be, we can be assured of one predictable outcome -- telephone users will have to pay more to communicate with one another.  It is because of the magnitude of the expected rate increases and the probable impact of the majority's Phase I decision on local telephone rates that I have dissented.

Our statutory mandate in telephone regulation is simply stated -- the public interest is best served by the establishment of the minimum rate of return consistent with a fair return to company stockholders and the maintenance of optimum service.  The implementation of the mandate is not quite so easy, for we cannot know beforehand what exact effects a rate of return decision will have in such areas as quality of service, range of prices, management incentives and the introduction of new equipment and innovative techniques.  In the recent past, we have witnessed substantial decreases in interstate telephone rates as a result of increases demand and technological efficiencies.  However, economic conditions have changed dramatically since the Commission's Interim Decision and Order in Docket No. 16258, 9 FCC 2d 30 (1967), which specified that AT&T should maintain interstate earnings to produce a return within a range of 7.0 to 7.5 percent.  In fact, as a result of our continuing surveillance of the Bell System's interstate operations, we subsequently noted significant changes in the economic climate that affects AT&T's revenue requirements and its ability to attract new capital (i.e., the sharp increase in interest rates on borrowed capital, the resulting increase in the company's cost of embedded debt, the higher rate of inflation and larger capital requirements), and, in 1969, we authorized the Bell System to exceed the upper limit of the range (7.5 percent) specified in 1967.  See 21 FCC 2d 654 (1969). Ironically enough, these same economic conditions eventually prompted the President's August 15, 1971, freeze on prices and wages, the announcement of a New Economic Policy (Phase II) and the establishment of a Price Commission pursuant to the Economic Stabilization Act of 1970.

Therefore, I am somewhat sympathetic with AT&T's contentions that it needs to improve its earnings position in order to attract the needed equity capital for plant expansion without an impairment of existing stockholders' interests and that the sharp decline in the company's interest coverage must be arrested to avoid a downgrading of its debt issues.  Nevertheless, I cannot accept AT&T's position that it  [*278]  should have the same or greater interest coverage than the Aaa electrics or that an equity return of 12.5 percent is needed to sustain an adequate interest coverage for the Bell System.  As the majority properly notes, AT&T's debt ratio continues at a level lower than that of the electric utilities, and, as a result, its equity holders are subject to less risk than the shareholders of the Aaa electrics.  Thus, it would not be fair to the Bell System rate payers to require them to pay the additional amounts necessary to enable the telephone company to earn the same return on equity as the Aaa electrics.  Nevertheless, as AT&T's market price/book value ratio has adequately demonstrated, n6 equity earnings appear insufficient to attract needed capital on fair terms, especially in light of the current cost of long-term debt, i.e., 7.25 to 7.50 percent.  n7 Since debt costs have increased by about 1 1/4 to 2 percentage points since 1967 and since the spread between debt costs and equity return narrows as interest rates rise, an appropriate return on equity for the Bell System would be in a range between 10.0 and 10.5 percent. 

 

n6 During 1972, the average market price of AT&T stock fell below the average book value.  Lately, AT&T common stock has witnessed marked improvement, which apparently reflects an increased quarterly dividend and the company's expectation of favorable regulatory actions on the federal and state levels.

n7 Equity earnings for the Bell System were 9.2 percent in 1970, 8.9 percent in 1971 and 9.0 percent in 1972 (annualized on the basis of the first six months of operation).

Based on the updated figures supplied by AT&T in August, n8 and utilizing a 10.0 percent return on equity, the indicated overall return on the Bell System's interstate and foreign operations may be computed as follows:

 

n8 The Commission scheduled an oral reargument in Phase I of Docket No. 19129 for September 19, 1972, in order to take account of relevant financial and operating data applicable to the period subsequent to the close of the hearing record on June 3, 1971, and of pertinent Price Commission regulations.  Pursuant to a request of the Common Carrier Bureau Trial Staff of August 3, 1972, AT&T supplied updated data concerning the Bell System's current cost of long-term debt, its embedded cost of debt, its current capital structure and its most recent operating results.  Even though the updated data is noted by the majority, the overall rate of return is computed on the basis of stale record evidence.

[Figures in percent]

 

Proportion

 

Proportion

Item

of

Cost rate

of

 

capital

 

total cost

Debt

46.50

6.01

2.79

Preferred

3.82

8.00

0.31

Equity

49.68

10.00

4.97

Total

 

 

8.07

 

If return on equity is fixed at 10.5 percent, then the overall rate of return would be 8.32 percent.  Unlike the majority, I would not increase the equity return in order to accommodate the cost of convertible preferred stock issued in 1971 since such an approach appears to favor the use of preferred stock financing.  The primary responsibility for financial planning rests with the Bell System management and not with the Commission.  I do agree with the majority's use of an "actual" debt ratio rather than a hypothetical structure, but I would employ the most current data available in this regard, which indicates a Bell System debt ratio of 46.5 percent as of June 30, 1972.

 

Contrary to the majority's position, I would make a downward adjustment in the computed rate of return to compensate for AT&T's  [*279]  earnings from Western Electric, its manufacturing subsidiary.  AT&T's return on its investment in Western Electric amounted to 11.59 percent in 1970, 10.07 percent in 1971, and 9.83 percent for 1972 (annualized on the basis of the first nine months).  While the majority appears to accept the logic of such an adjustment, it defers any appropriate action until conclusion of Phase II.  n9 Since the actual return received by AT&T from its investment in Western Electric is identifiable and should be considered in assessing the telephone company's overall rate of return on interstate and foreign operations, I would adjust the allowable return accordingly.  Moreover, I would not specify a range of return by which to measure the reasonableness of AT&T's future earnings and revenue requirements.  Consistent with our statutory mandate and Price Commission directives, it is sufficient to fix the minimum allowable rate of return and to reserve further action by the Commission when and if the Bell System's earnings exceed the minimum rate of return.  The majority's specification of a range of 8.5 to 9.0 percent appears to foreclose appropriate Commission action if earnings of AT&T within that range should result from factors other than efficiencies and productivity gains.  In addition, since the majority has not seen fit to penalize the Bell System for management errors affecting the company's capital structure and construction program during the 1966-1970 period, it should not now offer rewards in the form of a higher rate of return. 

 

n9 The second phase of Docket No. 19129 calls for an examination of those matters that could affect the revenue requirements of AT&T and the associated operating companies, including the reasonableness of the prices of Western Electric and the amounts claimed by the Bell System for investment and operating expenses.  Phase II also encompasses an examination of the interstate rate structure of MTS (message toll telephone service).  The Phase II issues were dismissed by the Commission on December 21, 1971 (32 FCC 2d 691 -- Commissioners Nicholas Johnson and H. Rex Lee dissenting), but were subsequently reinstituted on January 27, 1972.  See 33 FFC 2d 269 (1972).

Therefore, I would find that the minimum rate of return on AT&T's interstate and foreign operations should be set somewhere between 8.07 and 8.32 percent -- with an appropriate adjustment downward to reflect Western %electric's contribution to company earnings.  I am fearful that the majority's range of return will be interpreted by AT&T to mean that it can return at least 9.0 percent on interstate operations.  At that level, the majority's decision would permit the Bell System to generate additional interstate revenues of at least $540 million n10 and to earn nearly 12.0 percent on equity investment.  Such a return on interstate operations, I believe, would reflect economic expansion generally rather than Bell System efficiencies and productivity and could have serious inflationary impact as a result.  I am also concerned that our action will constitute the major precedent for state regulatory agencies in their evaluation of telephone company requests for higher returns on local operations.  The Bell System has already been granted permission to initiate well over $1 billion in rate increases by state commissions, and it presently has pending an additional  [*280]  $1 billion in proposed rate increases on the local level.  From any point of view, the majority's decision can be expected to have a profound impact on both interstate and local telephone charges. 

 

n10 In January, 1971, we permitted AT&T to increase its net earnings before taxes by $250 million pending the outcome of the hearing on the company's November 20, 1970, tariff proposals, as revised.  In its decision, the majority projects an 8.0% earnings level for the Bell System for the immediate future even though the company's current earnings level is only 7.69 percent.  If we assume that about $29 million in additional net income is required to increase AT&T's interstate earnings ratio by one-tenth of one percentage point, and we assume an earnings level of 8.0 percent, achievement of a 9.0 percent overall return would require upward rate adjustments to produce another $290 million.  If AT&T's current earnings level of 7.69 percent is used to project revenue requirements, then income must rise by some $377 million in order to achieve a 9.0 percent return.

