Among other takeaways:

• Improvement in the ongoing FY13 budget has been driven largely by one-time factors, including unexpectedly high tax revenues from late 2012 corporate payouts (designed to get ahead of 2013 tax increases) and Fannie-Freddie remittances relating to reversed earlier tax write-off allowances, or DTAs.
• Regardless of their ephemeral nature, the results will likely push back the day of reckoning over extension of the debt ceiling, or “x-date,” to mid-November.
• Separately, with the House and Senate marking up to FY14 discretionary spending totals as much as $91 billion (or 10%) apart, this will necessitate passage of perhaps a split-the difference “continuing resolution” by late September, to fund the government for three months or longer.
• The net seems likely to test defense stock investors’ seemingly sanguine expectations of ultimate relief from DOD budget pressures caused by the sequester. Discretionary spending on technology and other priorities will also be hit.
• Meanwhile, House Republicans may be boxing themselves into a corner this summer, as Speaker John Boehner (R-OH) signals that they will refuse to consider a debt limit extension that either fails to include their “asks” for a tax reform trigger and major entitlement cuts or otherwise would pass only with Democrats providing the majority of votes.
• In other words, after giving the markets a break this summer, Washington might blow a modest ill wind toward investors during the fourth quarter. And in the interim, observers will await evidence of what timing re an “x-date” the Obama administration might provide and whether and how the two parties might attempt to synch initial FY 2014 funding measures (i.e., CRs) with a pre-Thanksgiving debt limit hike.
• Under the best scenario, Bell posited that the desire to obviate if not turn off the sequester, extend the debt ceiling, and trigger tax reform (a notable new focus of House Republicans) could beget a budget deal in January or February of 2014. Democrats might want to declare short-term victory over the austerity imperative created by the Simpson-Bowles Commission’s late 2010 debt reduction report – and to change the subject from the Obama administration’s IRS and other scandals, he reasoned. Republicans, for their part, might resolve not to play small ball over funding levels, CRs and debt limits but instead go into the 2014 elections as the party of economic growth. Indeed, bipartisan interest in growth-oriented tax reform has noticeably grown, albeit amid lingering questions of how much in net new revenues might have to be sought in tandem. Meanwhile, as Capital Alpha has noted, with Congress credited for already having slashed ten-year deficits by $2.5 trillion (largely due to the 2011 Budget Control Act and tax hikes in the January fiscal cliff fix), a deal to cut $1.5 trillion more – to meet the Simpson-Bowles minimum of $4 trillion – just might have a chance to emerge.
• As a result of Bell’s comments, and the backloaded budget faceoff now anticipated, Capital Alpha is sharply reducing its odds of a deal late this year – perhaps to one in five, or 20%, from just below a toss-up before. Nevertheless, due to still-mounting sequester pressures, new focus on growth, and the wildcard of scandal-driven politics, we remain contrarian optimists, reinstating our 45% odds for a potential deal in 2014.

Previous Related Notes

• Capital Alpha Call on the FY14 Obama Budget – April 11, 2013
• Obama Health Care Budget: Mostly Same Old but With a Bag of Chips and a Diet Cola – April 11, 2013
• FY14 DoD Budget A Work in Process – April 10, 2013
• Mortgages/Housing FLASH: FHA Draw To Be Announced In Obama Budget, Discussed In House Hearing – April 10, 2013

Obama Recess Appointments Encountering Skeptical Judiciary
In January a three-judge panel of the Court of Appeals for the DC Circuit ruled in Canning that President Obama’s January 2012 recess appointments to the National Labor Relations Board were unconstitutional. Essentially, held the court, Obama improperly tried to sidestep the Senate confirmation process by proclaiming recess appointments when the Senate wasn’t really in recess.

Theories from both Republican and Democratic presidential administrations  had suggested that Obama would prevail due to executive prerogatives, but this assertion was rejected by the DC Circuit.

It has now been rejected by the 3rd Circuit as well, in a New Jersey case involving union organizing efforts in a nursing home (NLRB v New Vista Nursing and Rehabilitation – decision here, 157 pages). By itself, this decision doesn’t shift the landscape, but it does provide an incremental suggestion that the administration could be on course for a loss at the Supreme Court when and if they review Canning. It also reaches further back than Canning, concerning as it does the 2010 recess appointment of Craig Becker to the NRLB.

