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Stiff Competition & Economic Challenges Will Pressure Telecoms Operators in 2010

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Fitch Ratings says that it expects that many of the competitive and economic pressures of 2009 will remain for U.S. telecommunications and cable operators in 2010. Competitive overlap of services is ever growing for this sector and will continue to materially impact company's near term results and long term prospects. Economic challenges for the sector, particularly related to unemployment and housing starts are expected to continue well into 2010, also pressuring results.

Traditionally, U.S. telecommunications and cable service demand has lagged economic recoveries. Fitch expects this lagging trend to continue and any U.S. economic improvement in 2010 will likely not be reflected in telecommunications and cable results until 2011. Therefore, Fitch expects that the difficult operating environment that companies experienced in 2009 will continue through 2010.

"Although the telecom and cable industry has maintained strong liquidity and free cash flow, macroeconomic woes including unemployment rates and a struggling housing market will continue to limit financial growth for the sector," said Michael Weaver, Managing Director at Fitch.

Wireline Prospects

Fitch estimates that aggregate access line losses for 2009 will be approximately 10.5% for the telecommunications sector. Pressure from wireless substitution and weak housing starts continue to be key influences that will remain in 2010. A lessening impact of cable digital telephony erosion of residential access lines was offset by a material increase in business access line losses in 2009.

Business and residential access line losses should stabilize in 2010 and continue in the range of 3-3.2 million per quarter, which would represent a yearly loss of approximately 12% with the percentage increase reflecting the declining overall base. The on-going loss of legacy revenue increases the importance of other sources of wireline growth for telecommunications operators, such as high-speed data (HSD), network-based video and business/commercial services.

Fitch estimates that HSD subscriber growth slowed in 2009 to 1.7 million net subscriber additions. Likewise, Fitch forecasts that total HSD net subscriber additions will slow in 2010 to approximately 1.4 million. The slowing growth of the HSD market is reflective of higher penetration of these services and to a lesser extent a growing substitution by wireless data. With regard to network-based video, Fitch estimates that offerings by AT&T and Verizon Communications will grow by 2 million subscribers in 2009, but this rate will likely slow in 2010 to approximately 1.5 million. The slowing growth rate reflects increasing penetration and a slowing of coverage growth as these operators enter their final phase of deployment.

Finally, business/commercial service revenue erosion peaked in first-quarter 2009 (1Q'09) and Fitch expects the total 2009 decline to be over 6% for wireline companies with this trend the result of growing unemployment. It is likely that the unemployment rate is near its high so Fitch believes that reductions in business/commercial revenues should be modest, in the range of 1%, in 2010. In total, Fitch estimates that aggregate wireline revenues will decline in 2010 near the mid-single-digit range, a modest improvement over 2009. Operators with a larger growth services revenue mix should experience revenue erosion in the low single-digit range. EBITDA will similarly fall in aggregate by a low- to mid-single-digit range for the industry as benefits from headcount reductions offset losses of high-margin legacy services.

Cable Prospects

Cable multiple system operators (MSOs) experienced accelerating basic subscriber losses in 2009 with a reduction of approximately 2.75%. Subscriber losses are the result of weak new home growth, but more important, they are the result of competitive erosion from direct broadcast satellite (DBS) and network-based incumbent local exchange carrier (ILEC) video offerings. The basic subscriber erosion rate will accelerate in 2010 as competitive pressure remains fairly constant, but there will not be the lift from digital television conversion that benefited cable MSOs in the first and second quarter of 2009. Fitch estimates that basic subscriber erosion will increase to approximately 3.5% in 2010.

HSD subscriber additions also slowed materially for cable MSOs in 2009 with Fitch expecting subscriber growth of approximately 1.7 million in 2010. Cable MSOs should experience only a slight reduction in the level of HSD growth, as DOCSIS 3.0 enhances their competitive offering and penetration of a growing commercial services segment provide increased opportunities for subscriber growth. Cable telephony subscriber growth fell rapidly in 2009 with a reduction of over 40%, but with operators still adding approximately two million net subscribers.

Fitch estimates that cable telephony net additions will fall to 1.4 million in 2010 as wireless substitution and weak housing-starts impact results. While overall telecommunications business/commercial service revenue fell in 2009, cable MSOs successfully increased their share of the small business/home office market. Fitch estimates that commercial service revenue increased by approximately 25% for cable MSOs in 2009 and that this trend will continue with these operators moving up to the mid-size business customer segment in 2010.

