Tight credit markets, higher inflation, and rising interest rates have taken their toll on U.S. wireline telecom operators. Just a few years ago S&P Global Ratings viewed the outlook as promising because restructured balance sheets provided these issuers with greater financial flexibility to invest in fiber-based broadband to better compete with cable. However, macroeconomic headwinds are now causing some wireline operators to scale back their fiber builds to conserve cash flow. At the same time, their legacy businesses continue to decline, leading to lower overall revenue and EBITDA. Below, we address frequently asked questions about the effects of higher inflation, rising interest rates, and the prospect of a recession on the outlook for U.S. wireline operators as well as some company specific questions, including our recent downgrade of Lumen Technologies Inc.
What are some of the near-term challenges for U.S. wirelines following a tough year in 2022?
Global supply chain issues, inflation, and higher interest rates hurt profitability and free cash flow generation in 2022. While supply chain challenges appear to have abated, there are still several near-term headwinds that could exacerbate cash flow deficits, leading to higher leverage and a longer path to credit metric improvement. These include:
- Exposure to legacy products and services: Ongoing secular industry pressures from legacy products such as digital subscriber line (DSL) and multi-protocol label switching (MPLS) still outweigh growth from fiber-to-the home (FTTH) services.
- Higher labor costs: A tight labor market in 2022 hurt profitability and made it more difficult to reach FTTH targets. We do not expect this dynamic to improve in 2023, especially as the Broadband, Equity, Access, And Deployment (BEAD) program gets started, which will increase the demand for contractors to do fiber deployments.
- High interest rates: Fiber returns on investment were good when the cost of capital was low, but this may not be the case as interest rates rise and valuations decline. Some of these issuers are not fully funded for their build plan, which means they will need to access the capital markets at some point over the next couple of years. The higher cost of debt, coupled with inflation, prompted many of these companies to scale back their FTTH deployments to conserve cash flow.
- Converged offerings: U.S. cable providers are bundling their broadband product with wireless service while Verizon Communications Inc. and T-Mobile US Inc. are offering fixed wireless access (FWA) with mobile at competitive discounts. We believe this could make it challenging for U.S. wirelines to achieve penetration goals in recently built markets.
- Weak business wireline conditions: Business wireline services face secular industry pressures and technology shifts as these customers migrate to less expensive networking technologies. Large enterprise customers, in particular, are focused on accelerating their digital transformation to reduce expenses. This trend will extend business revenue and EBITDA declines for U.S. wirelines over the next several years.
How would a recession affect the U.S. wirelines?
S&P Global Ratings economists expect a shallow recession in 2023. However, recent events in the financial sector and credit tightening, stemming from bank failures, could result in a more severe outcome. We forecast very low U.S. GDP growth of 0.7% in 2023 and 1.2% in 2024, but there is greater risk to the downside.
U.S. telecom companies have historically been recession resistant because of the growing importance of data connectivity and the utility-like nature of their products. That said, a weaker economy could prompt consumers to look for less expensive broadband options. While the wireline operators are offering fiber broadband at attractive price points or with discounted promotions, convergence has enabled the cable providers and wireless operators to offer bundles at a competitive discount and have been very successful in growing subscribers. These bundles serve as an effective tool in a tight economy to lock in customers at lower prices and could impede FTTH share gains since the wirelines are marketing broadband on a standalone basis.
The small and mid-sized business (SMB) segment represents a lower percent of the wirelines' revenue base than it did 10 years ago due to market share losses to cable; but, the segment is at risk in an economic downturn since many of these customers will scale back operations or go out of business altogether.
In the enterprise market, there are more cyclical challenges where demand for IT services typically declines as customers tighten their budgets and take longer to make decisions. A deteriorating macroeconomic outlook could prompt enterprise customers to accelerate their migration to newer technologies. Companies with the largest exposure to business customers include Lumen Technologies Inc. (80%), Frontier Communications Holdings LLC (45%) and AT&T Inc. (20%).
How does S&P Global Ratings expect fiber builds to pace?
Overall, we expect the wirelines to scale back their FTTH deployments in 2023 relative to our previous expectations due to higher labor costs, inflation, and rising interest rates, which will likely alleviate some of the free operating cash flow (FOCF) pressures. Given their high leverage, funding needs, and exposure to floating-rate debt, we expect the pace of builds to slow over the next few years
AT&T, Lumen, Telephone and Data Systems Inc. (TDS), and Frontier all announced a reduction in their incremental fiber passings for 2023 relative to their original plans. AT&T added 2.9 million homes in 2022 and was previously targeting 3.5 million-4.0 million homes per year but is scaling back its build to 2.0 million-2.5 million passings annually over the next three years. Lumen's original plan was to cover 1.5 million-2.0 million homes per year but operational challenges and a change in management led the company to pause its FTTH passings in 2022. As a result, it only added 600,000 passings in 2022 and lowered its target to 500,000 additional homes this year. While Frontier is increasing its FTTH passings to 1.3 million in 2023 from 1.2 million in 2022, the build pace is still lower than its previous expectation of 1.6 million-1.7 million homes and we believe the company may not reach its 10 million build target until 2026 instead of 2025.