National Labor Relations Board: No Quorum, No Soup for You
Without a quorum supplied by Obama’s recess appointments, the NLRB is essentially paralyzed, unable to render decisions. This is a blow to the administration’s labor agenda, where union critics have feared for years that a Democratic-dominated NLRB would render decisions that not only enabled wider unionization efforts, but even amounted to “card check.”

Card check is the concept advanced by pro-union activists that workers should be able to simply sign a petition (aka “checking the card”) to unionize, rather than having the NLRB hold formal elections. The rub here is that the current elections system guarantees a secret ballot for workers fearing intimidation by union organizers – intimidation that would be unimpeded if workers could be pressured by organizers to sign a binding petition.

The AFL-CIO had hoped to pass a card check law through Congress in 2009, but even a 60-seat majority by Democrats declined to take up the legislation. However, the NLRB could potentially take steps toward allowing petitions to count towards union organizing – if it was able to operate.

Of course, that’s the far end of how aggressive a revitalized NLRB could be. The Board would more likely focus on smaller changes to ease union organizing. These could include allowing elections to be held more rapidly upon completion of a petition – giving companies less time to argue against unionization – and allowing elections to be held more often – allowing unions to come back quickly after a failed vote.

Labor Nomination Could Be in Trouble
Unanimous opposition by Republicans on the Senate HELP Committee does not on its own doom the nomination of DOJ official Tom Perez to head the Labor Department. The nomination was still approved by the committee – Democrats holding a 12-10 numerical edge – and now can be considered by the whole Senate.

But Republicans are digging into allegations that Perez improperly struck an agreement between the Justice Department and the city of St. Paul, MN for the two entities to drop three cases filed against each other. The normally mild Sen. Lamar Alexander (R-TN) – the top Republican on the panel – issued an unusually probing statement:

…my view of his record raises troubling questions about his actions while at the Department of Justice and his candor in discussing his actions with this committee…Mr. Perez’s involvement in [the St. Paul matter] seems to me an extraordinary amount of wheeling and dealing outside the normal responsibilities of the Assistant Attorney General of the Civil Rights…This exchange cost American taxpayers the opportunity to potentially recover millions of dollars, and, more importantly, violated the trust whistleblowers place in the federal government. His testimony has been contradicted by the testimony of other witnesses in contemporaneous documents. In short, it seems to me that Mr. Perez did not discharge the duty he owed to the government, to try to collect the money owed to taxpayers. He did not discharge the duty to protect the whistleblowers that were left hanging in the wind…Mr. Perez’s use of private email accounts to leak non-public information is currently being investigated.

Again, ordinarily, these reservations would not be a crippling blow to the nomination. However, the unfolding IRS scandal and other public relations blunders such as the Justice Department’s wiretapping of the Associated Press may embolden Republicans to argue that Perez’ record suggests a similar pattern of abuse of power.

Perez is significant as a longtime advocate for progressive labor policies. If confirmed, he would likely spearhead the administration’s push for a federal minimum wage increase, as well as aggressive enforcement of federal work and wage rules.

Should Congress pass an immigration overhaul this year, Perez would be at the center of its implementation. In our note series on immigration (most recently here), we have spotlighted the substantial new powers the Secretary of Labor could gain under the Senate’s Gang of 8 legislation. Perez seems almost tailor-made to help implement the law, as a savvy attorney and longtime advocate of many of the proposals within the bill.

Consumer Financial Protection Bureau: Why Canning Matters
As we wrote in January both before and after the Canning v NLRB decision was issued, last year’s recess appointment of CFPB Director Richard Cordray is also intimately tied to the disputed NLRB appointments at issue in Canning. All were made on the same day, in the same manner.

No direct challenge to Cordray’s status has yet been made. This is likely due to the affected parties waiting for a potential verdict by the Supreme Court in Canning. Should the Supremes agree that the NLRB recess appointments were unconstitutional, action to remove Cordray is highly likely.

While the NLRB ruling is dramatic – it renders the Board unable to issue rulings – the impact on the CFPB is arguably greater. The CFPB, of course, has never had a Senate-confirmed Director, having been created as part of the 2010 Dodd-Frank legislation. Republicans have been insisting since the agency’s creation that certain governance changes – including the installation of a board to oversee the director – be included before they will support any CFPB confirmation. Notably, given its latest difficulties, the IRS, like the CFPB, is led by a sole official rather than a board. That could potentially become a factor in the debate.

