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Credit FAQ: Stretched Balance Sheets Leave Little Headroom For U.S. Wireless Carriers Amid Macroeconomic Headwinds

Volatile financial markets, higher inflation, rising interest rates, and the increasing likelihood of a recession are likely to hurt corporate credit quality over the next year. U.S. wireless providers are typically resistant to macroeconomic headwinds given the increasing dependence on mobile connectivity of consumers and businesses. However, wireless service providers are not completely insulated from these challenges and spending in recent spectrum auctions increased their leverage, leaving little room for weaker financial performance. Below, we address frequently asked questions about the effects of an increasingly competitive environment, higher inflation, rising interest rates, and recession on the big three U.S. telecommunications companies: AT&T Inc., Verizon Communications Inc. , and T-Mobile U.S. Inc.

Frequently Asked Questions

How is cost input inflation affecting the sector?

Our economists forecast Consumer Price Index (CPI) will increase around 7.5% in 2022 and 3.4% in 2023, above the Federal Reserve's target of 2%. In the U.S. wireless sector, industrywide inflationary pressures started to emerge in second-quarter 2022 results and contributed to lower full-year guidance for the incumbents AT&T and Verizon. While both carriers implemented price increases on certain rate plans, it was not enough to offset higher costs. We believe the biggest exposure is labor and energy expense and estimate these two buckets account for 25%-30% of their costs. AT&T and Verizon have large, unionized workforces where collective bargaining agreements are renegotiated with various unions on an annual basis. We expect wages to rise as these agreements are renewed given low levels of unemployment. While the telcos typically enter short-term purchase price agreements for their energy needs, mitigating some of the risk, higher rates over the long term could hurt margins.

For AT&T, inflation will result in $1 billion of incremental cost pressures from wages, equipment, supplies, transportation, and energy, affecting all business segments but more detrimental to margins in business wireline. Management called out inflation in wholesale network access charges to provide services outside of its footprint, which contributed to an 8% EBITDA decline in the segment. While AT&T expects price hikes to at least partially offset rising expenses, we believe this could prompt more switching activity.

However, higher inflation is also affecting AT&T's customer base. The company noted that payments by consumers have extended, resulting in day sales outstanding (DSO) increasing by two days, which will negatively impact working capital by around $1 billion in 2022. Further, bad debt expense is rising above pre-pandemic levels in the mobility segment. While aggressive promotions are driving healthy postpaid subscriber net adds at AT&T, they are also contributing to weaker margins as these promotions are amortized over the life of the customer contract.

Chart 1


Similarly, Verizon management said it is experiencing cost pressures in labor, utilities, transportation, and logistics, which partially contributed to its decision to lower guidance to (1.5%) to flat EBITDA from 2%-3% growth for 2022. Higher prices are also affecting customer trends, particularly at the lower end where higher food and gas prices are squeezing consumers' budgets. However, unlike the rest of the industry, Verizon lost about 215,000 consumer postpaid customers during the quarter and service revenue growth was weaker than expected. Verizon's gross subscriber additions declined 11% in the consumer segment while postpaid phone churn increased by 10 basis points to 0.75%. Overall, we believe Verizon is most at risk to margin erosion since it has already completed its $10 billion cost savings program while AT&T is still implementing its $6 billion expense reduction initiative and T-Mobile is realizing synergies from its acquisition of Sprint. While rate increases could partially offset higher expenses, we believe Verizon's network competitive advantage and brand loyalty has eroded as AT&T and T-Mobile close the gap, making it more likely for customers to switch. Given its incumbent position with a dominant postpaid market share of around 39%, it has the most customers to lose.

Chart 2


Even though inflation is having an impact on some parts of T-Mobile's business, the company has locked in long-term rates with providers for a significant portion of its costs, including wireless backhaul and tower lease expense. Similarly, it has secured short-term purchase price agreements for most of its energy requirements, although it is exposed to higher rates as these contracts come up for renewal. Although labor expense is likely to rise in the near term, we do not anticipate it will make a significant dent on earnings growth given the unrealized cost synergies from its acquisition of Sprint, which should more than offset near-term expense pressure. Further, we expect T-Mobile to benefit from recent rate increases AT&T and Verizon implemented, which could drive more customers to its network.