We expect the pace of builds to remain at these lower levels over the next few years unless interest rates decline and inflation moderates. As a result, we now assume FTTH will cover about 48%-49% of the U.S. by 2025, down from our previous expectation of 55% about one year ago. (See "Credit FAQ: Stepped-Up Competition Will Slow U.S. Cable Companies' Growth," published June 29, 2022.)
What are the funding needs for U.S. wireline operators?
While most of the U.S. wirelines took advantage of good credit market conditions to finance their network upgrades and push out maturities, some still have near-term funding needs to address significant cash flow deficits.
- Lumen Technologies Inc.: Following the company's recent issuance of $925 billion of 10.5% senior secured notes due 2030 at wholly-owned subsidiary Level 3 Financing in exchange for multiple senior unsecured debt issues at Lumen, coupled with $1.6 billion of expected net proceeds from the pending sale of its Europe, Middle East, and Africa (EMEA) operations, we believe the company will have sufficient liquidity to address its debt maturities of about $1.7 billion in 2025 and $412 million in 2026. We also expect it to generate modest FOCF of $0 million-$200 million in 2024. However, Lumen has a large maturity wall of around $9.5 billion in 2027, which may be difficult to refinance if capital market conditions don't improve, and it is unable to turn around business operations.
- Frontier Communications Holdings LLC: Frontier does not have any meaningful debt maturities over the next few years. However, given its significant capital spending requirements, we expect it to record a FOCF deficit of around $1.7 billion in 2023 and $1.3 billion in 2024. In March 2023, it issued $750 million of first-lien senior secured notes due 2031, which enabled it to push out its next funding requirement to 2025 from 2024, although we believe it could look to access the markets earlier.
- Cincinnati Bell Inc.: Unlike its peers, Cincinnati Bell has been deploying FTTH for several years and has good coverage across its footprint in Hawaii and Cincinnati. For this reason, the company's revenue and EBITDA trends are relatively stable. That said, we expect capital expenditures (capex) to remain elevated because of market expansion activity, and therefore, FOCF will likely be negative over the next couple of years. However, most of the company's capex is discretionary and associated with network expansion, so it has some flexibility to reduce spending to conserve cash flow.
- Northwest Fiber LLC (Ziply): While Ziply does not have any meaningful near-term maturities, its cash burn is substantial, and we expect it to record negative FOCF of around $400 million in 2023 and 2024 as it builds out its network. Even with the $450 million equity infusion it received in 2022, we believe Ziply will need to raise additional capital by 2024.
- Consolidated Communications Inc.: Consolidated had about $336 million of cash and $213 million available under its $250 million revolving credit facility as of March 31, 2023. Additionally, the company does not have any material debt maturities until 2027. However, we expect it to record negative FOCF of around $250 million in 2023 and $175 million-$200 million in 2024. While we believe the company has enough liquidity to fund its build plan of 70% fiber passings, there is limited headroom for execution missteps.
|Funding requirements for U.S. wirelines|
|Issuer||Rating/Outlook||2023e FOCF (Mil. $)||Funding Shortfall||2023||2024||2025||2026||2027|
Telephone and Data Systems Inc.
Lumen Technologies Inc.
Cincinnati Bell Inc.
Frontier Communications Holdings LLC
Consolidated Communications Inc.
Windstream Holdings II LLC
Northwest Fiber LLC
When does S&P Global Ratings expect U.S. wireline leverage to peak?
Leverage for the wireline sector increased in 2022 due to the loss of Connect American Fund Phase II (CAF II) subsidy revenue, secular industry pressures, and elevated capex, although this was largely incorporated in our base-case forecast.
In 2023, we expect some improvement in revenue trends as fiber-based broadband penetration increases and the impact of lost subsidy revenue wanes. However, we do not expect these improvements to translate into EBITDA stability until 2024 or 2025, at the earliest, because of ongoing secular declines for legacy products, marketing expense, capitalized labor costs, and other expenses associated with fiber deployments. Furthermore, we do not expect S&P Global Ratings-adjusted leverage to improve until at least 2026 when FOCF deficits subside, although the time to breakeven FOCF will depend on how long borrowing costs remain elevated.
What is S&P Global Rating's view on fiber joint ventures (JVs)?
