Competition & Wireless Performance Risk Could Hamper Credit Profile Improvements - Fitch US Telecom '03 Outlook.

Business Editors

CHICAGO--(BUSINESS WIRE)--Dec. 13, 2002

The events of 2002 clearly changed the U.S. telecom competitive landscape including the strategic focus of many participants. While weakness still exists in the various telecom sectors predominantly due to competitive pressures, some stabilization of credit quality is also present going into 2003. All operators are focused more than ever on improving financial flexibility through growth in free cash flow and reducing debt in their balance sheets. The greatest tool for improving free cash flow remains reduction in capital expenditures and a focus on improving efficiency. Capital spending for the telecom sector will generally remain low in 2003, which will allow for a maximization of free cash flow. Event risk still exists in the telecom sector with particular examples around consolidation in the wireless sector, wireless churn risk associated with the introduction of local number portability and the conclusion of the FCC's review of local phone network unbundling policies and how this might affect the Unbundled Network Element Platform (UNE-P). While economic improvements could spur demand for telecom services, particularly related to data, this is not expected to be a source of wide spread strength for the industry in 2003.

Looking Back at 2002

While high-yield telecom credits bore the brunt of credit erosion in 2001, this trend shifted to the investment grade telecom companies in 2002, particularly as it related to operating performance and market access. Further reductions in IT spending by end-users has negatively pressured both voice and data revenues. Additionally, significant capital spending and merger and acquisition activity of the last few years leading up to 2002 left many companies will little financial flexibility and large debt burdens. Numerous SEC investigations and questions surrounding accounting of WorldCom and others hurt the level of confidence associated with the integrity of financial filings. As a result many telecom participants had little accessibility to the capital and bank markets particularly when needed the most. More than 35 telecom companies experienced significant downgrades of their credit ratings in 2002.

From a positive perspective, companies have responded to dramatic credit profile pressures by taking steps to enhance financial flexibility. Non-core operations and investments have been monetized with proceeds being used in part to reduce debt. Cost reduction programs that many carriers implemented near the end of 2001 and continued to expand in 2002, helped to support operating cash flow. Capital spending by the telecom industry in 2002 is estimated to be approximately 35% lower than 2001 and nearly 50% lower than in 2000. It is likely that this level of spending will increase with increased revenues, but that this will not occur before 2004.

Looking Forward into 2003

Local Exchange Carriers

In 2003, Fitch believes Local Exchange Carriers (LECs) will continue to reduce debt in an effort to mitigate the effect of weakening operating performance on their overall risk profiles. The lower wireline capital spending programs of 2002 are expected to continue -- and in some instances be further lowered -- due to reduced demand for services. Debt levels could further decline through the completion of additional non-core asset sales. A note of caution, however, would be the potential for carriers to use proceeds from non-core asset sales to expand in certain businesses, primarily wireless.

There is a lack of clarity with regard to the revenue and EBITDA growth prospects for the RBOCs in 2003. Even if there is a moderate recovery in the demand for services, competitive effects will lead to little or no growth. Fitch believes prospects are relatively better for Verizon Communications given the relatively greater proportion of revenues and EBITDA provided by Verizon Wireless in its consolidated financials compared the contribution of Cingular Wireless to SBC Communications and BellSouth. On the positive side, the RBOCs should experience continued revenue growth from long distance services, with the carriers likely to attain approval in their remaining states in 2003. In addition to aiding the carriers in reducing residential churn to long distance carriers' bundled offerings, the RBOCs will begin to expand in certain enterprise market segments.

In 2003, competition will continue to be the primary concern of the RBOCs. Modified regulations to be issued by the FCC in early 2003 will likely ameliorate some of the effects of competition from long distance carriers using UNE-P platforms and Fitch expects transition mechanisms to guide users of UNE-Ps toward increased use of and investment in alternative facilities. Longer-term competitive concerns center around further wireless substitution and cable operators' wireline telephony and high-speed cable modem offerings. To counteract competition from all providers, the RBOCs are expected to be more aggressive in marketing bundles of service that include local, long distance, wireless, and high-speed data services.

Wireless

Fitch holds a guarded view on the wireless industry outlook in 2003 due to fundamental issues including the uncertain ability of operators to generate positive free cash flow, the growth in net additions due to penetration rates in excess of 50% and the continued pressure on ARPU due to pricing decisions.

While average revenue per user (ARPU) was flat to slightly negative for a majority of the nationwide operators in 2002, pricing decisions initiated during the year could lead to increased pressure on ARPU in 2003 particularly if operators fail to see anticipated growth in data revenues. After the completion of large investments associated with the GSM/GPRS and CDMA 1XRTT data networks, carriers must successfully execute their wireless data strategies for consumer and enterprise customers in 2003 to drive rapid growth of data revenue. Carriers have indicated a focus on positive return for invested capital. In order to achieve this objective, companies will need to take actions that lead to profitable customer growth, which is measured by stable ARPU, lower acquisition costs, high retention and control of credit risk.

Due to the continued pricing pressures combined with slower growth, operators must implement rigorous cost containment as a key to maintaining reasonable margins and ability to meet free cash flow objectives in 2003. During 2002, operators consolidated call centers and billing systems, outsourced costs, reduced employee headcount, entered into network sharing agreements and deployed networks that were more efficient. In 2003, benefits should be derived from the improved scale of operations and cost efficiencies associated with the GSM and CDMA networks. Additionally through judicious capital spending, modest stability for ARPU and churn, the majority of nationwide operators should become free cash flow positive in 2003.

The picture for wireless industry consolidation is no clearer than in 2002 with several barriers such as regulatory hurdles, non-customary ownership structures and the different technology platforms encumbering operators from completing any agreements. Fitch believes during 2003, industry competitive forces will dictate two of the three GSM providers to merge operations. In addition, if the FCC adopts Nextel's spectrum proposal along with the continued improvement to its credit profile, Nextel could become an attractive acquisition candidate.

Long Distance

Long distance carriers will continue to be negatively impacted by competition in 2003 especially related to service substitution. Consumer voice long distance continues to operate in a deteriorating revenue environment for all the established carriers. This will likely continue in spite of recent price increases implemented in 2002. Carriers will continue to emphasize profits in this segment by maintaining a cost structure that varies directly with traffic volume and minimizes expense. It is expected that the RBOCs will continue to have success in penetrating the consumer retail market segment as they complete their section 271 approvals to offer long distance service. Competition in the business voice and data markets should continue to be fierce with the RBOC entry, but Fitch expects that it will take the RBOCs far longer to penetrate this segment then consumer retail. It is likely that stronger data service growth will not occur until an economic recovery is well in place and end-users increase their IT spending, which is not expected in 2003.

Long distance carriers such as AT&T and Sprint have benefited from the industry turmoil experienced in this sector in 2002 as customers have migrated to these relatively more stable operators. The financial impact of these customer migrations should begin to be felt in early 2003. Fitch recognizes that risk exists that carriers with newly restructured balance sheets could introduce irrational pricing to the market to gain market share. While this risk exists, it is unlikely that carriers will revert wholly to this strategy considering past results and the current investor focus on profits.