Cable vs. Telco: The Battle Heats Up

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From Standard & Poor's RatingsDirect

Fighting Back with Video Services

Since the threat to wireline companies is real and growing, does that mean they face nothing but stormy seas for the next several years? Not necessarily so. While residential-line losses will continue for some time, especially as cable telephony is more ubiquitously deployed and marketed, the telephone companies do not lack defenses.

First, DSL service has mitigated a lot of the access-line losses. In the high-speed Internet realm, the cable companies' modem product initially outpaced phone company DSL by a margin of almost two to one. But we've seen a marked turnaround, with DSL and cable now garnering roughly equal shares of new customer additions on a national basis. And, depending on pricing, DSL can offset much of the cash-flow impact of access-line losses. There are, however, signs that growth of the broadband market for both telephone and cable providers may be peaking.

The second, and potentially most potent, defense against cable operators is the telephone companies' video product. Both AT&T (T) (A) and Verizon, which together serve about three-quarters of the country's switched access lines, have begun offering their own video services. Verizon's FiOS product in particular has earned a lot of publicity and, because it's completely fiber optic, offers the potential for virtually unlimited bandwidth for the residential customer. At midyear, Verizon reported it had just over 500,000 video FiOS customers. While that number appears impressive, FiOS is clearly in a nascent stage, given Verizon's base of more than 40 million telephone customers.

Verizon intends to roll out FiOS to 18 million homes by the end of 2010. While FiOS has required intensive capital spending, Verizon has a strong enough balance sheet to support the buildout at the current A rating. FiOS represents Verizon's most powerful tool for answering cable competition and winning back customers.

AT&T's U-verse video offering is less ambitious from a technical perspective and is considerably less expensive than FiOS, but it shares FiOS' goal of reclaiming customers lost to the cable companies. The recently launched U-verse service had only 51,000 video customers as of June 30. And while FiOS has the longer track record, we view both FiOS and U-verse as early-stage undertakings. The jury will be out for some time, probably at least a year or two, before we have a more definitive verdict on the success of FiOS, U-verse, or any other similar video ventures.

Reducing Reliance on Wireline Service

Perhaps the best defense for a telephone company facing increasing competition for its legacy service is product diversity. Our decision in July to revise the outlook on both Verizon and AT&T to stable from negative took into considerable account the companies' declining reliance on their most vulnerable segment, residential wireline, as well as their strong free cash flows. The solid growth of Verizon's and AT&T's wireless segments, combined with their larger enterprise businesses (via their respective MCI and AT&T acquisitions) moderated the rating impact of their residential wireline segments.

Over the long term, if Verizon and AT&T can successfully deploy their video products and contain the associated operating and capital costs, they could realize a significant new revenue stream. Still, the obstacles to ratings higher than the current A for AT&T and Verizon are formidable. Given intense competition and uncertainty over the outcome of their facilities-based video strategies, it would take considerable time for each to demonstrate that they can win telephone customers back from cable; lure video customers away from cable, EchoStar Communications (DISH), and DirecTV Group (DTV); and maintain pricing in such a highly competitive environment.

Financial Policy Must Reflect Maturing Markets

Financial policy will play an increasingly important role in determining credit ratings. Currently, the ratings on Alltel (AT) (BB), Intelsat (B+), and Cablevision are on CreditWatch Negative because of pending leveraged buyouts.

Beyond the dramatic changes in credit quality that may result from LBOs and mergers is the broader issue of how companies use their cash flow as their businesses mature. Under these conditions, cable company ratings in particular will hinge more on financial policy. As cable markets mature, we expect cash flows to strengthen because the capital costs for system upgrades and consumer premise equipment related to the new services will drop. Allocation of at least a portion of this cash to debt reduction will lend stability to cable ratings at a time when cable providers will face the dual challenge of maturity and pricing pressure from FiOS, U-verse, and others. Conversely, policies that are overly friendly to shareholders could lead to financial parameters that might not support current ratings in a lower-growth environment.