The majority takes the position that the currently effective MTS rates, which went into effect on January 26, 1971, are not subject to the President's new economic program, but that any rate proposals submitted pursuant to the rate of return decision are.  Nevertheless, since the anticipated rate increases will be below the level of those filed by AT&T in November, 1970, the majority concludes that the Price Commission's general requirement for maximum suspension of interim rate increases has been met.  I have already had occasion to comment on this aspect of the majority's decision in the context of AT&T's request for special permission to resubmit its original $545 million interstate rate increase proposal.  See FCC 72-942, 25 RR 2d 692, released October 26, 1972.  As I explained in my prior statement, the voluntary postponement of the effective date of the 1970 tariff filing by AT&T did not constitute a "suspension" within the meaning of the Communications Act or of Price Commission regulations.  The majority's contrary interpretation is clearly erroneous and only serves to undercut the role of the Price Commission in the implementation of NEP guidelines.  In fact, the majority has made no serious attempt to view its rate of return decision against the backdrop of current economic stabilization policies.  Its discussion of applicable Price Commission regulations is cursory at best and offers no assurance that the 8.5 to 9.0 percent range of return specified for Bell System interstate operation is consistent with efforts to control inflationary pressures in the economy.

In summary, while I believe that some upward adjustment of AT&T's rate of return is justified in order to accommodate changes in the cost of debt and equity capital since 1967 and to insure that sufficient funds are available for construction of facilities, I cannot agree with the decision to permit AT&T to return up to 9.0 percent on interstate operations.  The range of return adopted by the majority is inconsistent with the hearing record, the recommendations of the Administrative Law Judge and the Trial Staff, updated Bell System statistics and the goals of the NEP.  Based on AT&T's current earnings level, the telephone company will apparently be permitted to generate additional net income before taxes of $627 million, including the $250 million already allowed, and it can be expected that the major burden will fall on the MTS user.  The majority's decision will have serious impact on local rate proposals that are now pending before state commissions.  It also proposes to reward Bell System management for efficiencies and productivity gains, but rejects any attempt to penalize the company for past mistakes in regard to capital structure and construction programs -- presumably on the theory that the Commission acquiesced in such corporate decisions.  It fails to reflect the contribution of Western Electric to AT&T earnings and, to that extent, enables the company to earn income on an inflated rate base.  While I am most anxious to insure the maintenance of quality service by AT&T, I am not willing to allow the Bell System to work within, and perhaps without, a range of return that can only have a serious impact  [*281]  on rate payers and a deleterious effect on the President's anti-inflation program.

For these reasons, I dissent.


APPENDIX:

APPENDIX A

BELL SYSTEM'S TESTIMONY AND DATA

Identify of Witnesses

1.  The Bell System, having the burden of proof (27 F.C.C. 2d at 163), presented witnesses who undertook to show that a rate of return of at least 9 1/2 percent was required under current conditions.  This evidence included: a review of the Bell System's policy with respect to earnings and capital requirements by Mr. John D. deButts, Vice Chairman of AT&T's Board of Directors; a review of trends in general economic and financial conditions by Dr. James J. O'Leary, Vice Chairman of the Board and Chief Economist of United States Trust Company of New York; testimony on current financial markets and investor requirements by Mr. Robert H. B. Baldwin, a partner in Morgan Stanley & Co., and Mr. Fergus J. McDiarmid, retired Chairman of the Investment Committee of Lincoln National Life Insurance Company; a description of the Bell System construction program by Mr. Richard R. Hough, President of AT&T's Long Lines Department and an analysis of Bell's cost of debt, cost of equity capital and capital structure by Mr. John J. Scanlon, Vice President and Treasurer of AT&T.  In addition, the Bell System presents Mr. W. W. Brown, Director -- Operating Results of the AT&T Long Lines Department, who testified on the financial and operating data for the Bell System; Dr. Alexander Robichek, Professor of Finance at Stanford University, who presented testimony in rebuttal to the Discounted Cash Flow (DCF) methods used by Trial Staff witnesses to arrive at their recommended rates of return; Dr. Martin B. Wilk, Director of Corporate Modeling Research for AT&T's Managerial Sciences Division who testified on the Gordon Model; and Mr. Robert W. Burke, Vice President of Moody's Investor Service, who testified on the rating of bonds.

Trends in Economic and Financial Conditions

2.  Dr. O'Leary testified that significant changes in economic conditions and the financial climate have taken place since the mid-1960's, and that they have had a significant impact on the cost of capital, both debt and equity.  There was a "period of stability" from 1960 to 1965, during which the rate of inflation was exceptionally steady; the Gross National Product (GNP) deflator rose at an annual rate of 1.4 percent, and the Consumer Price Index (CPI) had an average annual increase of 1.3 percent over that five-year period.  An "initial upsurge" in the rate of inflation took place in early 1966.  Then, the "inflationary movement subsided temporarily from the spring of 1966 to the summer of 1967:" during this period the indicators showed an arrest in the slight inflationary trend.  This period of price stability ended, however, in the fall of 1967, and from this period on there has been a period of rapid inflation.  The CPI increased 4.2 percent during 1968, 5.4 percent during 1969, and 6.1 percent during 1970.  He pointed out, that the effect on debt costs is shown in the following average yield on new issues of Moody's Aaa public utility bonds:

 

 

Percent

1960

4.77

1961

4.51

1962

4.36

1963

4.31

1964

4.46

1965

4.57

1966

5.44

1967

5.85

1968

6.57

1969

7.75

1970

8.59

 

During the latter part of 1970 and early 1971, interest rates dipped to about 7 percent, but since have climbed and, as of the close of the record, the yields on new bond issues were in the range of 8 percent.

3.  Dr. O'Leary testified that there have been three main forces accounting for the rising trend of interest rates: (1) during the expansion of the economy, as capital requirements have risen, the aggregate demand for capital funds has tended to outrun the available supply; (2) monetary policy (Federal Reserve and Treasury debt management) has often been forced to be restrictive as a means of combating inflation; and (3) inflation and the expectation of continuing inflation have greatly increased the aggregate dollar demand for capital funds, and at the same time reduced the willingness of savers to place their funds in fixed-income obligations unless the interest rate is high enough to offset the deteriorating effect which inflation is expected to have on the value of the dollar.  He states that, although governmental policy has been designed to moderate the rate of inflation, the expectation of a continuing high level of inflation is widespread.  Dr. O'l/eary testified that the Government's economic policy for 1971-1972, indicating an expansionary policy and an objective of a "full employment budget," has tended to rekindle the fear of inflation during the next few years.  The various indicators show a continuation of price increases in 1971: the wholesale price index for industrial commodities increased at an annual rate of 4.8 percent in April 1971, and the GNP implicit price deflator increased at an annual rate of 5.6 percent in the first quarter of 1971.  The pattern of wage settlements recently has also contributed to an expectation of further inflation.  Dr. O'Leary expects a gradual rise in the level of interest rates in the second half of 1971 because of: expected further increases in the total demand for long-term funds by corporations and the Government to record levels; the expected increases in the amount of Treasury borrowing in the latter part of the year; the continuing powerful expectation of a high rate of price level increases; the enormous backlog of demand for long-term financing by state and local government units; and the expected sharp rise in demand for home mortgage credit.  In his view, economic conditions in 1972 are apt to produce a sharper increase in interest rates.  This is based on an expectation of an inflation rate of about 4 percent in the next year, which, when coupled with a general improvement in the economy, would produce increased demands for credit.

4.  Mr. Scanlon testified that the dramatic rise in interest rates since the mid-1960's has had the effect of significantly increasing the returns equity investors require.  Mr. Baldwin testified that because the common stock investor requires a return substantially greater than the return he could get on a relatively riskless investment (i.e., on fixed income securities), when interest rates rise, the cost of equity also increases.  In an effort to measure the extent of changes in the capital markets since the mid-1960's, Dr. Wilk undertook to update the econometric model presented by Dr. Myron J. Gordon, a witness presented by the Commission Staff in the Docket No. 16258 proceeding.  (See 9 F.C.C. 2d at 87; 28 F.C.C. 2d at 612.) His objective was to reflect the intent and methodology of Dr. Gordon's analysis.  Dr. Wilk testified that whereas the Gordon model produced an overall rate of return of 7.29 percent as applied in Docket No. 16258, the application of the model to data reflecting current economic conditions produced an overall rate of return of 10.7 percent.

 

The Increase in Embedded Cost of Debt

5.  During the period since the mid-1960's, and particularly since 1969, the Bell System's requirements for new capital has increased substantially.  Respondents' witness claims that this is the result of the high level of demand for communications services, the introduction of new technology, and the price increases resulting from the high rate of inflation which further enlarged the dollar volume of construction expenditures.  These increases in the level of construction expenditures resulted in substantial increases in the amount of external financing required.  With the exception of a limited amount of capital obtained from the Bell System's employees' stock plan (which terminated in 1969, virtually all of the external capital funds were obtained in debt form since 1964.  In the mid-1960's Respondents' cost of additional debt was in the range of 4 1/2 to 5 1/2 percent.  The costs of the most recent issues of Bell System debt have ranged from 7.68 percent to 8.22 percent.