How does S&P Global Ratings think a recession would affect U.S. wireless companies?

Our economists believe the chances of a recession are rising and assess recession risk at 45%, reflecting a larger spike in prices with even more aggressive Fed policy heading into 2023. Our baseline forecast assumes the GDP grows 2.4% in 2022 and 1.6% in 2023 while unemployment rises from 3.7% in 2022 to 4.1% in 2023.

Mobile devices have become a necessity for most people and consumers are unlikely to rid themselves of wireless services in an economic downturn. Against this backdrop, we would expect the U.S. wireless industry to hold up reasonably well relative to other corporate sectors but still not completely insulated from an economic deceleration. With U.S. penetration levels above 100%, we would expect some pressure on subscriber trends, especially as companies reduce headcount to preserve margins, since a large portion of postpaid customer additions came from the proliferation of second handsets as businesses distributed smartphones and tablets to employees, especially since hybrid work has become more prevalent.

In the consumer segment, we would expect customers to migrate to less expensive data plans, or even prepaid services. In particular, we believe subscribers would flock to value providers, including T-Mobile and cable operators Comcast Corp. and Charter Communications Inc, the latter of which are bundling mobile services with their broadband product via mobile virtual network operator (MVNO) agreements to bundle customers and keep churn low. We also expect higher bad debt expense and churn levels in a recession scenario.

How does S&P Global Ratings view the competitive landscape?

The wireless industry had a strong year for postpaid phone subscriber and service revenue growth in 2021. Service revenue for the big three telecoms grew about 4% compared with pandemic-related flat service revenue growth in 2020 while the industry added about 9.5 million postpaid subscribers, up from 6.5 million the prior year and substantially above historical trends. Further, subscriber and service revenue trends remained healthy in the first half of 2022. However, we expect the cable providers to be more aggressive in wireless as their in-home broadband service faces greater competitive pressure from fixed wireless access and fiber to the home (FTTH) broadband service.

In addition, DISH Network Corp. entered the retail wireless market by purchasing Boost Mobile from T-Mobile after it acquired Sprint. As of the June 30, 2022, DISH deployed spectrum to cover 20% of the U.S. population and is committed to cover 70% by June 2023. The company also entered into a ten-year MVNO agreement with AT&T, enabling it to delay its buildout into rural markets, which are more costly to deploy. However, a projected $10 billion of network buildout costs, its lack of scale as a mobile startup, and limited financial flexibility could constrain DISH's ability to compete.

Cable took about one-quarter of postpaid phone net adds in 2021; bundling mobile service with wired broadband at a discounted price creates a compelling value proposition. We expect cable will capture about one-third of postpaid net adds in 2022 as the primary beneficiary of consumers looking for less expensive mobile options in an inflationary environment. MVNOs haven't fared well historically given their lack of scale, scope, and asset ownership, the latter of which is important for network management and profitability. Still, cable operators have pieced together some network capabilities by combining Wi-Fi hotspots and acquiring spectrum licenses in heavily trafficked markets. These providers--including Comcast Corp. and Charter Communications Inc.--have the financial resources to absorb low EBITDA margins as long as the wireless business benefits overall churn for higher margin Internet services. While earlier cable MVNO agreements proved unprofitable and ultimately were dissolved, we believe cable could take share and mitigate EBITDA dilution to the overall base of business as it gains customers by leveraging spectrum holdings and Wi-Fi hotspots to improve the economics of the wholesale business.

At the same time, mature industry conditions and increasing competition place mobile service providers in a difficult situation. They can offer aggressive promotions to take share, though this strategy will hurt profitability. However, without these promotions, subscribers will likely defect because cable offers more competitive pricing. We believe this trend is more likely to affect results at Verizon and AT&T, which are defending their existing customer bases and already have high margins.