Senate Majority Leader Harry Reid (D-NV) is expected to file for cloture on Cordray’s and other nominations, and has once again threatened to resort to the “nuclear option” in order to avert an expected GOP filibuster. We’re doubtful Senate Democrats will take that step at this point, but the political challenges currently facing the White House could prompt efforts to change the subject.

Republicans are also arguing that the wording of the Dodd-Frank legislation requires a Senate-confirmed director before the CFPB can launch new regulatory initiatives relating to non-bank financials. Cordray’s uncertain status thus creates a significant level of regulatory uncertainty.

Previous Notes on Labor Issues

• Labor Pick Previews Aggressive Obama Strategy – FDX, CTAS, MON, Others – March 20, 2013
• Labor Rules: Ruling Stymies Obama Administration – January 27, 2013
• Industrials: ‘Right to Work’ Likely in Mich.; Could Cut Labor Costs – December 9, 2012
• Labor Rules/FAA Reauth: Activist NLRB Could Raise Heat on Labor Rules – January 6, 2012

Relevant Stocks
FDX, CTAS, WMT, DAL, DEG, UPS, F, GM, TM, HMC, MON, ADM, CNH, and DE.

• The Senate has voted to confirm Ernest Moniz as Secretary of Energy by a margin of 97 to 0. This clears the way for at least one LNG export permit and a policy statement from DOE governing future exports as soon as July 1, if not earlier.
• We still think an LNG decision could come sooner than July, but we are not making a strong call for Friday before Memorial Day weekend (May 24). This would be a logical opportunity, but we explain in the note that many factors go into timing.
• We see the timing of the President’s decision–and it is the President’s decision–on LNG in the context of the buildup to a more difficult call on Keystone XL and ultimately the 2014 election cycle. We think it helps the President politically to approve at least a few export permits as soon as possible. However, we will be disappointed if the policy turns out to approve some now, and wait a year for more.

This note contains video tributes to David Bowie, Akira Kurosawa, and the rock super-group Blind Faith, as well as our updated LNG permit application tables.

Discussion

On LNG, what’s happening?  We’re big fans of David Bowie and recommend that you check out his video for “Where Are We Now?”

Meanwhile, back at the ranch, the U.S. Senate has just voted to confirm Ernest Moniz as Secretary of Energy by a lopsided tally of 97 to 0.

July or June?

In the normal course of things, we would expect DOE to move forward on LNG exports within about a month of Moniz’s swearing in, as we first wrote on February 25. Since we expected Moniz to be confirmed around Memorial Day, we did simple math, added one month, and arrived at the July 1 target date we have been writing about ever since.

However, we do have the sense that DOE could move faster and will not necessarily wait that long. We don’t think it is necessary for DOE or the White House to wait a full month after Moniz has been confirmed. Nor did we think it was particularly necessary to have Moniz confirmed at all, save for due form and appearance’s sake.

We are tempted to say that at least one LNG export permit and a long-awaited policy statement could come out by Memorial Day weekend, which is barely a week away. Since the Interior Department’s long-awaited regulations for hydraulic fracturing on federal lands have come out this afternoon (Thursday, May 16) as expected, then as result, the other major decision that might have been announced going into the holiday weekend will have been taken off the table.

However, we are a little hesitant to call a date so soon until we have something to work on. We do think that an accommodation with Sen. Wyden (D-Ore.) has been reached, and that the terms of this accommodation include approving one or just a few LNG export applications, and then waiting a long time before approving any more. No one has officially said this, but as we have written previously, that is how we read the body language from the Moniz confirmation hearing.

The Rashomon Theory

In the trade press (notably here,

subscription required) and among the industry community, we hear various accounts: yes, a decision is coming soon; no, a decision won’t be coming for a while; yes, there could be a couple of permits; no, nothing is final. The pattern suggests to us that the White House is reaching out to various stakeholder groups.

We suspect the White House is shading its message to each group, telling them what it thinks they want to hear. Otherwise, as would be perfectly normal in Washington, each group is hearing what it wants to hear and spinning its take with reporters. We call this the “Rashomon Theory,” after a great old Japanese movie in which everyone tells tells a different story about the same event.