In a period of high interest rates and inflation, we believe fiber JVs could be attractive way for U.S. wirelines to fund their fiber build projects and reduce overall risk associated with these deployments. In our view, not building fiber is a lost opportunity that increases the risk of declining revenue and cash flow as the wirelines lose copper-based broadband customers to cable. Joint ventures with third-party investors could alleviate some of the financing risk, notwithstanding the loss of an economic stake. For example,AT&T entered into a JV agreement with Blackrock to build out FTTH to about 1.5 million homes in 2023 so that it could target attractive markets that are outside of its service area. While financial terms of the JV are not public, we do not expect it to meaningfully affect AT&T's credit metrics given its relatively small size. AT&T will have joint control and we viewed the transaction favorably since it will reduce the risk associated with fiber deployments.
Typically, the impact of JVs on S&P Global Ratings-adjusted credit metrics will depend on two factors:
- Materiality: If the impact on the parent company's credit metrics is not material, we will often use the company's accounting approach. In the early stages of a fiber JV, such as with AT&T, the financial impact is unlikely to be significant but could become more relevant over time.
- Strategic importance: If the effect is material, we would have to make a determination as to whether or not the JV is strategic to the parent. For most telcos, we would likely view the JV as strategic given the importance of fiber to the overall business.
Therefore, if the JV is material and has strategic importance to the parent, we would likely proportionately consolidate its financials when calculating our adjusted credit metrics. If not, we would likely use the company's reported accounting treatment.
Is FWA a competitive threat?
Yes, the wirelines are aggressively trying to migrate their existing DSL customer base to fiber as they overbuild their existing footprint. Since FWA has a speed to market advantage because its mobile network is already in place and can offer faster data speeds, customers that were using DSL or VDSL may find FWA to be an attractive value proposition, especially when bundled with mobile services, thereby impeding the telcos ability to migrate existing customers. Longer-term, households that demand greater bandwidth would likely be attracted to FTTH broadband offerings, although value conscious consumers may find FWA as sufficient to meet their needs.
What are the opportunities from the $42 billion BEAD program?
The BEAD rural broadband funding program is set to begin awarding subsidies in 2023. The program aims to make broadband available to all unserved locations in the U.S. Unserved is defined as lacking reliable internet at speeds of less than 25 Mbps downstream and 3 Mbps upstream, which may include certain copper-based telco markets (but not existing cable markets).
It is still unclear which providers will be awarded government subsidies, although the wirelines could take advantage of the program to help fund planned fiber deployments to reach their long-term targets. Specifically, we expect the wirelines will bid in certain markets where there is an existing copper plant that can be more affordably upgraded to FTTH than greenfield builds. That said, the program requires the provider to cover no less than 25% of the project cost. Given their high cost of capital and rising leverage, it may be difficult for some issuers to aggressively bid on these contracts relative to the cable operators.
Why did S&P Global Ratings lower the ratings on Lumen Technologies?
On March 22, 2023, we lowered the issuer-credit rating on Lumen one notch to 'B' with a negative outlook following the announcement of an offer to issue 10.5% senior secured notes due 2030 at wholly-owned subsidiary Level 3 Financing Inc. in exchange for tendering a series of Lumen senior unsecured notes at a discount to par. The company ultimately issued $925 million of Level 3 secured notes in exchange for $1.5 billion of the Lumen unsecured debt.
We viewed the transaction as opportunistic, rather than distressed, since we did not believe there was a risk of default in the near to intermediate term absent this transaction. The company does not have any debt maturities in 2023 or 2024 and can repay the $1.7 billion of debt due in 2025 with estimated net proceeds of $1.6 billion from the sale of its EMEA assets, which is scheduled to close at the end of 2023 to early 2024.
That said, the lower rating was due to uncertainty regarding management's strategy, including its plan to invest $435 million-$600 million in 2023 to reposition the business for growth, low levels of near-term FOCF, and rising debt yields that will make it difficult to address longer-dated maturities if Lumen is unable to execute on its strategy. We believe investors are increasingly concerned about the company's strategic direction under new management, which is focused on technology and innovation, rather than hiring a more experienced telecom operator to lead the company.
Why did S&P Global Ratings lower the rating on the Lumen unsecured debt two notches to 'CCC+'?
Despite the reduction of unsecured debt at Lumen, as part of our recovery analysis we allocated more of our estimated emergence value to Level 3 (to about 42% from 33% previously) given its larger and increasing EBITDA contribution. Therefore, the reduction in value available to the Lumen unsecured debt reflects a shift in value attribution from Qwest and Lumen to Level 3. Residual equity value in Qwest is the primary source of recovery at the parent after accounting for the approximate gross enterprise value we attribute to Lumen's direct operating subsidiaries and the remaining Embarq assets.
This report does not constitute a rating action.
|Primary Credit Analyst:||Allyn Arden, CFA, New York + 1 (212) 438 7832;|
|Secondary Contacts:||William Savage, New York + 1 (212) 438 0259;|
|Ryan Gilmore, Washington D.C. + 1 (212) 438 0602;|
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