6.  In each of the years 1968 and 1969 the Bell System raised about $1 1/4 billion in the long-term debt markets.  In 1970 the external financing requirements increased to $4.2 billion, and this necessitated a step-up in the amount of Associated Company long-term debt issues to over $2.1 billion.  The 1970 debt financing program of the Associated Companies involved 17 issues, at a rate of one every three weeks averaging about $125 million per issue.  In addition, AT&T made an offering of $1.57 billion of debentures with warrants in April 1970.  This issue permits the warrant holder to purchase AT&T common stock at a price of $52 per share until May 15, 1975.  In November, 1970, AT&T also sold $350 million in long-term debentures and $150 million in intermediate-term debt.  The Bell System's 1971 debt financing program involves Associated Company debt issues totaling about $2.5 billion, about one issue every three weeks, and one issue of AT&T debt in the amount of $500 million.  Since new long-term debt has been selling at an appreciably higher cost than the average cost of existing debt, Bell's embedded cost of debt has increased from 3.9 percent in 1965 and 4.1 percent in 1966 to 5.8 percent at the end of 1970.  Assuming long-term rates in the range of 7 to 8 percent during the remainder of 1971, Bell's embedded cost of debt will reach a level of about 6.0 percent.

 

Credit Standing and Capital Structure

7.  Bell System witness stated that bond ratings provide the investor with a means of evaluating the investment quality of debt issues and that the quality of bonds depends essentially on how well interest payments and principal are protected.  Two of the most significant factors in determining the quality of an issuer's bonds are its debt ratio and its coverage of fixed charges.  Coverage of fixed charges indicates the amount by which a company's earnings.  Coverage of fixed charges indicates the amount by which a company's earnings cover its contractual obligations of a financial nature.  Coverage figures may be expressed in terms of coverage before taxes on income (pre-tax coverage) or income taxes (post tax coverage).  Debt ration should be considered with reference to interest coverage as the two measures are closely interrelated.

8.  Bell System's debt ratio and interest coverage have changed since 1965 as follows:

 

Debt ratio --

Post-tax

Year

end of year

interest

 

(percent)

coverage

 

 

(Times)

1965

31.5

6.4

1966

32.9

6.3

1967

34.5

5.5

1968

36.4

4.8

1969

39.5

4.3

1970

44.9

3.3

 

As the end of 1970, Bell's post-tax interest coverage had fallen to 2.9 times.  Witnesses claimed that the decline in interest coverage is due to the substantial /ii increase in the proportion of Bell debt, high interest rates, and the lack of earnings improvement.  Mr. Burke testified that interest coverage is one of the most significant factors influencing Moody's opinion about AT&T's credit rating; that AT&T is slipping toward the lower end of the range of the Aaa-rated utilities, and the ratings of certain Bell System companies are in a particularly vulnerable position.  Mr. Baldwin also expressed concern about the maintenance of the Bell System's credit standing if an all-debt financing policy were to be followed in the near future and if earnings improvement is not forthcoming.  He noted that some Bell System issues are on the edge of being downgraded if there is no rate relief.

9.  Mr. Baldwin expressed the view that, because of its unprecedented and continuous needs for new capital, it is of critical importance for the Bell System to maintain the highest credit rating on its debt securities.  He said that during a period of persistent inflation and tight money, there has been a marked change in investors' attitudes toward the advisability of tying up funds in long-term, fixed income securities and an increasing desire for high quality investment.  As a result, the market for lower quality debt issues has narrowed.  He said that the increasing importance of individual inestors in the bond markets has added to the need for Bell to keep its highest credit standing.  In times of a higher level of interest rates, individuals become substantial purchasers of debt securities.  In the issues of AT&T and the Bell operating companies in 1970, a substantial percentage (from 25 to 50 percent) was purchased by individuals, whereas a much smaller percentage of issues of less quality was taken by individuals.  Mr. Scanlon also testified

"We are concerned about losing the Aaa ratings and falling perhaps to Aa or A.  The concern does not rest solely on the differences in cost between what it might cost us to sell at an Aaa versus Aa... but it rests more on our assurance of the broadest possible market for our debt.  Because of the heavy draft we make on the market, because of the frequency with which we come to market, we have been advised on all sides in the investment community that it is highly desirable for us to keep this Aaa rating.  A combination of a household name and an Aaa rating assures us of access to the broadest possible market."

10.  Mr. Baldwin testified that a high credit rating permits a company to finance exclusively through debt when conditions for the issuance of common stock are unfavorable and that even a downgrading to an Aa rating would have serious effects on the Bell System's ability to finance.  The cushion to resort to all-debt financing in a period when equity financing is unfavorable would be seriously impaired and such downgrading would sake investor confidence in Bell debt.  Mr. Baldwin testified that a downgrading of Bell securities would not only have serious effects on the Bell System but it would have adverse effects on the market for other corporate debt (Tr. 1810, 1879, 2027; also Tr. 3660-61).

11.  The Bell System's interest coverage has changed substantially in comparison with that of the Aaa electrics.  As compared with Bell's post-tax coverage of 6.3 times in 1966, the Aaa electrics' coverage was 4.7 times.  Since then, there has been a decline for both the Bell System and the electric utilities, but the decline for the Bell System has been steeper.  For the year 1970 Bell's post-tax coverage of 3.3 times was about the same as the Aaa electrics' coverage of 3.2 times.  At the end of 1970, however, Bell's post-tax interest coverage had dropped to 2.9 times, below the average of the Aaa electrics for the year.  The claim by the witness is that Bell System debt issues in the past have sold at yields somewhat above those of the Aaa electrics despite Bell's lower debt ratio and higher interest coverage, and that these margins are required to sustain its competitive position in the debt market and to merit continued investment interest in Bell debt issues.

12.  Mr. Burke stated that it is Moody's view that AT&T, in comparison with the electrics, requires higher interest coverage and should maintain a lower debt ratio in order to retain an Aaa credit standing.  From the standpoint of Moody's evaluation of investment risk and the criterion of stability of earnings, the telephone business by its nature is more subject to fluctuations and is more vulnerable to adverse business conditions than the electric utility business.  Thus, he says that AT&T needs greater interest coverage than the electrics, since AT&T has a lower percentage of pre-tax earnings per revenue dollar to assist in meeting its interest requirements than does the electric utility industry.  Accordingly, he claims AT&T cannot have as high percentage debt in its capital structure as do the electric utilities.

13.  In the opinion of the Bell System witnesses, the current 45 percent ratio represents the prudent limit of debt in Bell's capital structure.  The basis for this conclusion was summarized by Mr. Scanlon as follows (Bell Ex. 34, pp. 15-16):

"I believe it is essential that we maintain our Aaa rating.  The frequency and volume of Bell System debt issues to be marketed in the years ahead require that, at the least, we maintain our present credit standing.  Accordingly, we must continue to carry a debt ratio somewhat below that of the Aaa electric utilities and to show an interest coverage somewhat above that of the Aaa electrics if we are to assure our access to the capital market for the requisite amounts of debt capital on terms that are fair to our customers and shareowners.  In the present circumstances, it is my belief that a debt ratio of 40% to 45% of total capital would be an appropriate objective for the Bell System, and that we should strive to structure our future financing so as to achieve that objective.  Such a capital structure would restore a margin of borrowing capacity for periods such as the present, when the raising of equity capital is impractical.  And such a capital structure should serve to maintain our competitive position in the market for debt capital."

 

Mr. Scanlon testified that a capital structure of 50 percent debt, along with its adverse effects on the credit standing of Bell System debt, would not diminish the return on total capital that AT&T requires.  He stated that "we have pushed our debt ratio and cost up to the point where the calculated earnings requirement would be at least as great with more debt than it would be with what we now have in the way of debt." Mr. Scanlon claimed that, with a 50 percent debt ratio, Bell's embedded cost of debt would increase, approaching the 6.5 percent level in the next two years and with an equity return requirement of at least 12.5 percent, the resulting return on total capital would still be 9.5 percent.  The increased leverage in the capital structure under a 50 percent debt ratio, he claimed, further increases the risks to the equity holders and pushes up the necessary return on equity.

14.  In the opinion of Mr. Baldwin, a policy of maintaining a debt ratio in the range of 40-45 percent is a reasonable policy for the Bell System to pursue under present conditions.  He said that debt ratio which does not exceed the top of this range would appear to be a reasonably safe figure if the System is to protect its Aaa ratings, assuming adequate coverage is maintained.  Mr. Baldwin recommended as a prudent financial policy, however, the maintenance of a debt ratio below the desired maximum to provide some reserve of borrowing capacity.  Such a reserve is of particular significance for the Bell System, which is not able to defer capital expenditures without adversely affecting service to its customers.  He said such a reserve would enable Bell to continue necessary financing during periods of adverse conditions in the equity markets.