Our search for objective truth and observable fact points to only one thing, which is that three of the first four projects of on the DOE’s Order of Precedence have moved out of the “pre-file” stage at FERC and are now in the full permitting process. These are Freeport, Cove Point, and Cameron, as indicated on our updated LNG permit application status chart available for Capital Alpha Partners clients here.

Cheniere’s Corpus Christi is likewise out of pre-file, but it is further back in the DOE queue. Thus, if DOE wanted to move on several permits at once, and needed plausible justification in the record for doing so, it could greenlight those first three projects on its list for rapid action in a sequence or as a group.

The Political Calculus of Timing

The timing of DOE’s announcement is another mystery. At a speech in New York City on Tuesday, May 14, Acting Assistant Secretary of Energy Chris Smith made his usual opaque comments, saying that he could offer no guidance whatever on timing, and that DOE was moving cautiously because they expected to be sued by someone no matter what they did.  His exact comments, as reported in Platts, were: “If we say ‘yes’ to everything we’re going to get sued,” he said. “If we say ‘no’ to everything we’re going to get sued. If we go fast, if we go slow, we’re going to get sued.”

We think that there are a couple of things going on. There is the usual gamesmanship about the timing of any announcement, and thus our normal suspicion that a holiday weekend is the most important to time to watch.  In Washington, there is a term for this: “taking out the trash” means timing any announcement that may be inconvenient for a time on Friday afternoon when the offices are closed and the bars are open, with no one watching TV or the wires at that particular moment.

But we don’t mean to suggest the timing is completely arbitrary. Nor is it capricious. Any federal government that involves interagency review as this one does is subject to bureaucratic delays that are never fully explained and are perhaps inexplicable. We think the administration is close to ready. They have been almost ready for some time. But nothing undergoing interagency review–a complex process– can be fully ready to go until it actually goes.

Don’t Call It Trash

What’s more, we would not characterize this announcement as “taking out the trash” in the strictest sense. The administration is not trying to hide its decision on LNG. In fact, we think the administration wants to take credit in a precisely modulated way for being pro-producer and pro-export at the appropriate way. The President has a very difficult decision to make later this year on the Keystone XL pipeline. We think that he is going to approve it, but he will want leverage to request conditions. He also needs to protect himself from criticism for taking too long, or pursuing obstructionist policies.

By no means do we believe the President urgently cares about exporting as much fossil fuel as quickly as possible; in fact, we suspect the reverse. But from a political perspective, he can’t be overtly anti-production, anti-export, or anti-infrastructure. The sweet spot for the President is allowing things to happen, and taking credit for them, but not driving the process any faster than it might naturally unfold.

A properly ballyhooed LNG announcement could do just the trick. The White House may choose a weekend announcement for purposes of message control, but not because they are trying to minimize the importance of the announcement as such.

We see the BLM regulations and the LNG export decision as steps in a complex choreography of events leading up the Keystone decision and perhaps even the 2014 elections. Earlier this month, as a prelude to the OTC in Houston, Interior Secretary spent two days visiting an Ensco semi-submersible rig and Chevron’s Blind Faith production platform, tweeting all the way. For good measure, she has made constructive comments about hydraulic fracturing at every possible opportunity.

The Big Ballyhoo

As we wrote earlier today, we expected the administration’s final rule on hydraulic fracturing to come out with a pro-industry cast when it appears. This has proven to be the case, as witnessed by the Houston Chronicle Fuel Fix headline, “Feds make concession to oil industry in new hydraulic fracturing rule,” available here.

The rule will be less restrictive than prior rules, and thus a “win” for industry, prompting charges by environmentalists that the President has sold out to big oil.  But as we explain in the previous note, it will be plenty restrictive compared to rules for lands the federal government does not manage directly. This is why the vast bulk of hydraulic fracturing activity occurs on state and private land, and the new rule will do nothing to change this.

An LNG export decision that lets up to three projects go forward could be spun as a win for industry and a win for the President. And this will be true. But we don’t like the idea of doing three permits and then waiting many months, if not a year, before doing any more. Nearly every economic study not financed by opponents of LNG exports demonstrates that the United States will benefit, in literally every scenario. This argument is over, on any substantive economic level.  Those who still pursue it are industrial energy consumers and public gas utilities with an ax to grind, and environmental activists who see slowing exports as a way to keep a lid on U.S. drilling activities.

