DBRS Comments On New U.S. Telco Ratings

Paul Holman; Rory Buchalter/416-593-5577 ext.2234, ext.2268/pholman@dbrs.com

 

“P” indicates rating is based on public information only.

 

DBRS has assigned new ratings to the companies listed above.  Over the past several years, DBRS has produced research on each company and now is upgrading coverage to include credit ratings.  DBRS’s decision to proceed as such is based on a growing interest from institutional investors, who are demanding greater diversity in credit research.  The “p” indicates DBRS has used public information only.  DBRS’s assignment of the credit ratings is based on its research over the past several years (refer to DBRS’s study on the U.S. Telco Industry published this month) and the high level of disclosure these companies provide to the public on a timely basis. 

 

DBRS’s newly assigned credit ratings are based on a number of factors, including:

(1)   Industry risk – competition, evolving products, new technology, and consolidation/structural change;

(2)   Company risk – performance measures, operating margins, and return on equity (ROE);

(3)   Financial risk – leverage, maturities, leases, and off-balance sheet items;

(4)   Liquidity risk – capital market access, cash, bank lines/commercial paper, cash burn; and

(5)   Ranking issues – structural subordination, security, guarantees, and covenants.

 

With incumbent telephone companies around the world facing growing competition, driving industry risk higher and higher, credit ratings have generally fallen to the “A” range from the AA range when the franchises were quasi monopolies.  Even so, the “A” range still indicates significant market power. 

 

In the U.S., where regulators in the mid-1980s separated long distance and local service, the evolution will be especially challenging since this historical separation must disappear in time.  This pertains to the regional Bell operating companies (RBOCs) that include Verizon Communications Inc. (“Verizon”), BellSouth Communications Inc. (“BellSouth”), SBC Communications Inc. (“SBC”), and Qwest Communications International (“Qwest”) plus long-distance companies like AT&T Corporation (“AT&T”).  This will not be an easy transition as massive state and federal regulations continue to hobble market-based change.  Regulation will likely continue to lag technology-driven competitive change for some time.  For companies that have always been fully integrated, like Sprint Communications Inc. (“Sprint”) and ALLTEL Corporation (“ALLTEL”), this is less of a concern. 

 

Other structural issues include: (1) competitors to gain greater access to the networks of the incumbent telcos, at attractive wholesale rates to expand service areas (for example, the Unbundled Network Elements Platform (UNE-P) guidelines); (2) competitors to provide more services, including local telephone service, long distance by wireless, high-speed Internet, and (3) longer term, traditional telco networks to convert to broadband IP/packet networks with fibre closer to the premise from switched-circuit networks.  In time, more and more competitors will have greater access to ubiquitous IP platforms, with greater opportunity to bundle new services, along with current services including wireline, wireless, Interest access, and video.  Sales and marketing will become a key driver as significant cost-cutting targets are achieved.  The interest in new technologies will ease as platforms become standardized and transparent. 

 

In general, the RBOCs’ margins and cash flow have already fallen with the changes in product mix, based on many of the following factors, including: (1) declining number of full service local lines in use (with less residential second lines and more wireless phones); (2) growth in less profitable national (interLATA) long distance; (3) growth in less profitable wholesale lines (UNE-P lines); and (4) growth in less profitable high-speed DSL Internet access service.  The RBOCs’ underlying strength is derived from a solid financial footing.  They generate good free cash flow and maintain strong balance sheets.  They have good liquidity and access to capital markets.  Leverage is reasonable, as are their maturity schedules.

 

BellSouth and SBC represent the strongest telco holding companies in the U.S. with ratings of A (high).  BellSouth has effectively managed its increased competitive risk to date, and has a strong balance sheet and strong free cash flow.  However, the competitive intensity is expected to increase and by owning only 40% of Cingular, its wireless business, BellSouth does not have a consolidated wireless growth engine that other telcos like Verizon, Sprint, and ALLTEL have.  SBC has a similar risk profile, but has faced greater business risk to date as a more liberal regulatory environment has enabled competitors to gain strong in-roads into its local market.  Similar to BellSouth, SBC has helped mitigate this risk through strong free cash flow and increased financial flexibility.

 

Verizon Global Funding Corp. (guaranteed by Verizon) and ALLTEL are each rated “A”, but for different reasons.  Verizon, like the other RBOCs, has experienced access line erosion as a result of UNE-P and technology substitution.  However, some of this pressure has been offset by its industry-leading position in wireless.  Verizon has also reduced debt levels substantially over the past three years and has significantly reduced operating expenses through headcount reductions.  ALLTEL, a rural local exchange telecommunications company (LEC) and wireless operator, has:  (1) a strong local business in secondary markets with EBITDA margins in the high 50% range and experiences minimal competition; and (2) a large regional wireless operation providing growth.  The company does operate in a very competitive wireless environment, but has a strong financial profile to support a rating in the “A” range.

 

Two of the traditional inter-exchange carriers, AT&T and Sprint, are each rated BBB.  AT&T is experiencing pressure on its consumer long distance and business data units, but has mitigated this pressure by: (1) bundling local and long distance services; (2) cutting costs; (3) reducing debt significantly; and (4) generating strong free cash flow.  Sprint’s rating profile has stabilized over the past year as the company sold its directories business, reduced debt levels, and generated positive free cash flow.  Sprint also operates a sizeable wireless business (the fourth largest in the U.S.), which is generating strong operating cash flow growth.  Additionally, Sprint has experienced only limited pressure on its: (1) local business, which is in secondary markets; and (2) consumer long distance business to date.

 

The improvements in the financial profile for most carriers over the past two years will be the key offset to increases in business risk, which will allow most incumbent telcos to maintain ratings in the “A” range.  However, the inability to adapt quickly to the changing environment and to be at the forefront of new services and technologies may mean even a strengthening financial profile may not be enough to avoid some rating pressure in the mid term.

 

 

Dominion Bond Rating Service Limited (DBRS) has published a full report that provides additional analytical detail.  To see this report, please click on http://www.dbrs.com/web/sentry?COMP=2900&DocId=132880, http://www.dbrs.com/web/sentry?COMP=2900&DocId=132881, http://www.dbrs.com/web/sentry?COMP=2900&DocId=132940, http://www.dbrs.com/web/sentry?COMP=2900&DocId=133060, http://www.dbrs.com/web/sentry?COMP=2900&DocId=133061, and http://www.dbrs.com/web/sentry?COMP=2900&DocId=133100.  If you do not have access to this document, please contact us at info@dbrs.com.