 

The Need for Equity Capital

15.  The Bell System's claim is that its operations are highly capital intensive and, if it is to meet service demands, the sale of securities cannot be limited to periods when the financial climate appears to be favorable.  The capital markets must be tapped repeatedly for a continuous flow of tremendous amounts of new funds which cannot be deferred in the hope that the market may improve.  The Bell System's needs for external financing in 1971 are estimated to be in the range of $4.0 to $4.2 billion.  To finance the construction expenditures for 1971 estimated to be about $7.7 billion, the Bell System will have available internally generated sources of funds from depreciation and other accruals, amounting to about $2.7 billion, and from retained earnings in the range of $1 billion.  The 1972 construction program is estimated to be somewhat higher than in 1971, about $8.2 billion.  With a construction program expected in the next several years to be at least as much as in 1971, the Bell System must obtain more than half of the needed funds from external financing.  This means that the Bell System must annually raise new money in the range of $4 billion in the capital markets for the next several years -- more than $10 million for each day of the year.  Such external financing requirements must be met by attracting both debt and equity capital.  With a $7.7 billion construction program in 1971 and depreciation accruals supplying $2.7 billion, the remaining $5 billion must be generated by retained earnings and external financing.  To keep the capital structure of debt and equity in about the same proportion as now exists, nearly half of the $5 billion must come from debt and one-half from equity.  This requires new equity financing of about $1.5 billion (with retained earnings supplying the remaining $1 billion of equity).

16.  Mr. Scanlon testified that with construction expenditures of the magnitude described above, the Bell System's return requirements must be set in such a way as to insure the necessary flow of a very large volume of capital funds.  He testified further that, even if no external capital had to be attracted, fairness to existing investors would call for a rate of return determined by the cost of attracting capital in the money markets.  When capital must be attracted in substantial amounts, as is now the case, the public's interest in assuring the provision of adequate service constitutes an additional and compelling reason for prescribing a rate of return sufficiently high to attract funds in the light of current costs of capital.

17.  As to debt, Mr. Baldwin was of the view that there are financial constraints limiting the frequency and magnitude of Bell's debt financing under current money market conditions.  He noted that the Bell System is the largest single issuer of corporate debt securities in the United States and he concluded that the present annual volume of Bell System straight long-term debt financing is approaching the current maximum that can be accomplished on a continuing basis in the conventional debt market on reasonable terms.  If Bell were to offer substantially more straight debt every year, a substantial rate differential would develop between Bell debt and that of other utilities of high credit standing.  He said that the present frequency as well as the size of Bell debt issues, has contributed to a congestion in the debt market and the market is close to a saturation point on absorbing Bell debt.

18.  As to short-term debt the Bell System embarked on a program in 1968 where they obtained the major portion of their short-term needs from bank loans and the sale of commercial paper.  This process helped for a time to mitigate the Bell System's reliance on the long-term debt market. Mr. Scanlon concluded that the size of such short-term obligations has now reached the maximum range (about $2 billion) and that additional amounts of such debt cannot prudently be carried.  Mr. Baldwin testified that AT&T and its subsidiaries have reached a desirable maximum under present conditions on their short-term borrowings and that it is an unsound business practice to use short-term debt to pay off long-term debt.  Mr. Scanlon also noted that, although the Bell System has employed a limited amount of intermediate-term (i.e., 5 to 7 year maturities) debt recently, the market for this type of financing is not as widespread as for long-term debt.  Further, he stressed that the issuance of such debt in large amounts could create enormous problems in refunding if there are adverse circumstances in the capital markets in the mid-and late-1970's.

19.  In addition the Bell System claims that its access to the debt markets is greatly limited by its present earnings position and deteriorating credit standing.  An all-debt financing program in 1971 and 1972 would result in a debt ratio of 48.4 percent at the end of 1971 and 51.4 percent at the end of 1972.  If earnings were held to the rate of return prior to the filing for increased rates, and long-term debt were issued at an average cost of 7 1/2 percent, Bell's interest coverage (post-tax) would decline to 2.64 times at the end of 1971 and to 2.33 times at the end of 1972.  This level of post-tax interest coverage is below that of the Aaa electrics, which was 3.2 times in 170 and would be below the coverage of the single A electrics (2.5 times in 1970).  It is, therefore, Bell System's claim that all-debt financing would result in a downgrading of its credit standing and that, in view of the increase in Bell's debt ratio, and the continuing decline in its interest coverage, new equity capital must be injected in Bell's capital structure in order to maintain Bell's credit standing.

 

Current Equity Earnings Inadequate

20.  Bell System witnesses claimed that the current market price for AT&T stock effectively precludes a common stock offering at a price that would be fair to existing shareholders.  It is stated that the market price for AT&T has been persistently depressed since 1965 as follows:

 

Average market

 

price per share

1965

$66.83

1966

55.92

1967

54.87

1968

51.87

1969

52.92

1970

46.75

 

The low price of $40 3/8 reached in June 1970 is about 40 percent below the high of $75 reached in July 1964.  There was a brief rally in AT&T's market price in early 1971, where prices in the low $50's were reached for a short time, but since then AT&T's market price has generally been in the range of $44 to $49.  It was selling at $44 1/2 at the close of the hearings.  Although the market generally recovered significantly in 1971, AT&T's market price remained stagnant during the recovery, as shown below:

 

 

Dow Jones

A.T.&T.

 

average

market

 

 

price

Date of Dow Jones Industrial Low (May 27, 1970)

631.16

$43.12

Date of Dow Jones at 920 level (May 19, 1971)

920.04

46.63

Percent increase (percent)

45.8

8.1

 

In recent years AT&T stock has had a poorer price record than either the industrials or the public utilities and AT&T's market price in relationship to the performance of these other stocks has placed the Telephone Company at a material disadvantage in the sale of new equity.  As a result more than half of the Company's shareowners find the present market price of their shares below the price at which they first bought their shares.

21.  The relationship of market price to book value is of critical importance according to the opinion of the Bell System witnesses.  The following shows how market price for AT&T compared to book between the 1960's and 1970:

 

 

Average

Average

Market/book

 

market price

book equity

relationship

 

per share

per share

 

1960

$43.76

$26.91

1.63

1961

59.71

28.78

2.07

1962

58.09

30.15

1.93

1963

61.73

31.49

1.96

1964

69.90

34.08

2.05

1965

66.83

35.80

1.87

1966

55.92

37.43

1.49

1967

54.87

39.00

1.41

1968

51.87

40.54

1.28

1969

52.92

42.10

1.26

1970

46.75

43.52

1.07

 

As of the close of the record (June 3, 1971) AT&T's market price ($44.50) was below its net book value of $44.75.

22.  The testimony was that AT&T's ability to finance in the future would be seriously impaired if it were forced to resort to a sale of common stock that would yield an amount less than book value; that such a sale involves a dilution of investment and earnings value per share of existing shareowner; that such dilution would effectively preclude AT&T's access to the equity markets in the future to raise sufficient amounts of capital; and that shareowners and investors generally would be extremely wary of investing in a company that followed a policy of undermining the value of existing investment.  For the Bell System, that has recurring and substantial capital needs, to make repeated efforts to market new shares at prices below existing book value, would prove to be self-defeating.  Mr. Baldwin states that AT&T shareholders in the past have been an important source of new equity financing for the Bell System, and such investor loyalty is an extremely valuable asset in financing equity.  A good earnings and dividend record is essential if this support is to be retained.  If, as a result of dilution, shareholders were to find that their participation in offerings worked to their detriment rather than in their favor, this large source of new capital might well be lost.

23.  It is also claimed that the market/book relationship for AT&T stock when compared to other utilities, has an important bearing on AT&T's ability to attract new equity through a common stock offering.  Electric companies generally sell at a market price significantly above book value.  All of the Aaa electrics sold above book value for 1970, the market/book ratio ranging from 1.15 to 2.38, with the average being 1.61.  In January 1971, the average of Moody's 24 utilities sold at 145 percent of book value.  The assertion is that the companies with favorable market book relationships are in a position to issue new equity; they have ready marketability because of their higher investor appraisal; and such new issues not only improve the ability of those companies to attract new capital, but they also enhance the position of their existing shareholders by further contributing to the growth in earnings per share as well as increasing their proportionate underlying investment.

24.  Mr. Baldwin testified that a rights offering is an important means of raising capital for AT&T and that an equity rights offering should be set at an offering price that is at least 15 percent to 20 percent under the market price.  That is, if the book value is $44. the market price for the stock should be selling at a minimum of $55 per share in order to permit a rights offering that does not result in dilution.  Mr. Scanlon concluded that in order to sell common stock without dilution. the premium of AT&T's market price above book value should be in the order of 20 percent. Mr. Scanlon also testified that "because of the importance of the rate of growth in earnings per share and satisfying equity investors' return expectations it is important that when you do sell equity you do it if at all possible at prices above book value." He explained that a sale of common stock that would permit the Company to receive proceeds just at book value would not be adequate to contribute to an increase in the growth rate in earnings per share that is necessary to satisfy investor expectations.

 

A Return on Equity in the Range of 12 1/2 Percent Is Required

25.  The Bell System's witnesses contended that the two major changes affecting AT&T's cost of equity are (1) the increased leverage in AT&T's capital structure substantially adding to the risks assumed by the equity holders, and (2) the general increase in the cost of both debt and equity capital since the mid-1960's.  It is claimed that the Commission found that at the time of its decision in Docket 16258, the electrics were earning 11.7 percent on equity and that the Commission recognized that as the Bell System moved toward a higher debt ratio, its equity return would move closer to 11.7%.  The Commission, it is claimed, thus recognized that the increase in Bell's debt ratio involved greater risks to the equity holders, but at the same time it assumed that the shareholders would be compensated for such greater risks through increased equity returns approaching 171. percent under 1965-1966 economic conditions.