Our Gift to Canada

The administration will get credit for moving ahead on three projects.  But waiting any length of time after these could mean that the window of opportunities for U.S. LNG export developers to enter the global markets will close as competition comes on line elsewhere.  Three and pause could very well mean three and stop, we believe.  North America can live with this, since Canada will export.  But it is a loss for the United States.

Additional Resources

Darren Good, “Natural Gas Rules May Be in the Pipeline,” (subscription required), Politico Pro, May 13

Jennifer A. Dloughy, “New Interior Secretary Makes First Offshore Rig Visit,” Houston Chronicle Fuel Fix, May 3, 2013

David Bowie, “Where Are We Now?” March 25, 2013

Blind Faith, “Can’t Find My Way Home,” 1969

Akira Kurosawa, “Rashomon,” 1950

In the most important rule-making, the CFTC made some key concessions for swap execution facilities (SEFs), allowing voice-brokering to continue, lowering the request-for-quote requirement from five to three (and just two during an initial transition year), and modifying the 15-second delay so that in at least some cases less time will be required (in cases where the contracts have less liquidity).

The CFTC staff also provided for an expedited review process for SEFs to become at least “temporarily registered.” The rule provides for a 60 day “desk“ review so that each of the expected 15 to 20 SEF applications that will simply ensure that all of the necessary information is provided in the application.  Once that information is provided, the temporary registration will be granted, the CFTC over the next two years will perform a more thorough review to ensure substantive compliance with all of the new SEF rules.

The CFTC also finalized a rule that establishes a procedure for determining which trades must be “made available for trade,” meaning they must be executed on an exchange or SEF.  Any swaps designated as “made available for trade” must be executed either through a central order book or using a request for quote method.  As noted above, only 2 RFQs will be required for the first year, and 3 will be required after that.  However, even for these “required trades,” execution can be accomplished via voice brokering (or even emails or chat requests) may be used to meet the RFQ requirement.

All other swaps, such as physical commodities (which are not yet part of the mandatory exchange trade mandate yet), or where one counterparty is a commercial end user, are considered “permissible” contracts and SEFs can execute them without having to comply with the order book or RFQ requirement.

The final SEF rule will become effective in 120 days after publication in the federal register, which should happen shortly after today’s approval. Given the expedited 60 day review period for SEF applications, all SEFs who want to can start competing for business around the same period of time.

In another vote, the CFTC finalized the rule for what minimum size a swap trade must be to be exempt from some of the real-time reporting and other requirements.  The final rule allows for 14% of interest rate swaps and 15% of credit default swaps to qualify for block size exemptions during the first year, but after a year of data gathering, the percentage for both swaps will be limited to 6% of trades.

Finally, CFTC Chairman Gensler pointed out that the final rule allows for “work ups” of initial bids or offers.  We expect these final rules to kick off serious competition among SEFs, some of which will team up with various clearinghouses that often are associated with particular exchanges.

CFTC Links to Additional Information:

Fact Sheet: Final Rulemaking on Procedures to Establish Appropriate Minimum Block Sizes for Large Notional Off-Facility Swaps and Block Trades; Further Measures to Protect the Identities of Parties to Swap Transactions

Questions & Answers: Procedures to Establish Appropriate Minimum Block Sizes for Large Notional Off-Facility Swaps and Block Trades; Further Measures to Protect the Identities of Parties to Swap Transactions

— Approved 3 – 2

Fact Sheet: Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade under Section 2(h)(8) of the Commodity Exchange Act

Questions and Answers: Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade and Schedule to Phase In Compliance with Section 2(h)(8) of the Commodity Exchange Act

— Approved 3 – 2

Fact Sheet: Final Rulemaking Regarding Core Principles and Other Requirements for Swap Execution Facilities

Questions & Answers: Core Principles and Other Requirements for Swap Execution Facilities

Fact Sheet: Interpretive Guidance and Policy Statement on Disruptive Practices

Questions & Answers: Interpretive Guidance and Policy Statement on Disruptive Practices

Opening Statements:

Opening Statement of Chairman Gary Gensler

Statement of Support of Chairman Gary Gensler

Opening Statement of Commissioner Jill Sommers

Opening Statement of Commissioner Scott O’Malia

Opening Statement of Commissioner Bart Chilton

Opening Statement of Commissioner Mark Wetjen

We maintain our long-held thesis that NIH will be flat funded for FY14, which yesterday’s hearing seemed to support as chairwoman Mikulski (D-MD) promised to do everything in her power to protect the agency. Recall NIH is headquartered in her state. However, there has been almost zero progress on replacing sequestration, so medical research will continue to face a challenging funding environment for the foreseeable future.

