DBRS Dwgrds SBC Comm. to Ap & R-1(low)p, Rmvd from UR-Neg

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

DBRS has downgraded the ratings of SBC Communications Inc. and SBC Communications Capital Corporation (collectively, “SBC” or the “Company”) to Ap and R-1 (low)p, all with Stable trends, from A (high)p and R-1 (middle)p. This comes after DBRS placed SBC’s ratings “Under Review with Negative Implications” on February 17, 2004, after its subsidiary, Cingular Wireless LLC (“Cingular”), announced its intensions to acquire AT&T Wireless Services Inc. (“AT&T Wireless”).

With SBC and BellSouth Corporation (BellSouth) providing Cingular with the funding for the acquisition, DBRS has confirmed Cingular’s rating at A (low)p, with a Negative trend, and raised AT&T Wireless’ rating to match, at A (low)p, with a Negative trend. Cingular and AT&T Wireless are now treated as consolidated credits.

The rating actions for SBC reflect several key factors:
(1) Increased leverage at SBC of up to US$9 billion to support Cingular’s financing of the acquisition of AT&T Wireless;
(2) SBC’s increased exposure to wireless services, which still remains a highly competitive segment of the U.S. telecom industry; and
(3) The continued pressure on SBC’s circuit switch fixed-line operations through substitution and technological change that has resulted in access line erosion and declines in operating margins that are likely to continue under pressure.

With these changes, SBC’s Ap rating and BellSouth’s Ap rating (downgraded at the same time) are now comparable to Verizon’s (specifically, Verizon Global Funding Corp.’s) Ap rating given their similar:
(1) Mix of businesses that are exposed to competitive communications services; and
(2) Financial risk profiles.

In completing the transaction, SBC provided approximately US$21.6 billion in funding to Cingular through an equity injection. SBC funded this through existing cash on hand, free cash flow, asset sales, and approximately US$8.75 billion of new debt (bank debt initially, which was subsequently repaid with long-term notes and commercial paper). In the near term, SBC will likely receive no operating cash flow from Cingular other than the existing interest on inter-company loans. Thus, liquidity and coverage ratios will decline as a result of operating cash flow being muted by additional interest expense combined with the increase in debt.

If Cingular can successfully integrate AT&T Wireless, it will likely have the ability to inject additional cash back to SBC through dividends or repayment of existing inter-company loans. However, DBRS notes that it is still somewhat unclear as to when these payments would begin and the amounts involved. Therefore, Cingular’s support to SBC’s increased financial risk profile could be modest for some time.

With the acquisition, SBC will now have a higher exposure to the wireless sector. Although this is currently a growth area within the telecom industry, and can generate substantial operating cash flow, it is still a highly competitive industry attributable to:
(1) Four national operators plus one niche player and many regional operators competing in the U.S.;
(2) The ease of changing wireless carriers through wireless number portability, thus increasing customer retention costs and keeping acquisition costs still quite high; plus
(3) The evolution of wireless data services, as carriers upgrade networks to support both voice and advanced data services.

In addition to the above, SBC will be exposed to the increased risks associated with the integration of Cingular and AT&T Wireless. Success in this integration will not only be measured in terms of cost reductions, but also the ability of the combined entity to reduce churn in the long term from current levels. This reduction in churn will be critical in the success of SBC’s bundling initiatives, where wireless plays a key role.

Notwithstanding the foregoing, SBC’s traditional franchise remains considerable. It maintains a substantial customer base, with excellent distribution channels that help generate substantial operating cash flow, albeit now against an increased debt level. The Company will maintain strong liquidity and coverage ratios. However, competitive risks are increasing. There is a growing shift in business mix to more wireless and broadband exposure, where it does not get the same protection from its legacy status. Also SBC, along with the other U.S. regional Bell operating companies (RBOCs), continue to experience greater pressure on operating cash flow from the core fixed-line voice operations. This is due to access line erosion attributable to substitution and technological changes. SBC has tried to counter this erosion through: (1) bundling services, (2) the expansion into newer services such as DSL, (3) inter-state long distance, and (4) video services, along with its recently announced fibre initiatives.

Even so, these areas face substantial competition from cable operators and other communications operators that can offer bundles of services including video, broadband, and voice. Accordingly, DBRS believes the dominance that SBC once had in fixed-line communications will be fundamentally altered with advances in technology, especially as broadband penetration competes for the last mile to the customer.

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