26.  It is further argued that, at the time of the Commission's decision in Decket No. 16258, interest rates were in the range of 5 1/2 percent and were expected to go lower: that this was a level substantially below the range of 7 to 7 1/2 percent rate of return found to be fair at that time; and that the Commission's premise -- that within any allowable overall rate of return, earnings on equity will increase as the proportion of debt rises -- was arithmetically correct under such conditions.  However, when interest rates for new debt are about equal to the level of the return earned on total capital, increasing leverage does not serve to improve equity earnings and when interest rates for new debt exceed the level of the overall return, a decline in equity earnings takes place with increased leverage.  This, it is stated, was the situation during recent periods when current interest rates were significantly in excess of Bell's overall return.  Under recent conditions, therefore, increasing the debt ratio has had a depressing effect on equity earnings, which is the reverse of the situation anticipated by the Commission in its Docket No. 16258 decision.

27.  Bell System's witnesses testified that in a situation where current interest rates exceed the return earned on total capital, equity earnings are not improved by merely raising the allowable rate of return on total capital to reflect the increase in the embedded cost of debt and nothing more.  Such action would simply maintain the return on equity at the level that had existed at the time the debt ratio was lower.  Thus, a marked rise in interest rates coupled with a substantial rise in the debt ratio requires that the return on equity also be increased for two important reasons.  First, the substantial increase in the debt ratio significantly increases the risks borne by the equity holders by concentrating the risks of the enterprise into a smaller proportion of the total capital, with an accompanying sharp decline in the proportion of earnings available for equity.  Second, and quite apart from the increase in the equity risks, the same forces at work in the financial markets which caused the cost of debt to rise so markedly also increase the cost of equity capital.  The Bell System's rate of return on equity since 1965 is as follows:

 

 

Percent return

 

on average

 

common equity

1965

9.5

1966

9.9

1967

9.7

1968

9.3

1969

9.5

1970

9.2

 

As a consequence of the recent decline in the rate of return on equity, the earnings per share in 1970 ($3.99 per share) showed no growth over the earnings per share in 1969 ($4.00 per share) despite the fact that Bell's equity investment had been increased by $760 million through retention of earnings from stockholders.

28.  It is claimed that changes in the capital structure since the Commission's decision in Docket No. 16258 alone would call for a substantial increase in Bell's rate of return on equity.  The debt ratio has risen from 31-33 percent to above 45 percent, but its equity earnings in the 9 percent range are still no higher than at the time of the Docket No. 16258 decision.  Thus, even if the returns required by investors were the same today as they were in the mid-1960's, the greater risks to the equity investors caused by the substantial increase in its debt ratio, and the concomitant reduction in interest coverage, would require an improvement in equity return.

29.  Witnesses testified that a level of equity earnings in the range of 12.5 percent is reasonable compared to the current level of interest rates available on fixed-income obligations -- investments of much lower risks.  Current interest rates on Aaa bonds (the highest quality debt investment) have been in the 8 percent range.  Yields on other fixed income obligations are even higher than interest rates on Aaa debt.  Although interest rates have subsided somewhat since their highs in 1970, they are still several percentage points higher than in the mid-1960's.  The Bell System's equity return objective, as Mr.  Scanlon testified, was based on an expectation of interest rates at a level of 7 to 8 percent.

30.  With respect to the spread between AT&T's cost of current debt and its average return on equity, as AT&T's debt ratio increased, this spread has decreased as follows:

 

 

Debt ratio

Current cost

Return on

Percentage

 

 

of debt

equity

point spread

1961

32.8

4.6

9.5

4.9

1962

34.5

4.4

9.5

5.1

1963

33.9

4.4

9.5

5.1

1964

31.5

4.5

9.5

5.0

1965

31.5

4.6

9.5

4.9

1966

32.9

5.5

9.9

4.4

1967

34.5

5.9

9.7

3.8

1968

36.4

6.6

9.3

2.7

1969

39.5

8.0

9.5

1.5

1970

44.9

8.8

9.2

0.4

 

Restoration of the prior five point spread would require a rate of return on equity exceeding 12.5 percent according to Bell System's witnesses.  Respondents further contend that, at the time of the Commission's decision in 16258 the current cost of Bell debt was in the range of 5 1/2 percent with an expectation of going somewhat lower; and that the rate of return on equity associated with the Commission's determination of 7 1/2 percent as the allowable overall rate of return and a 45 percent debt ratio was 10.4 percent.  Thus, it is argued that the Commission considered a five percentage point spread between current interest rates and return on equity appropriate.

31.  The claim is asserted that, in determining an appropriate level of equity earnings for AT&T, comparison with the electrics is another appropriate measure.  Mr. Scanlon concluded that the financial risk for AT&T stock is now about in parity with that of the electrics, and that, with the increase in business risks attending AT&T since 1966, AT&T now requires a return on its equity fully comparable to that of the electrics.  The price/earnings ratios of the electrics are comparable to that of AT&T.  Mr. Scanlon pointed out various respects in which he considered that the electrics have greater stability, and hence, less risk than the Bell System because the earnings of the electrics indicate a lower vulnerability to a turndown in business (the Moody's Aaa electrics had an increase in their rate of return on total capital in 1970); the electrics operate under a rate structure that is less susceptible to adverse business conditions; and the electrics have a lower complement of labor which makes them less vulnerable to the recent inflationary effects of wage increases.  Other witnesses also testified that AT&T is as risky, if not more so, than the electrics.

32.  Mr. Scanlon testified that, during the period 1966-1969, the earnings rate on equity for the regulated electrics has been in the range of 12.5 percent.  Many electrics are seeking rate increases to attain higher returns on equity.  In current rate cases in progress, the electrics are their equity.  On the basis of these data, Mr. Scanlon concluded that in order to asking for 13 1/2 percent and upward on attract equity capital in competition with the electrics and other companies coming to the market for equity financing, AT&T must earn in the range of 12.5 percent on equity.

33.  Mr. Scanlon stated that the level of return required to attract equity investment is substantially influenced by the institutional investors which are a dominant force in the market for equity securities today and that the approach of the institutional investor is to look for a total return on his investment through a combination of dividend and price appreciation.  The price appreciation is presumed to derive chiefly from growth in earnings per share -- from which increases in dividends and market price should follow.  Consequently, growth in earnings per share is an important factor in investment analysis and decision-making today.  Mr. Scanlon's review of market letters and the Company's discussions with representatives of institutional investors indicate that such investors in general are requiring annual growth rates in earnings per share for AT&T of 6 percent or better.  Mr. Scanlon concluded that this growth rate, coupled with AT&T's current dividend yield, indicates that investors require an earnings rate on AT&T stock to be at least 11 percent on market value.  With AT&T's return on book equity at a level of only 9 percent, its current growth rate in earnings per share is only a little more than 2 percent per year.  He contends that AT&T must realize a substantial improvement in its equity earnings to achieve the earnings growth rate and market return needed to attract equity investment.

34.  Data from a simulation model were presented by Bell witnesses to show that, if Bell maintained its current debt ratio of 45 percent and if new debt costs were in the range of 7 percent to 8 percent, a return on total capital of 9.5 percent (which would produce an equity return on the range of 12 1/2 percent) would result in an annual growth rate in earnings per share from 4.2 percent to 5.4 percent (depending on whether the price/earnings ratio for AT&T stock is 11 times or 13 times).  In contrast, an 8.5 percent return on total capital (producing equity earnings in the 10 1/4 percent range) would result in an annual growth rate of only 2.4 percent to 4.0 percent.  A 7.5 percent return on total capital (with equity earnings in the 8 1/2 percent range) would produce a growth rate ranging from a negative 1.1 percent to a positive 1.7 percent.  Accordingly, the contention is that a return on total capital at the 9 1/2 percent level is necessary for AT&T to achieve an earnings growth rate near the 5 percent level through retention of earnings.  Additional growth in earnings per share would result from AT&T's ability to issue new common stock on terms where the proceeds per share would exceed the book value per share.

35.  Mr. Baldwin testified that AT&T must be able to attract equity capital from new investors with its offerings as well as from existing shareholders.  The increasing trend among American corporations to issue new equity significantly adds to the supply of securities available for investment and heightens the already highly competitive nature of the equity markets.  He observed that in order to issue equity in such highly competitive capital markets, the potential investor's expectation of the likely return on an investment in AT&T must be at least equal to expected returns on comparable investments.  In the view of Mr. Baldwin the informed investor of today is looking for market returns (dividends and market appreciation) on his common stock investment in the area of 11 to 13 percent.  He concluded that AT&T's current dividend yield coupled with its low recent earnings per share growth is inadequate to attract investors.  Mr. Baldwin states that an upward trend in earnings per share and dividends will have to be re-established for AT&T to attract the large amounts of new equity capital needed and that AT&T must bring its equity return up to the range of 12.5 percent in order to offer investors the minimum return on market value necessary to attract substantial amounts of new capital.

