October 20, 2008
Debt-Heavy Telecoms Won’t Escape the Credit Crunch
The $1 trillion telecommunications industry has long been one of the most resilient parts of the economy. But as the financial crisis has intensified, it has recently become clear that telecom can't escape the fallout of the credit crunch.
Although most analysts believe the damage won't be nearly as bad as the last telecom bust -- when hundreds of firms went bankrupt, including giant Worldcom -- there is growing evidence that the financial crisis is going to depress the debt-heavy telecom industry. To start with, rising capital costs are likely to take a bite out of earnings. In addition, the softening economy will probably crimp demand for such telecom services as land lines, cell phones, and Internet connections. Over the last week several Wall Street analysts trimmed their 2009 earnings estimates for AT&T (T), Verizon Communications (VZ), Sprint Nextel (S), and other operators. "Everyone is going to pay more for credit," says Craig Moffett, a senior analyst with Sanford Bernstein who has been bearish on telecom stocks.
A telecom slowdown could ripple through the technology sector. If the operators' cash flow declines as expected, that's likely to cause them to cut back on their capital spending plans. This would hurt the primary equipment makers that supply gear to the industry, as well as those that sell to them. It would also slow down the build out of future wireless and terrestrial networks.
Idled consumers might use more services Steve Rago, an analyst at iSuppli, expects capital expenditures on worldwide wire line networks for the second half of 2008 to decline 20% from levels that telecom carriers expected earlier this year. Analysts also predict that the growth rate of spending on wireless networks will decelerate through 2010. Such cutbacks would hit equipment makers such as Alcatel-Lucent (ALU), Nortel Networks (NT), Cisco Systems (CSCO), Juniper Networks (JNPR), and scores of smaller players. "There is going to be significant sales weakness over the next couple of quarters," says Ari Bensinger, an analyst with Standard& Poor's. "A lot of these aggressive deployments are getting pushed out."
The impact, of course, would be softened if credit markets settle down. In fact, some big telecom operators such as Verizon say they have yet to see signs of a slowdown. Rather, Verizon execs believe that a recession could lead Americans to become even greater couch potatoes, saving money by gabbing on the phone, watching TV, and surfing the Internet. "I don't see any evidence of us slowing down," says Verizon spokesman Eric Rabe. "If you need to find a job, a broadband connection is pretty critical."
But if credit remains tight, telecom carriers will surely feel some pain. After all, telecommunications is one of the most capital intensive businesses in the technology industry. It costs billions of dollars to build and buy the networks that enable people to communicate. Earlier this year, Verizon dropped $9.4 billion alone for wireless spectrum that will enable it to build an even faster mobile network.
A Squeeze in Commercial paper To help pay for these investments, telecom carriers use various forms of debt, such as commercial paper, credit facilities, and corporate bonds. These work well in good times. But with the financial system in a state of panic, credit has become much more expensive -- and impossible for some companies to get. While credit analysts believe that the carriers' huge cash flows make them solid credit risks that are highly unlikely to default, the analysts say higher borrowing costs will reduce earnings and force the carriers to scale back on their ambitious plans. "If you had to place debt you'd have to pay a high rate," says Mike Weaver, managing director with Fitch Ratings. "There will be less profitability."
AT"T sounded the first warning signal in late September, when CEO Randall Stephenson said the telecom giant was unable to sell commercial paper for terms longer than overnight. AT"T is the industry's biggest user of commercial paper, with about $8.5 billion in paper outstanding at the end of June. Since then, AT"T says it has regained access to the market and is "getting reasonable rates."
Although Verizon is not a big player in the commercial paper market, it does have $7 billion of debt coming up for renewal in 2009. The company also needs to borrow another $22 billion to pay for its acquisition of wireless carrier Alltel Wireless, which the company hopes to close by year-end. Bernstein analyst Moffett expects the interest rates that Verizon pays to increase soon by a percentage point, which he says could wipe out 35% of the anticipated $1 billion in cost savings from the Alltel deal.
Moreover, should Verizon's free cash flow drop by more than 5%, Moffett says the company could not afford to pay for its dividend and capital spending without additional borrowing. Scott Kessler, an analyst with Standard " Poor's, says Verizon will be "inclined to pull back on their capital spending modestly." He expects to see a reduction by a single-digit percentage.
Eyes on leveraged Sprint Of all the U.S. carriers, Sprint faces the greatest risk. This summer, Sprint said it wanted to sell the iDen network it acquired as part of its merger with Nextel. But tight credit and the sagging economy mean the struggling operator will be unlikely to find a buyer for the iDen network at an attractive price.
Sprint is the most leveraged carrier. It holds a junk bond rating and its ratio of debt to earnings before interest, taxes, depreciation, and amortization [or EBITDA] is expected to reach 3.2, Bernstein's Moffett says. With Sprint's declining profit, some analysts worry that the company could move past that ratio. If Sprint breaches 3.5, it will default on its credit agreements. While most analysts say creditors would be reluctant to push Sprint into bankruptcy, a default likely would mean higher borrowing terms and bank fees. "They would have to work out some waiver or amendment that would cost them," says Fitch managing director Weaver.
Thanks to years of consolidation and rational investment, the telecom industry is in relatively good shape. But the financial contagion is so strong that even companies with strong credit will find it hard to avoid some level of infection.
-- With Olga Kharif