Markets & Finance

SBC Debt Rating Lowered


On May 28, 2003, Standard & Poor's Ratings Services lowered its corporate credit and senior unsecured debt ratings on San Antonio, Texas-based regional Bell operating company (RBOC) SBC Communications (SBC) and its subsidiaries to 'A+' from 'AA-'. The short-term corporate credit and commercial paper ratings were also lowered to 'A-1' from 'A-1+'.

The ratings have been removed from CreditWatch, where they were placed on Apr. 15.

The outlook is stable.

The downgrade primarily reflects heightened business risk experienced in the local telephone industry by RBOCs such as SBC. This risk has manifested itself in the form of increased retail access line losses, as well as total switched access line declines. In addition, the growth of unfunded pension and other post-retirement benefits has somewhat weakened SBC's overall financial profile.

For 2002, SBC experienced a retail access line loss of about 8%, and an overall switched access line decline of 4%. Like its peers, SBC has faced heightened competition in the past 12 to 18 months in the residential market. This has come principally from AT&T Corp. and MCI Communications Corp., both of which have used the unbundled network element platform (UNE-P) services of the RBOCs. The UNE-P framework was established by the FCC in its implementation of the Telecom Act of 1996. It allows competitors to purchase access to the RBOCs' local network at prices that often represent a significant discount not only to the company's retail price, but to its wholesale service tariffs as well. In its early 2003 Triennial Review, the FCC determined that the states would be required to revisit the level of competitive impairment in the residential market before ruling that UNE-P access would be no longer required to foster competition.

In the meantime, UNE-P services continue to be made available to competitors. SBC's UNE-P line additions for the first quarter of 2003 totaled 770,000. This line migration to wholesale from the more profitable retail segment slowed somewhat from the previous quarter. However, the continued reduction in the retail base still remains a sizeable constraint on SBC's overall cash flow prospects.

SBC has also faced some continued decline in its overall access line count due to some wireless substitution, and more importantly, loss of second lines to broadband alternatives. However, to the extent it is able to capture these customers for DSL service, the impact on cash flows would be mitigated. As of Mar. 31, 2003, the company had 2.5 million DSL customers and the majority of its more dense service territories are DSL capable. SBC's business line losses have been less pronounced, and are more reflective of some economic pressures, providing some upside growth potential as the economy begins to improve.

In addition, unfunded pension and other post-retirement employee benefit (OPEB) liabilities have significantly escalated. SBC's reported shortfall has increased from $6 billion in 2001 to nearly $21 billion in 2002 on a pretax basis, due in large part to much higher unfunded OPEBs. The company does not incorporate contractually allowed medical cost caps in its OPEB calculations, as it has waived the caps in recent relevant periods. Yet, even if the caps are assumed, the unfunded liability still remains substantial.

As one of the largest local telephone companies in the U.S., SBC continues to have a strong business profile. It generated some $17 billion of EBITDA in 2002, excluding its share of Cingular, and its free cash flow after dividends and capital expenditures tallied about $5.5 billion. Its near-to-intermediate term liquidity is therefore extremely solid. SBC's local win-back efforts are also expected to help stabilize residential line losses over the next year. The company has received interLATA relief in its Southwestern Bell and Pacific Telesis regions, with the five Ameritech states expected to gain approval before year-end 2003. The caveat to win-back offers is the initial discounting required to regain customers, an activity that risks creating increased price elasticity and potential churn. California has been particularly competitive, with SBC pricing long distance at five cents a minute or less to stave off competitors in one of its largest markets.

The company also has a 60% share in national wireless operator Cingular LLC. Cingular is very profitable and its 22 million total customer base produced total EBITDA of about $4.3 billion for 2002. Analytically, Standard & Poor's prorates the cash flows and external debt to owners SBC and BellSouth. Yet Cingular has faced some challenges, including a loss of subscribers in the second half of 2002. A new president was appointed in late 2002 to address disappointing operating results. Given the heightened degree of competition facing all the national wireless players in the current market environment, however, Cingular's ability to increase its subscriber base and attendant operating cash flows in 2003 remains unclear.

Outlook: SBC is expected to continue to follow a conservative financial policy in the face of higher business risk. SBC benefits from current significant cash and investment balances. These total about $15 billion on a book basis, including about $7 billion of cash. The combination of continued debt pay-downs and ongoing cash and investment balances will likely allow the company to achieve a net debt to EBITDA of about 1.4x for 2003, including adjustments for pension and OPEB shortfalls. Debt for this calculation is net of both cash balances, as well as a conservatively estimated value of the company's investment holdings. Despite a strong balance sheet and associated healthy credit metrics, the company will need to limit additional local line losses in 2003 to levels experienced in 2002. The 2003 switched access line losses are therefore expected to be no greater than about 8% in the retail area and no more than about 4% overall. From Standard & Poor's RatingsDirect


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