36.  Mr. McDiarmid was of the opinion that an appropriate return on the equity capital of AT&T is in the range of 12.5 to 13 percent.  He stated that this return provides only the minimal spread over the current cost of senior capital, and only modestly higher than those returns (close to 10 percent) available to institutional investors on many bonds and mortgages.  Mr. McDiarmid testified that his recommended return on equity is in line with that return earned in recent years by the electric utilities, which return the electrics are now seeking to improve.  He said that even under this recommendation there is room for substantial doubt whether it is high enough.  In his opinion, a 12.5 to 13 percent equity return is the lowest rate AT&T should earn to enable the Company to sell new common stock without diluting the equity interests of existing stockholders.

37.  Mr. Scanlon testified further that with a 9 1/2 percent return on total capital, with a 12 1/2 percent return on equity and maintenance of 45 percent debt ratio, there would be a halt to the further decline in the Bell System's interest coverage and Bell would be able to maintain interest coverage in the range of 3.2 to 3.3 times, which is comparable to that of the Aaa electrics.

 

Rebuttal to Trial Staff Witnesses

38.  Dr. Robichek disagreed with the concept of applying a DCF rate, based on a market evaluation of investor expectation, to the net book value of the equity investment as was done by Dr. Myers and Mr. Kosh, witnesses for the Trial Staff.  A distinction must be made between the concepts of (1) the rate of return expected by investors purchasing a security at its current market price (i.e., a "market" oriented DCF rate), and (2) the rate of return related to the net book value of capital (i.e., a "book" rate).  It is a contradiction, he says, to use such a "market" rate as a multiplier to be applied directly against a net original cost rate base, which has a per share value different from the market price per share.  Application of the DCF net book value of capital (i.e., s "book" method in this manner has the consequence of forcing the market price per share to its net book value.  Such a policy would be a circular process, it is claimed.  Moreover, he claimed that the DCF method depends upon "hazardous" estimates of investor expectations, since the growth factor "g" in the DCF formula depends in large degree upon the level of carnings regulatory agencies will allow.

39.  Mr. Burns submitted testimony and date, which its is contended show that a 50% debt ratio proposed by Mr. Kosh would not provide the interest coverage claimed by Mr. Kosh; but such interest coverage would be somewhere between the A and Baa electrics which have a debt rating substantially below the Aaa electrics.

 

Exhibits Other Than Testimony of Witnesses

40.  In addition to the testimony of the aforementioned witnesses, the Bell System provided for the record a number of additional exhibits briefly described as follows:

Number of AT&T Shares Outstanding (pg. 902 of Bell System Statistical Manual)

Cost of Debt for Bell System (pg. 112 of Bell System Statistical Manual)

Percentage Composition of Total Capital (pg. 408 of Bell System Statistical Mannual)

Bell System Capital and Debt Ratio as of February 1970

Number of AT&T Shareowner Accounts

Commission's Public Notice dated 11-5-69 ($150 million reduction)

Commission Memorandum Opinion and Order 12-31-69

Commissioner Cox's and Johnson's dissent to $150 million reduction

Major Collective Gargaining Settlements, 1970

Current Wage Developments May 1, 1970 Issue No. 269

Current Wage Developments Jan. 1, 1971 Issue No. 277

Comparison of Rate of Return on Market Investments-Lincoln Life Performance versus various mutual fund summaries

Market prices for Moody's Utilities plus 3 companies

Changes in Ratings for Bonds $5 million and over issued since 1913

Major non-MTS Rate Changes 1952-1970

Effect on Rate of Return on MTS Rates effective 10-1-53

Interstate MTS and Private Line Revenue Compared to Total Interstate Revenue

Interstate MTS and Private Line Revenue as shown in Exhibit 19 revised and updated to include years 1952-1970

Dividend Payout Ratios for AT&T and Other Industries

Statement of W. W. Betteridge

Interestate Cost of Service Study 8/31/7 under 7 methods (not offered in evidence)

Speech by R. W. Burke on Rating Service for Utility Bonds

Quality of Service Report

20 City Report Data Summary (Quality of Service)

Analysis of Causes i Change in Interstate Maintenance Expenses

Analysis of Change in Maintenance Expense

Analysis of Causes in Change in Interestate Traffic Expenses

Analysis of Change in Traffic Expense

Bell System Interstate Service Revenue 1960-1970

Number of Bell System Employees added for Maintenance 1965-1970

Interstate Data re Messages, ARPM, Av. Length of Haul and Call by Mouth since 1966

Embedded Cost of Debt 1971

Percent Wages are of total Expenses 1969, 1970 and Est. 1971 for the Bell System

Margin of Safety (certain Electrics vs. AT&T) 1969 and 1970

Debt charges in relation to Available Income (Bell System)

AA Electric with Pre-Tax Interest Coverage 4.9 or more in 1969

Bell Telephone Debt held by 18 Large Insurance Cos.

Total Electric Utility Industry, Revenues, KWH and Cents per KWH for 1969

Revised Staff Exhibit 20 re Debt and Equity Earnings

Table showing that 40% Debt for Subsidiaries + 40% for Parents results in 60% Debt for Combined

Bell System debt Ratio and Interest Coverage 1970-1972

1965 Common Stock Subscription offcers -- Utilities

Interest Coverage (SEC Method) and Debt Ratio 1970

Companies with Debt Rated AAA by Moody's -- April 1971

Consolidated Edison Terms of New Common Equity Offers 1959-1970

Cost of Bell System Issues and Money Rates 1950 -- 3/30/71

Vandalism Costs -- Coin Stations

Employee-Shareowner Account Activity 1965 to 1968

New Purchases and Sales of Mutual Funds during 1970

Return on Average Common Equity Investment 1960-1969

Return on Average "Common Stock and Surplus" 1960-1969

Past Average Rates of Return on New York Stock Exchange Common Stocks and Corresponding High-grade Bond Yields

New York Times Article of 4/21/71 entitled "Market Place".  How the funds look at AT&T

Estimating an Infinite Stream of Dividends

Calculations re Rate of Return Assuming Certain Changes on Equity, Debt and Embedded Costs

Except of D. Kosh Testimony regarding Capitalization Rate submitted Feb. 1971 in connection with C & P Tel. Co. Case of W. Va.

Computation of the Capitalization Rate at Various Rates of Growth

DCF Calculations for AT&T, W.U. and Airlines

Table Showing No. of Shares Traded by AT&T and those Principle Telephone Company Subsidiaries used by D. Kosh in his Study

Discount Price Underlying Kosh's 3 Year Average

Recalculation of Cost of Debt originally submitted by Kosh by AT&T Using a Higher Interest Rate for 1971

Excerpt from FCC Exhibit No. 2115 "Cost of Capital to AT&T from the Original Investigation Study of the Telephone Industry (1936)"

Bell System Long-term Debt Issues 1970-1971

Recent Monetary and Interest Rate Developments

Moody's Bond Survey May 1971

Wholesale Price Index for Industrial Commodities

Changes in Dow-Jones Industrial Average and AT&T Stock 1970-1971

First National City Bank Monthly Economic Letter May 1971

Simulation Results of Model (Financial)

List of Open Requests from Transcript

Dollar Returns from a 35 Year Investment in a 35 Year $45 Bond at 10% Interest with Mandatory Reinvestment of 40% of Interest Payment on Bond

AT&T Prospectus on $4 Convertible preferred Shares

List of Bell System Rate Case filing since 1968

Bell Date Officially Noticed

41.  In addition to matters elsewhere officially noticed here, we take notice of the approximately 65 pages of material submitted by Bell at the request of the Trial Staff in its letter to Bell of August 3, 1972.  This additional material is identified as follows by tab numbers:

Tab 1 --

Consumer Price Index

Yield on Moody's Aaa utility bonds

Growth in construction expenditures and new money requirements

Bell System Long-Term Debt Issues

Bell System Intermediate-Term Debt Issues, 1970 to date (Same format as for Long-Term Debt Issues)

Bell System debt ratio

Bell System debt costs

Bell System preferred stock ratio, 1970 to date

Bell System preferred stock cost, 1970 to date

Interest Coverage (post-tax)

Debt ratio, AAA electrics

Costs of new bond issues

Market prices -- Moody's 125 Industrials, Moody's 24 Utilities and AT&T

AT&T market and book values

Market/book ratios -- Moody's 125 Industrials, Moody's 24 Utilities, AT&T

Price-earnings ratios -- Moody's 125 Industrials, Moody's 24 Utilities, and AT&T

Equity earnings of alternative investments

Bell System equity earnings vs. debt costs

Bell System short-term debt at year end 1970 and 1971 and July 31, 1972 and cost rate at each of these dates.