Next up, the Senate Labor-HHS subcommittee typically votes on its bill in late summer before the August recess or in the early fall, so it may be several months before we get numbers on NIH. The House Appropriations Committee should follow roughly the same schedule.

The Senate Appropriations Committee’s Labor-HHS Subcommittee yesterday held a hearing on the President’s FY14 NIH budget request, featuring testimony from agency director Collins. It is early in the FY14 appropriations process, but the hearing provided some incremental insight into how next year’s NIH funding may shape up.

In general, the hearing demonstrated the strong bipartisan support most members have for NIH. Sen. Shelby (R-AL) even said NIH’s medical research is the “top investment” the subcommittee can make and that he hopes there’s a time when NIH spending can be doubled again. Unfortunately, Collins’ testimony yielded no new information on sequestration or NIH priorities. He noted the agency has been “has already been dealt a devastating blow,” will fund 700 fewer grants for FY13 than last year, and will lose a total of $19 billion in forgone funding if sequestration continues through 2022.

For us, the most illuminating points came from full Appropriations Committee Chairwoman Mikulski’s (D-MD) apparent response to comments from Labor-HHS Subcommittee Chairman Harkin (D-IA).  Harkin (D-IA) praised NIH’s work but then stated it will be impossible not to cut agency funding in FY14 under sequestration, and that he would not “pit [the agency] against other critical programs that fall under Labor-HHS.”  He ended his opening remarks on a political note, lamenting that Republicans have refused to compromise on replacing sequestration with targeted cuts and tax increases.

Later in the hearing Mikulski – who represents NIH’s headquarters in Bethesda, MD – made what we saw as a direct response to Harkin’s comments about possible NIH cuts, saying she will “work her earrings off” as full committee chairwoman to make sure the agency is protected.  Recall that in 2011, Harkin’s Labor-HHS bill included a $190 million cut to NIH, which he said was necessary due to Republicans’ insistence on reducing spending.  NIH was eventually flat funded for FY12 when Congress eventually its appropriations legislation that fall.

We think Harkin was angling to make the same sort of move in the FY14 bill to highlight what he sees as Republican intransigence on sequestration.  We don’t want to read too much into her comments, but Mikulski seemed to indicate that may not be an option with her as full committee chairwoman.

Next up, the Senate Labor-HHS subcommittee typically votes on its bill in late summer before the August recess or in the early fall, so it may be several months before we get numbers on NIH.  The House Appropriations Committee follows roughly the same schedule.  As usual, we do not expect Congress to follow the standard appropriations process due to the deep political and spending priority divide between the Democratic Senate and Republican House, so we’re probably looking at another partial year CR that will be passed late in FY13.

• We are still answering investor questions on the status and outlook for the Federal Communications Commission’s (FCC) first-ever “incentive” auctions of broadcast television spectrum to wireless carriers. With this note, we provide a brief consolidated update on the state of play.
• We are watching for two key milestones this year that we expect will ultimately determine the timing and participation in the program: finalization of the auction mechanics and procedures, and any final changes to the FCC’s “spectrum screen.”
• Best to our knowledge, we have not seen reliable estimates as to how much spectrum is expected to be freed or how much auction revenue might be generated. We believe spectrum in the range of low double-digits (20, 30, 40 MHz) in prime markets is more likely than the FCC’s 2010 goal of 120 MHz.

Discussion

If it feels like Washington has been discussing the FCC’s proposed incentive auctions (where television broadcasters can choose to vacate their spectrum in exchange for a portion of the auction proceeds) for a long time, it is because they have.

The idea was first proposed by the FCC in their March 2010 National Broadband Plan, but was not written into law until February 2012. One year and three months later after Congressional authorization, the FCC is working to finalize the program rules and procedures.

We are still receiving investor inquiries as to the status and outlook for the incentive auctions, so we thought it would be convenient to provide a quick consolidated update on where we are.