Chart 3


Has S&P Global Ratings' view on the U.S. wireless industry changed since the beginning of the year?

Yes, somewhat. While we continue to view the U.S. wireless sector as resilient to macroeconomic headwinds, it is not completely insulated. The U.S. economy has not been through a period of high inflation since the 1980s, which puts us in unchartered territory. While a recession may or may not come to pass in the second half of 2022 into 2023, the effects of inflation and global supply constraints this year are undoubtedly clear. The first half of 2022 results suggest the following headwinds in the near-term:

  • Customers take slightly longer to pay bills as higher gas and food prices squeeze them, resulting in higher DSOs and negatively impacting working capital. AT&T said that higher DSOs will pressure free cash flow by about $1 billion in 2022.
  • Higher inventories from global supply chain issues hurt working capital and free cash flow. During the first quarter of 2022, Verizon stated that inventory levels rose as the company pre-ordered devices to stay ahead of supply chain challenges.
  • Operating expense pressure, including higher wages and energy prices.
  • Bad debt expense rises.
  • Carriers implement rate increases to offset higher operating expense, which could result in more switching as consumers look for cheaper plans.
Which company is most exposed to rising rates?

About 20%-25% of Verizon's debt is floating rate, making it the most exposed to rising interest rates. As a result, the company said that interest expense for 2022 would be about $300 million higher. In contrast, AT&T's debt is 95% fixed and almost all of T-Mobile's debt is fixed.

How did AT&T's recent results and revised guidance affect our expectation for adjusted leverage and credit quality improvement?

While AT&T did not lower its EBITDA guidance, it did reduce its free cash flow outlook by $2 billion for 2022. The lower guidance was primarily due to higher DSOs, inflation, and business wireline pressures despite reporting strong postpaid net subscriber gains and raising its wireless service revenue growth forecast. The lower free cash flow, in turn, reduces cash available for debt repayment. Our previous base-case forecast assumed that S&P Global Ratings' pro forma adjusted debt to EBITDA would be 3.7x-3.8x for 2022 following the spin-off and sale of Warner Media LLC, declining to 3.5x-3.7x in 2023, and comfortably below our downgrade threshold of 3.75x. We now forecast adjusted leverage will be slightly higher, 3.8x-3.9x in 2022, declining to 3.6x-3.8x in 2023.

AT&T spent $36 billion in the C-band auction and Auction 110 and increased its capital expenditure (capex) to fund the buildout of these licenses, resulting in higher leverage. Even with the sale of Warner Media, pro forma leverage was still somewhat elevated and left AT&T with little headroom at the 'BBB' rating. We believe AT&T's leverage can tolerate some earnings pressure at the current rating given its subscription-based, recurring revenue model and solid discretionary cash flow generation. That said, deteriorating market conditions due to more aggressive competition or long-lasting inflationary pressures could result in lower levels of EBITDA and free cash flow such that leverage remains above 3.75x for a prolonged period.

Table 1

S&P Global Ratings' Forecast Revisions For AT&T
2022 Previous forecast 2022 Current forecast 2023 Previous forecast 2023 Current forecast
Adj. Debt/ EBITDA (x) 3.7-3.8 3.8-3.9 3.5-3.7 3.6-3.8
Reported free operating cash flow (mil. $) 15,000-15,500 13,500-14,000 17,000-18,000 16,500-17,500
DCF/debt (%) 5-7 4-6 6-8 6-8
Mobility service revenue growth (%) 2-4 4-5 1-3 2-4
Mobility EBITDA margin (%) 39-40 39-40 39-40 39-40
Business wireline EBITDA margin (%) 38-39 36-37 38-39 35.5-36.5
Source: S&P Global Ratings
How did Verizon's recent results and revised guidance affect our expectation for adjusted leverage and credit quality improvement?