Tab 4 --

Bell System Interest Coverage -- Pre- and Post-Frderal Tax

Tab 5 --

Summary of Aaa Electric Utilities (Capital Structure Ratios)

Summary of Moody's 24 Utilities (Capital Structure Ratios)

Post-Tax Interest Coverage -- Summary of Aaa Electric Companies

Pre-Tax Interest Coverage -- Summary of Aaa Electric Companies

Post-Tax Interest Coverage -- Summary of Moody's 24 Utilities

Pre-Tax Interest Coverage -- Summary of Moody's 24 Utilities

Tab 6 --

Present AT&T shareowners bought shares intially at prices

Tab 7 --

Construction Program Data -- Class A & B Privately Owned Electric Companies

Tab 9 --

Bell System Debt Maturing Annually

Tab 10 --

Anticipated Bell System Construction Expenditures, Interestate and Intrastate

Estimated sources of internal financing, excluding retained earnings

Tab 12 --

AT&T Warrant Prices

APPENDIX B

TRIAL STAFF'S TESTIMONY AND DATA

Dr. Myers

1.  The Trial Staff submitted the testimony of two expert witnesses on the cost of capital and fair rate of return for the Bell System.  The first, Dr. Stewart C. Myers, is an Associate Professor of Finance at M.I.T.  He discussed the applicability of finance theory to public utility rate cases and to the rate of return issue and concluded that AT&T's return on equity should be 10.5% and that the overall rate of return should be 8.5%.  Dr. Myers used the Discounted Cash Flow (DCF) method to estimate the cost of equity capital.  He made a study of and examined the characteristics and past performance of AT&T common stock, in comparison with the market as a whole over various periods of time.  He concentrated on the volatility of price changes in AT&T stock as against those of the market as a whole in order to judge the relative riskiness of AT&T stock as an investment compared with all other stocks.  He concluded that AT&T has a marked sensitivity index of.7 as compared to 1.0 for the market as a whole.  Dr. Myers also studied the total yield on a large number of stocks over a number of different internals (1926-1965; 1945-1965, etc.), and concluded that "investors are expecting a return of 10-12% from an 'average' security".  His view is that, taking into account various complicating factors, these bounds can be taken as probable, but not absolute view is that, taking into account various limits on investors' expectations for the market as a whole.  However, since, in his view, AT&T is less risky than the average, Dr. Myers concludes that it should provide a return in the lower part of this 10-12% range which he recommends be fixed at 10.5%.

2.  Dr. Myers testified that an increase in the Bell System's debt ratio to 50% would decrease the overall cost of capital to the company slightly.  He stated that the cost of equity capital is sensitive to changes in interest rates, and that consideration of the rise in long-term interest rates of.4 of one percentage point since the date of submission of his written testimony would lead him, if considering that aspect of the matter in isolation, to increase that cost of equity to about 10.9%.  He stated, however, that other factors might well have changed since the date of the submission of his testimony affecting his other conclusions and that interest rates were just one factor.  He said his overall recommendation would not necessarily be changed any time interest rates change because there are many other factors involved.

3.  Dr. Myers expressed the view that the Commission, once having found the fair rate of return, should apply conscious use of regulatory lag and should allow the experienced overall rate of return to fluctuate 2 percentage points on either side of the fair rate found by the Commission.  He also claimed that reliance on regulatory lag would result in a "looser system" than one where earnings are equal to cost of capital at all times and applied to book value so as to push market price to book value.  Under his recommendations, he stated that market would be higher than book.

Mr. Kosh

4.  The staff's second expert witness on rate of return was Mr. David A. Kosh.  Mr. Kosh is a recognized public utility consultant who has testified in numerous regulatory proceedings including many involving Bell System companies.  He testified before this Commission in The Western Union Telegraph Co., 27 FCC 2d at 524-530.

5.  Mr. Kosh also used the DCF method (Staff Ex. 58, pp. 33-34) to estimate the cost of equity capital, although there are differences in the details of the studies made by Dr. Myers and Mr. Kosh.  Mr. Kosh concluded that the overall cost of capital to Bell is 7.9%, with an equity return of 9.75%, based on his recommendation that the Bell System adopt a 50% debt ratio.  For estimating the sustainable, long-run growth factor used in his DCF formula, Mr. Kosh refers to data on five selected operating companies of the Bell System as the best indicia of what might be expected for the future.  He concluded that investor expectations for dividend yield were 5.1% (after allowance for pressure) and 4.5% for growth.  The cost of equity capital of 9.6% was increased to 9.75% by addition of a "margin of safety" of 0.15%.

6.  Mr. Kosh stated the view that, with an increase in the debt ratio there should be, theoretically, an increase in equity earnings.  However, he testified that he was able to make definitive analytical statistical studies based on data of electric and combination gas and electric companies, to test the effect of capital structure on the cost rate of equity and that these studies showed that for equity ratios in the range of 35% to 50%, capital structure had no effect on the cost of equity.

7.  Mr. Kosh stated that, in a Wisconsin case, he had testified that: "When the rate actually being earned on equity is equal to the cost of equity as computed by the discounted cash flow formula, i.e., cost of equity equals dividend yield plus growth, then market price of stock equals book value", but he explained this earlier testimony herein as follows:

"I used the term cost of equity in the economic sense of cost.  Cost being the minimum supply price.  What I say there is this, when you use the DCF and put into the factors that are barely sufficient so that the end result is the bare minimum, the barely sufficient figure, the figure that an economist calls cost, the minimum supply price, under these conditions market price is going to be equal to book value.

"On the other hand, if you put in allowances and safety factors in a component, the end result is the cost of equity usable for rate regulations.  It is above the minimum supply price and under those conditions the market price will be above the cost of equity -- the market price will be above its book value."

8.  Mr. Kosh also testified that, in applying DCF procedures, there is a need for a reliable estimate of what the market is anticipating in the way of future growth of earnings and that the problem is that such an estimate is a subjective judgment based upon data and analytical material.  Mr. Kosh contends that the DCF procedures are not circular in that the use of the market DCF formula via the dividend yield breaks any such circularity.

9.  Mr. Kosh adjusted the historical data on dividends and book value per share for the benefits received by the AT&T shareholders through subscription rights.  The effect was to produce a higher growth rate than would have been obtained by the use of unadjusted historical data.  The rate of growth in book value per share was: 1950-1970 -- 4.2%; 1954-1970 -- 4.56%; 1957-1970 -- 4.85%; 1962-1970 -- 4.49%; and 1965-1970 -- 3.63%.  Mr. Kosh used a growth rate component of 4.5%.

10.  Mr. Kosh used the dividend yields that existed during the years 1968 to 1970 as the best approximation is his view of the near term future situation at the improved rate of return level.  The price-earnings ratio implicit in Mr. Kosh's DCF return estimate is around 12 at the improved level of earnings compared with the current level of around 11 and the average price-earnings ratio of 18 for the decade of the 1960's.  This implicit price earnings ratio of 12 at the improved earnings level provides a margin of safety in that it is at the lower end of the price-earnings ratio range experienced by AT&T from 1960-1971.  Mr. Kosh analyzed the cost of capital in alternative investment opportunities which he considered to be of comparable risk to the common stock of AT&T.  These were the publicly traded equities of the operating companies of the Bell System.  Mr. Kosh did not use the equities of the electric utilities because he contends that the equities of electric utilities are not alternative investments of comparable risk to AT&T equity.

11.  Mr. Kosh gave weight to the capitalization rates of the Bell System operating companies in arriving at the cost of capital of AT&T.  He found the indicated AT&T cost of equity capital to be 9.6% and the average cost of equity capital for the 5 Bell operating companies to be 9.9%.  Mr. Kosh testified that "This then is my range [9.6-9.9%] of the cost of equity." He then raised the 9.6% cost of equity capital to AT&T to 9.75% in light of the cost of equity capital evidence for the alternative investment opportunities of comparable risk "[in] order to provide a margin of safety."

12.  With regard to Bell System's bonds Mr. Kosh testified: "In don't regard the maintenance of a triple A rating, no matter what, is of great significance; no, sir." The relevant issue, Mr. Kosh states, is the revenue requirements cost of maintaining any given number of times interest coverage by earnings.  "So the real question is, do you save enough interest to overcome the increase in revenue required to achieve the higher interest coverage." Mr. Kosh testified that a post-tax coverage of interest by earnings of 3.6 times rather than 2.6 times obtained with a capital structure of 50% debt under his recommendations would be a "very bad bargain indeed" for revenue requirements would have to be increased by $670 million per year to save $5 million in interest.  He testified that Bell's cost of debt would have been changed by less than one-tenth of one percentage point by a change in post-tax interest coverage from 2.6 to 3.6 times.