Timing

The FCC’s long-standing guidance is that they hope to finalize the auction rules in 2013 and hold the auctions in 2014. There is no public guidance on specifically when the auction would occur in 2014, but our baseline expectation is a late 3Q/early 4Q date. This would be generally in-line with departing FCC Chairman Julius Genachowski’s March letter to the Commerce Department indicating its intent to auction other pieces of spectrum (some occupied by federal users) as soon as September 2014.

As we wrote last month, we have seen public commentary by stakeholders and observers attempting to lower expectations for timing. Investors also ask us whether the timing might slip into 2015. We currently believe that an “on-schedule” auction in 2014 is likely. We think that concerns around timing detract from more important questions around potential participation and the amount of spectrum to be freed.

Key Milestones

We are waiting for two key milestones to better inform the timing and participation of the incentive auction: 1) release of a final FCC order establishing the auction mechanics and other procedural issues; and 2) any final changes to the FCC’s “spectrum screen” used to tally carrier spectrum holdings during spectrum acquisition transactions.

We expect the final incentive auction rules to establish the timing and process for bidding for both the broadcasters and wireless carriers. Proposed rules were released on October 2, 2012 (multiple bureau docket 12-268) and the final reply comment period ended on March 12, 2013. The FCC has since been meeting with stakeholders, accepting ex parte filings, and holdings workshops to discuss technical and logistical issues. We are watching for final rules to be released by 4Q or this year or 1Q 2014.

Public statements from the FCC have also indicated that they hope to finalize any changes to the spectrum screen (Wireless Telecommunications Bureau docket 12-269) before the auction, so wireless carriers have their updated spectrum aggregation profile ahead of bidding. If any changes formally promulgated, we expect them to be released around the same time as the final auction rules. Though, as we have explained to investors, the FCC is not required to release an updated screen. In the absence of any promulgated changes, the FCC can continue its ad hoc, case-by-case reviews in the course of transactions. We do not view a failure to issue a new spectrum spectrum as dispositive for the incentive auctions

Broadcast Participation

Investors have asked us which broadcasters might actually participate in the auctions. Aside from any company’s public communication with investors, we note that broadcasters indicating their interest in the program have done so confidentially at the FCC. The FCC has configured the docket to allow anonymous comments and other confidential filings to protect proprietary business plans.

With that caveat, we see one key characteristic as the key determinant of whether broadcast assets will successfully clear the auction: location in desirable big-city, densely populated markets. These urban areas generally have the highest number of full-power stations and the most spectrum demand from congested carriers.

While there may be one-off opportunities for smaller regional carriers to acquire spectrum in smaller markets, we generally believe that stations in more rural or less densely populated areas will find it harder to clear the auction. Larger carriers might already have sufficient capacity in those markets or are otherwise uninterested in building out there. Smaller carriers might not have the financial resources to buy that spectrum at the asking price.

We have not seen any reliable estimates as to how much spectrum the FCC might reclaim through the incentive auction process, though we agree with most in Washington that the FCC’s original 2010 goal of 120 MHz from the National Broadband Plan is unlikely. The 120 MHz goal represents approximately 40% of all spectrum allocated for broadcast television (total of 294 MHz).

Our expectation is that low double-digits (20, 30, 40 MHz) on average in a market is more likely.

Wireless Participation

Investors have asked us about whether the FCC might try to explicitly exclude Verizon and AT&T from participating in the auctions (due to competition concerns) or otherwise promulgate rules that have the effect of excluding those companies.

Our quick answer is that we have a status quo view of FCC spectrum aggregation policies and don’t believe AT&T or Verizon would be barred from the program. Though we note that the FCC has given investors plenty of reasons to be concerned: LightSquared mandated business conditions barring VZ and T, non-committal language in its annual wireless competition reports, and the rejection of the AT&T/T-Mobile deal.

The key policy lever at the FCC’s disposal is the spectrum screen and adjustments to make carriers look more or less concentrated and ultimately change the behavior of carriers bidding into the auction.

Potential modifications to the screen include adding or removing certain frequencies to the total inventory deemed suitable and available for wireless use; adjusting the levels at which a carrier’s total holdings would trigger further review; or other proposals such as value weighting of frequencies or establishing separate screens.

We have long held a status quo view of the FCC’s spectrum screen and the formal review of it that was launched last fall. As noted above, the review itself is not deterministic and does not require a final outcome. We do not expect changes to the screen to materially change the ability of large or small carrier to acquire spectrum at the auction.

