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U.S. Telecom and Cable Credit Profiles to Weaken in 2009

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Debt ratings agency, Fitch has issued a report where it says it believes that growing event risk associated with economic, competitive and regulatory pressures will weaken the credit profile of most operators within the U.S. telecommunications and cable sector in 2009. Growing unemployment, continuing home foreclosures, the acceleration of cord cutting, evolution of wireless smart phone based data services, and a changing regulatory environment with a new Federal Communications Commission (FCC) make up and key regulatory programs up for reform represent some of the challenges to the industry in 2009.

These challenges will result in a changing landscape and difficult operating environment for many companies.

Fitch believes that revenue and EBITDA growth for U.S. telecommunications and cable operators will slow in 2009, but that overall aggregate capital spending will likely be flat compared to 2008. As a result, free cash flow will weaken in 2009 for the industry and overall leverage will increase. Fitch expects that the industry weakening will move some companies to the lower end of their current ratings and, if more severe than expected, could lead to negative rating actions during 2009.

Economic Pressure

Economic pressure has been material for the industry in 2008, particularly related to housing. The increase in foreclosures along with the weak new-home growth has taken away an important offset to competition for legacy wireline voice and video service providers. Without this offset, incumbent local exchange carriers (ILECs) have experienced increased access-line losses. Similarly, cable multiple system operators (MSOs) have also experienced increased basic video subscriber losses. Additionally, the weak new-home growth and high data penetration is resulting in slowing high-speed data growth. This home trend is expected to continue in 2009 and Fitch believes it will in part result in even greater erosion for switched access lines and basic video subscribers for ILECs and cable MSOs, respectively.

Another negative economic trend that will put pressure on the industry is unemployment, which will likely have a negative impact on business service revenue for all operators. As unemployment rises, companies reduce or groom their business service requirements. While some services are contractual, this typically only applies to government entities and large business contracts are generally for only three years with a portion renewing every year. Therefore, growing unemployment will lead to lower demand for business services; this is particularly true as unemployment has increased significantly in the financial services sector which is a heavy user of telecommunications services. Fitch also expects that unemployment and economic pressure will affect small business, which has been a source of relatively strong growth for the industry over the past couple years. Thus, Fitch expects that ILECs could see flat to negative growth of aggregate business service revenue in 2009. Likewise, small office and home office (SOHO) commercial service revenue has been a new source of growth for the larger cable MSOs and this should materially slow in 2009 reflecting increasing economic pressure.

Finally, higher unemployment rates will also likely have an impact on wireless operators as it relates to net additions and bad debt. Fitch estimates that net additions will fall in excess of 20% in 2008 compared to 2007. Rising unemployment will likely accelerate this trend in 2009 and result in net additions reaching a level that is nearly half the rate of 2007. The decline in total net additions is particularly severe in prepaid net additions, with those customers expected to be more sensitive to economic stress. Additionally, there is material risk that bad debt will rise in 2009 as lower credit quality post-paid customers are affected by economic pressures and are unable to pay their invoices. While this measure has shown no material change to date, Fitch expects it to increase in 2009, which could pose a significant problem for those wireless operators with material subprime customer bases. Fitch also expects that a rise in churn rates in 2009 is likely as involuntary churn is increased by customers sensitive to the economic pressures present.

Competitive Pressure

Competition remains a strong influence on the U.S. telecommunications and cable industry, particularly as service overlap by ILECs, wireless operators, and cable MSOs has become more widespread. Both ILECs and cable MSOs have used bundled service offerings to compete for retail customers. Aggressive marketing and retention campaigns will likely be a focus in 2009 for operators as they compete for market share of a fixed connection pie that will experience flat growth or even a slight contraction in 2009. Another trend that could accelerate as retail consumers balance economic pressure is the cord-cutting of wireline voice services and substitution with wireless.

Fitch believes that wireless-only households reached approximately 20% in 2008 and that this will continue to grow in 2009, potentially at a higher rate as some retail consumers look to reduce duplicate services in an effort to save money. Fitch also believes that wireless substitution represents the greatest threat to ILEC switched access lines in 2009 and will exceed line losses to cable MSOs.

As a result, switched access line erosion, which Fitch estimates at 9% in 2008, will grow to 10%-11% for the industry in 2009. Likewise, the success of ILEC network-based video offerings, which reached approximately 2.4 million customers at third-quarter 2008 (3Q'08), a nine-month increase of 1.2 million, will continue and, along with economic pressure and satellite competition will lead to an increase in basic subscriber losses for cable MSOs to 1%-1.5% of the total subscriber base in 2009. Wireless competition remains strong among the four national and various regional operators, particularly among data service revenue. While voice average revenue per user (ARPU) is falling, data is rising rapidly. This trend is expected to accelerate with the industry's push toward greater 'smart phone' penetration in 2009. However, this competition and aggressive 'smart phone' marketing is leading to high acquisition costs through greater subsidies, and results in near-term margin erosion. It should be noted that 'smart phone' users have a much higher average ARPU compared to traditional wireless customers and this will likely lead to stronger long-term revenue growth, at the cost of some near-term financial pressure.