13.  In addition to the testimony of the aforementioned witness, the Trial Staff presented for the record additional data and information in exhibit form.  These are briefly described as follows:

Rate of Return for Associated Bell Telephone Companies for 1970

Increase in Earnings Required by Bell System to produce 9 1/2% return

Revenue Requirement effect on 1971 Volume for the 1952 and 1953 rate increases

Interstate message and ARPM Data from 1953 through 1970

Earnings per share for AT&T Stock from 1940-1970

Maintenance expense projection from 1965-1970 compared to Actual

Chart showing Actual and Potential Gross National Product 1951-1970

Selected Economic Indicators by month for 1970 (Unemployment, Dow-Jones, Productivity)

Decline in Bond Rates (Wall Street Journal Article)

Disposable Personal Income and Personal Savings 1958-1970

Net Flow of Savings into Institutions 1961-1970

FRB discount rate, Prime Rate, and 3-month treasury bill rate, Ja. 1965 -- March, 1971

AT&T and Associated Bell Companies Public Bond offers since 1947

Southern New England's Debt Ratio 1946 through 1969

Explanation of Standard & Poor's and Moody's Bond Ratings

Moody's, and Standard & Poor's AAA Utilities and Industrials 1970

Equity and Debt Earnings at 7.5 and 8.5% on $660 million 1971-1975

Several examples of Debt and Equity earnings re changes in Debt and Equity

Brown's Attachment A Updated by Company Letter 1-4-71

Interstate monthly reports (No. 1) for Decembers (1960-1970)

Long Lines monthly report (1B for Decembers 1960-1970)

Interstate monthly report No. 1 for January 1970

Interstate monthly report No. 1 for January 1971

9-way cost study

Bell System construction expenditures 1970-1972

A list of Bell System central office equipment margins 1960-1970

Annual interstate growth rates for operating expenses, maintenance, messages and average telephone plant, 1961-1970 and 1971 view

Western Electric, Average Capital, Equity Earnings and Rate of Return on AEC in 1970

Calculation of rate of return required Communications Business of AT&T under specified conditions

Western Electric Return on Net Investment and Stockholders' equity for selected years

Selected Interest Rates and Bell System Cost of New Debt

Annual Rates of Growth of Total Capitalization and Telephone Plant Less Reserves of AT&T and Annual Rate of Growth of CNP

Moody's Ratings for Bond Issues of the Parent Company, AT&T and Selected Bell System Operating Subsidiaries, 1945, 1947, 1957, 1959 and 1960

Capital Structure of Class A and B Electric Utilities 1945, 1948, 1950, 1960 and 1968

Total Long Term uses of Capital Funds 1950, 1955, 1960-1970

Cost Spread between Issues of Differing Maturity offered in 1970 on the same day by AT&T and Electric Utilities

Moody's Electric Utilities -- Debt issues, Rating, Outstanding amounts, and perecent they are of total

Bell System and AAA Rated Electric Bonds -- Cost in 1969 by Month

Bonds of the Bell System and Rated Bonds of Moody's 24 Electrics issues 1960-1969 by term to maturity

Standard and Poor's Earnings and Dividends Ranking for Common Stock of AT&T and Moody's 24 Electrics

Relative Range of Return on Book Equity 1966-1969

Debt Issues of Privately Owned Electric Utilities in 1970 Rated by Moody's

Debt Issues of Private Owned Electric Utilities in 1970 Rated by Moody's

Selected Financial Data for 1970 (Simulation Model) with a 9 1/2% and 8 1/2% Return -- All External Financing by Debt with Other Specified Assumptions

Earnings and Dividend Ranking for Stock from Standard & Poor's "Stock Guide"

Illustration of effect of increasing Debt Ratio upon rates and return rates under specified assumptions

Dividend Yield for Moody's 24 Electrics in February 1971

Moody's 24 Electrics -- Earnings per Share 1965-1970 and Rate of Growth in Earnings per Share

Comparison of Debt Ratios and Leverage Figures for Principal Bell System Subsidiaries

Variation in price of AT&T Stock with Investment Rate under Alternative Rates of Return on Net Assets and Under Specified Assumptions

Variations in Price of AT&T Stock with Investment Rate Under Alternative Rates of Return on Net Assets and Under Specified Assumptions

Current Interest Rates for AT&T Predicted Under Mr. Wilk's Formulas at Different Marginal Leverage Rates when the Investment Rate is 103

Variation in Price of AT&T Stock with Investment Rate Alternative Rates of Return on Net Assets and Under Specified Assumptions

Statement of Frank Laden

DCF Test (Hypothetical)

Comparison of Dollar Returns from a 35 Year Investment in Equity Purchased at $45 under stated Assumptions and a 35 Year $45 Bond at 8% Interest

14.  Pursuant to the request of the Trial Staff, at reargument, we take official notice of the following current data relating to Bell's long term, intermediate term and composite debt costs:

 

Date issued

Cost of

Cost of

Composite

 

long term

intermediate

cost

Jan. 5, 1972

7.27

6.48

6.95

Jan. 19, 1972

7.76

 

7.76

Jan. 25, 1972

7.37

6.82

7.10

Feb. 1, 1972

 

7.01

7.01

Feb. 15, 1972

7.30

6.62

7.10

Mar. 22, 1972

 

6.62

6.62

Apr. 10, 1972

7.53

6.89

7.32

May 2, 1972

7.45

6.70

7.23

May 22, 1972

7.39

6.63

7.01

June 13, 1972

7.51

6.65

7.17

July 19, 1972

7.50

6.58

7.13

Aug. 8, 1972

7.43

 

7.43

 

15.  In addition, pursuant to the request of the Trial Staff, we take notice of the "formal legislative basis for Phase II of the new economic policy, the rules and regulations issued by the Price Commission, the Wage Board and the Cost of Living Council * * * what has happened to the consumer price index, the gross national product, actual income after due allowance for inflation, and other recognized measures and indices of economic activity * * * experience of Respondents since the record was updated in connection with the first oral argument herein;" the fact that the Consumer Price Index has "decreased from a going rate of about 6% in the 1970 period to less than 3% over the past 12 months;" that the "purchasing power of the average worker increased 2.9% between July 1, 1971 and June 30, 1972," and that "the government's composite index of leading economic indication rose 4.3% for the second quarter of 1972."

APPENDIX C

OTHER PARTIES' TESTIMONY AND DATA

USITA

1.  The United States Independent Telephone Association (USITA) presented two witnesses.  The first, Mr. Tyler W. Ryan, submitted written testimony which was essentially a description of the settlement agreements and methods between independent telephone companies and the Bell System.  Dr. J. Rhoads Foster, a public utilities consultant, employed both a market approach and a comparable earnings approach and concluded that the minimum fair return on either basis is 9.5% for the Bell System.  According to his studies, the required equity return for investors in AT&T is 12.0%.  He used the general approach followed by witnesses for Bell, particularly Mr. Scanlon.  To the extent that Dr. Foster departed from the approach used by Bell, he relies on a study of the earnings of 13 food processing companies.

Telephone Users Association

2.  The Telephone Users Association (TUA) tendered the testimony of Computer and Management Consultant, Melvin J. Laney, who stated his opinions as to the insufficiency of the analytic or actual scientific evidence presented by AT&T in this proceeding.  most of Mr. Laney's testimony was stricken.  However, the few statements criticizing AT&T's subjective use of the Gordon Model were allowed to remain in evidence.

Secretary of Defense

3.  Dr. Norman C. Lerner testified on behalf of the Department of Defense and for the Executive Agencies of the U.S.  Government.  He is the Manager of the Economics Department of Computer Sciences Corporation.  The purpose of Dr. Lerner's testimony, which is divided into four major sections, is to show that the proposed rate of return requested by AT&T is not justified.  In the first section of his testimony Dr. Lerner discusses the relationship of long-term interest rates to the demand for capital, to the money supply, to Federal Reserve policy, and to inflation.  He contended that the trend in long-term rates is downward; that there will not be an excess demand for long-term capital in 1971; that there will be an increase in the available money supply for investment purposes; that Federal Reserve policy will continue to act as a restraint on any rise in long term interest rates and that the expectation of inflation is declining.

4.  In the second section of his testimony, Dr. Lerner discusses the investors' affinity for AT&T stock, the element of risk, and the return on equity.  He concluded that AT&T stock is attractive to both the institutional and the individual investor and that the element of risk is low.  He further states that AT&T's return on equity had not deteriorated compared to other large companies and adds that the effect of including preferred stock in the cost of capital calculation could reduce the cost of capital to AT&T.

5.  In the third section of his testimony Dr. Lerner expresses the opinion that the maintenance of a low debt ratio in the Bell System's capital structure has been unwarranted and has unduly penalized the ratepayers.  Additionally, he states that while Bell System's interest coverage has declined in recent years, their credit rating has not yet been placed in any great danger.  While the credit rating of Southern New England Telephone Co. (SNETCO) was recently lowered, he contended that the downgrading of SNETCO was a special situation and should not be construed to mean that the credit of the AT&T organization is in jeopardy.  The special situation is that SNETCO is only about 18% owned by AT&T and does not consider itself to be a subsidiary of AT&T.

6.  In the final section of his testimony, Dr. Lerner deals with AT&T's general financial and economic forecasts, and operating results.  He finds the company's forecasting deficient because it does not appear to be related to projections of long-term capital requirements and because their forecasting methodology relies on past relationships between economic variables that may no longer be applicable.  Because of these deficiencies, Dr. Lerner has serious doubts about the validity of AT&T's request for such a high rate of return.


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