We ultimately expect any changes made to the screen to be incremental adjustments reflecting recent market and policy developments that have made some frequencies newly available (e.g., AT&T’s WCS spectrum, officially recognized in the T-Mobile/MetroPCS review) or no longer available (the 700 MHz D block that was reallocated to public safety). We think proposals to assign “weights” to certain frequencies (e.g., value lower-band spectrum greater than higher-band spectrum) are inherently problematic and difficult to implement.

Recent Research on this Topic

Thirteen Telecom Policy Issues for 2013: May Edition of the Capital Alpha Telecom Scorecard, May 1

Notes on Incentive Auctions; Rural Telecom — Capital Alpha Telecom Tuesday, April 9

USM: An Alternative Perspective on FCC “Incentive” Auctions, February 7

Boeing is holding its annual investor conf. on May 21-22. We will attend that event and have a follow-up note later next week on what we learned from a DC-perspective. Additionally, we will update our BDS sales model for Base Case, Upside, and Downside scenarios. We get it that the overwhelming focus of investors and analysts is Boeing Commercial Airplanes, but BDS (Boeing Defense Space & Security) remains an important contributor to the company. Also, there are read-throughs for other defense stocks based on managements’ comments at the conference.

• As of March 31, 2013, the backlog of C-17s was 12 aircraft and the latest 10-Q noted that Boeing is producing these aircraft at a rate of 10/year. That filing notes that: “Should additional orders not materialize, it is reasonably possible that we will decide in 2013 to end production.” An issue for discussion at the conference is visibility on timing of additional orders – if any – in order for Boeing to sustain the C-17 program beyond 2014.
• The FY14 DoD budget request shows Navy EA-18G and F/A-18E/F deliveries ending in late calendar 2015. Boeing has a number of active and potential campaigns to sell F/A-18s internationally and it is conceivable that Navy plans could be reassessed for extended production in the FY15 DoD budget (the Base Case forecast in Exhibit 1 doesn’t assume this). Brazil, Canada, Denmark, and Qatar all are potential F/A-18E/F buyers. Besides the unit fly-away cost of the aircraft, we believe a key metric for management to discuss at the Investor Conference is the hourly all-in flight operating cost of the F/A-18 compared to other aircraft and the F-35. So anything the company can say on the status of international campaigns would be helpful in assessing the longer-term outlook for F/A-18.
• We would be surprised if any negatives emerge on the KC-46 tanker program or the P-8, as both appear to be proceeding smoothly and Air Force officials stated in Congressional hearings last week that KC-36 remains a very high priority program. Both programs will have to navigate sequester cuts, but could see outyear growth on higher unit deliveries.
• Boeing is competing for the LRS-B (Long-Range Strike Bomber). This program is classified but potentially quite large. Anything that could said on timing, size or potential contribution of that program would help investor confidence in BDS over the balance of this decade and into the next.
• Helicopter programs appear stable (CH-47 and V-22), though the AH-64 was cut in the FY14 budget request and there have been transmission-related delays on recent deliveries. Still, an issue is how helicopter needs could change in the U.S. if there are deeper cuts to Army and Marine force structure that, in turn, truncate requirements for Boeing rotary wing aircraft.
• The GBI (Ground Based Interceptor) program has benefitted from North Korea’s recent actions, though the interceptors are built by Orbital Sciences. Still, Congress retains an interest in establishing an East Coast U.S. base to counter a potential Iranian ICBM threat after 2015. We presume that since Boeing is prime on GBI, it could also benefit from an East Coast base. Another point of interest for BDS is how sales are progressing on its relatively new all-electric 702SP satellite design.
• Global Services and Support includes “shorter cycle” O&M work on U.S. airframes (C-17, F/A-18 and others) that should be impacted by sequestration cuts, though this sector has seen growth in international integrated logistics, and the Saudi F-15 upgrade program is another significant program that should mitigate against U.S. cuts. The DoD has been interested in greater use of Performance-Based Logistics contracts to support fielding equipment, but our sense is this aspiration has been lagging. Boeing did not win the KC-46 aircrew training system (it went to FlightSafety Services, which is owned by Berkshire Hathaway). That contract was announced May 1 so Boeing should now have been briefed on the Air Force decision.