Regulatory Pressure

With the Democratic party winning the presidential election, the majority in the FCC will shift to the Democrats. The commissioners in the FCC could change significantly, since Republican Commissioner Deborah Tate's term will expire at year-end 2008 and Republican Chairman Kevin Martin may leave or be replaced by President-elect Obama. Many expect that the new FCC will be tougher on industry operators and more protective of consumers. The most likely outcome of this type of position would be far more difficult merger reviews along with new reviews of positions on Net Neutrality, the spectrum cap, wireless automatic roaming and home market exemption along with long-coming reform on Universal Service Funding (USF) and intercarrier compensation. While it is not likely that all these issues would be resolved in 2009, the new direction could have an impact on industry consolidation.

Merger & Acquisition Activity

The increase in regulatory uncertainty, a more difficult operating environment, and a tighter credit market could lead to further industry consolidation within the mid-tier level of companies. Clearly the industry has seen a recent increase in activity with Verizon Wireless acquiring Alltel, CenturyTel acquiring Embarq, and AT&T acquiring Centennial Communications. However, the new Democratic FCC majority may give some pause to future acquisitions by the large industry participants.

One known important divestiture activity in 2009 is Verizon Wireless' requirement to divest 105 markets for approval of its Alltel acquisition. Verizon estimated that this represents approximately 2.3 million customers as of 3Q'08. Fitch estimates that this would represent a value of $4 million-$4.5 billion. With the number of recently completed or announced acquisitions some operators within the industry will, or already, face a significant amount of integration expense in 2009, which along with economic, competitive and regulatory pressures already expected to be present will create a management challenge. This presents an element of risk in their credit profiles that may already be stressed from a leverage and free cash flow perspective for the individual rating category.

Financial Outlook

Looking at the large subsectors within the U.S. telecommunications and cable industry, Fitch expects that revenue and EBITDA for wireline services will experience a low-single-digit negative growth rate in 2009. In contrast, Fitch expects that wireless and cable service revenue and EBITDA will grow in the 5%-7% range in 2009. Capital spending is expected to be flat in 2009 compared to 2008, with spending concentrated in wireless, ILEC network based video and cable customer premise equipment (CPE). Free cash flow will likely be reduced in 2009 representing lower EBITDA and flat capital spending and relatively higher debt amounts. Likewise, leverage will likely be moderately higher in 2009 versus 2008 reflecting industry acquisition activity along with lower EBITDA.

Recovery Multiples

As a result of a tighter credit market, it appears that EBITDA multiples have fallen in recent transactions, with the Verizon Wireless acquisition of Alltel Corp. at 8.6 times (x), CenturyTel Inc. acquisition of Embarq Corp. at 4x and the AT&T acquisition of Centennial Communications Corp. at approximately 7x. A relative comparable for the Alltel Corp. acquisition is the year earlier acquisition of that company by TPG Capital and GS Capital Partners for approximately 10.2x. These data points suggest that multiples have fallen between 15%-30% in the current credit environment. Nevertheless, these multiples are still within the methodology utilized by Fitch for the U.S. telecommunications and cable sector, which discounts median transaction values by 35% to establish three recovery multiples, 9x, 6.5x, 4.5x, that are applied based on the strength of business position, operating environment, and financial flexibility of the entity in question.

Nevertheless, a continuation of the current tight credit cycle along with a more difficult operating environment could erode multiples to the point that recovery values and ratings, which apply to speculative grade issuers, could be adjusted downward in 2009. Fitch will continue to monitor this situation closely and make changes as appropriate.

Liquidity

Financial flexibility and liquidity for the U.S. telecommunications and cable sector is stable with companies covered by Fitch generating last 12 months (LTM) free cash flow as of 3Q'08 of approximately $17.6 billion and maintaining a balance sheet cash level of approximately $18.7 billion. This internal liquidity compares to a 2009 maturity schedule of approximately $17.4 billion. Revolving credit capacity for the industry remains strong with an average availability of 77% or approximately $33 billion. Additionally, only two companies have revolvers expiring in 2009, Verizon Communications and Telephone & Data Systems. However, Fitch views revolving credit capacity as a weaker source of liquidity due to a lower level of confidence that it will be accessible during times of severe stress. Nevertheless, there are companies within the sector that have weaker liquidity, such as Charter Communications, Inc., which has substantial negative annual free cash flow along with limited liquidity that Fitch estimates will fund the company through 2009. Level 3 Communications, Inc. also has limited liquidity and is just reaching free cash flow neutral, but faces significant maturities in 2010. It should be noted that the company has entered a period where it will repurchase $1.14 billion of debt maturing in 2009 and 2010 at discounts to the face value. If successful, this repurchase will provide the company with significant financial flexibility and address its near-term liquidity concerns.

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