We have updated our forecasts to reflect Verizon's lower EBITDA guidance for 2022. Our previous base-case forecast assumed Verizon's S&P Global Ratings'-adjusted debt to EBITDA would be 3.0x-3.2x in 2022, just below our downgrade threshold of 3.25x for the 'BBB+' rating. We now project adjusted leverage will be 3.1x-3.3x. However, 2022 is Verizon's peak capex year as it builds out its C-band licenses (we estimate $23 billion-$23.5 billion), and we expect capex to decline to $18 billion-$19 billion range in 2023, which should improve free cash flow available for debt repayment. As such, we forecast adjusted leverage of 2.9x-3.1x in 2023, still somewhat worse than our previous forecast of 2.7x-2.9x, but supportive of the 'BBB+' issuer credit rating and stable outlook. That said, we believe that credit risk for Verizon is increasing since it has the most postpaid market share to lose in an increasingly competitive environment. It has substantially higher leverage after spending $53 billion in the C-band auction and another $10 billion of capex to build out those licenses. At the same time, revenue opportunities from 5G wireless technology, including Internet of things and enterprise applications, are still uncertain. While we still believe that Verizon has good prospects to modestly improve leverage through 2023, higher costs, deteriorating business wireline conditions, or accelerating consumer postpaid phone subscriber losses could push leverage above our 3.25x downgrade threshold.

Table 2

S&P Global Ratings' Forecast Revisions For Verizon
2022 Previous forecast 2022 Current forecast 2023 Previous forecast 2023 Current forecast
Adj. Debt/EBITDA (x) 3.0-3.2 3-1-3.3 2.7-2.9 2.9-3.1
FOCF/debt (%) 11.5-13.5 11-13 16-18 15-17
DCF/debt (%) 5-7 4.5-6.5 9-11 8-10
Consumer EBITDA margin (%) 42.5-44.5 41.5-43.5 43-45 41.5-43.5
Business EBITDA margin (%) 23-25 22-24 23-25 22.5-24.5
Source: S&P Global Ratings
Is T-Mobile poised to benefit from adverse economic conditions or could it also experience deteriorating operating and financial performance?

T-Mobile is exposed to the same macroeconomic factors as AT&T and Verizon. Similar to AT&T, T-Mobile management called out longer payment cycles and higher bad debt during the second quarter. It also said inflation was affecting some parts of the business but that much of its cost structure, including tower leases, wireless backhaul, and energy needs are on long-term fixed contracts. Further, cost synergies from the acquisition of Sprint should more than offset higher expenses in the near term.

As the value player in the U.S. wireless market, T-Mobile will likely benefit from lower churn and customer switching during periods of high inflation and recession as consumers look for less expensive mobile options. For example, we expect more customers to switch to T-Mobile during the second half of the year because of recent rate increases AT&T and Verizon implemented.

When we raised the ratings on T-Mobile to investment grade, why did we affirm our 'BB+' ratings on Sprint's debt?

Following the upgrade to 'BBB-', we expect T-Mobile's debt will maintain its subsidiary guarantees from both T-Mobile and Sprint. This is because there are $3.5 billion of pre-merger notes ($3 billion of 4.75% notes due 2028 and $500 million of 5.375% notes due 2027) that do not allow for the release of subsidiary guarantees until there is $2 billion or less of these notes outstanding.

At the same time, while the $16.5 billion of Sprint unsecured notes have parent-level guarantees from T-Mobile U.S. and T-Mobile USA Inc. as well as cross guarantees from Sprint Capital, Sprint Communications, and Sprint Corp., they do not have any subsidiary guarantees from T-Mobile or Sprint. Since the Sprint unsecured debt is junior to the Sprint spectrum notes and the T-Mobile debt, we rate this debt one notch below issuer-credit rating at 'BB+'. That said, when the pre-merger T-Mobile notes have been paid down to $2 billion, the subsidiary guarantees on the T-Mobile debt will fall away, at which time we expect to raise the ratings on the Sprint debt to 'BBB-', the same as the issuer credit rating.

This report does not constitute a rating action.

Primary Credit Analyst:Allyn Arden, CFA, New York + 1 (212) 438 7832;
Secondary Contact:Ryan Gilmore, Washington D.C. + 1 (212) 438 0602;

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