In aggregate, Fitch estimates that cable revenues will increase in the 3%-5% range in 2010 and that firm margins will lead to a similar level of EBITDA growth.

Wireless Prospects

Overall total net additions in wireless continued to slow reflecting lower gross additions due to higher penetration, but equally important were factors reflecting the weak economy such as high unemployment. Fitch estimates that the total subscriber base grew by about 5% in 2009 and this will slow to approximately 4% in 2010.

Postpaid net additions were materially affected by the economy and unlimited prepaid plan offerings, which increased churn, resulting in total post-paid net additions declining by approximately 42% for 2009 compared to 36% in 2008. However, subscriber interest in 3G data services and advanced devices such as smartphones, netbooks and aircards kept post-paid gross additions relatively flat in 2009. Fitch expects that post-paid gross additions will remain stable in 2010 and that the rate of decline of net additions should improve slightly.

In contrast to post-paid, pre-paid subscriber additions were strong in 2009 due to the popularity of unlimited plans and economic sensitivities of subscribers. Fitch estimates that prepaid net additions will increase by nearly nine million in 2009 compared to approximately five million for post-paid. Fitch expects that pre-paid additions will again achieve in 2010 a level similar to 2009 as economic sensitivities remain and competitive pressures for pre-paid subscribers increase.

Of significant interest beyond 2010 is whether interface device selection may limit the appeal of prepaid service plans particularly in the face of economic recovery. Voice ARPU continues to erode at a growing pace approaching double digits in 2009 in part due to lower roaming revenue. This trend will continue in 2010 and at a level equal to or even higher than 2009. Data ARPU growth has limited the impact of voice ARPU erosion on total ARPU, which has remained relatively steady. Despite economic pressure in 2009, data growth remained robust in part due to the successful penetration of smartphones such as AT&T's iPhone offering. At the end of 2009, Fitch expects that wireless data will generate in excess of $44 billion in revenue on an annualized basis. Fitch continues to believe that strong data growth will again be achieved in 2010 as additional leading-edge smartphone devices such as the Android will be available, which should push subscriber interest in these services. Again, high unemployment rates will limit the overall potential of this growth, but Fitch believes it will reach a run-rate of $51 billion by year-end 2010.

In aggregate, Fitch forecasts that wireless revenue will increase in the mid- to high-single-digit range in 2010 and that margins may erode slightly from higher marketing and retention costs and success of unlimited prepaid plans, but still remain in this range.

Free Cash Flow

Telecommunications and cable capital expenditure was down approximately 12% in 2009, reflecting the generally success-based nature of this spending. Companies invested selectively in areas with the strongest future growth prospects such as wireless while cutting back in legacy service areas. Fitch expects that capital expenditure will be flat in 2010 as growth prospects for the industry lag an economic recovery. Fitch estimates that free cash flow (FCF) for the industry increased by approximately 20% in 2009 as companies materially reduced capital expenditure and focused financial strategies on improving financial flexibility. Furthermore, FCF conversion increased in 2009 to a Fitch-estimated 5.1% of revenues compared to 2008's level of 4.3%. Fitch believes that FCF will again increase in 2010 by approximately 10% due to modestly higher aggregate EBITDA and continued low levels of capital expenditure. Fitch expects that a material amount of FCF will be used for debt reduction in response to higher debt levels from consolidation and wireless spectrum investment that has occurred over the past few years. Nevertheless, Fitch also expects that some companies will increase their shareholder-friendly activities based on their improved financial flexibility and growing confidence in improved economic prospects. Fitch also expects that acquisition and merger activity will continue in 2010 as companies attempt to address growth needs and strive for improved operational efficiencies.

Regulatory

While there are a large number of regulatory issues that need to be addressed in the telecommunications and cable industry, led by universal service funding (USF) and intercarrier compensation, these issues will be complicated and take a long time to resolve. Instead, it appears that in 2010 the Federal Communications Commission (FCC) will focus on their involvement in the broadband development allocation of the American Recovery and Reinvestment Act (ARRA) and net neutrality. Neither of these issues is likely to have a material impact on financials or prospects for the industry in 2010.

Liquidity

The U.S. telecommunications and cable industry continues to maintain relatively strong liquidity. Those companies with Fitch credit ratings generated last 12 months (LTM) FCF, as of 3Q'09, of approximately $34 billion and maintained balance sheet cash of approximately $23 billion. This level of internal liquidity compares to a Fitch-estimated 2010 maturity schedule of approximately $20 billion. Revolving credit capacity for the industry is strong with an average availability of nearly 85% or $46 billion.

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