Fitch Outlook: U.S. Telecom Enabling Technologies Broadening Competitive Overlap.

CHICAGO -- Fitch's expectation is that there will be much greater variability in the prospects of individual U.S. telecommunications operators in 2006 than ever before. Enabling technologies are broadening the competitive overlap of a diversity of operators, which is leading to higher service substitution and competitive risk. Clearly, demand for telecommunications services continues at a very positive pace due to end-user reliance on, and value perception of, bandwidth hungry Internet and data applications. Furthermore, operators have the enabling technologies in third-generation (3G) wireless and voice over the Internet protocol (VoIP) to integrate the vast array of telecommunications services in new ways that should add to end-user value perception, which is an additional demand positive. Fitch believes that the framework is being built for long-term success that rewards companies with the greatest amount of service, customer, and geographic diversity along with the strategic benefits of scale. Fitch also believes that operators with the greatest amount of flexibility to meet end-user bandwidth and integration needs have the most stable long-term outlook and those operators with more limited capabilities have more negative long-term rating prospects.

An additional characteristic of an industry facing technology transition and competition is increasing event risk associated with mergers and acquisitions as operators look to increase scale and improve competitive positioning. It is notable that U.S. telecommunications consolidation activity has reached a Fitch-estimated value of approximately $80 billion-$90 billion over the past 12-month period, fourth-quarter 2004 to fourth-quarter 2005, which exceeds any similar time periods since 1999, and that this rate is likely to continue in 2006.

From a recovery ratings perspective, which applies generally only to speculative-grade issuers, the coming year could create a variety of changes as a result of consolidation altering perceived enterprise values with an evolving competitive landscape. Additionally, capital structure components and the relative weight of secured debt could change due to funding needs for acquisitions as well as refinancings.

Wireline revenues, which would include traditional voice services as well as data are expected to be flat to slightly down in 2006 versus 2005. Traditional voice services will continue to be pressured by access line erosion, particularly associated with wireless substitution and the increasing scale of cable multiple system operator (MSO) telephony offerings. Business access line erosion has been relatively stable in 2005 at an annual decline of 2.5%, but residential has suffered dramatically with a decline of over 6%. Clearly residential line erosion is still being affected by high-speed data (HSD) substitution of secondary lines as well as wireless substitution and cable MSO erosion. As a result of these negative factors, residential line erosion will likely exceed 6% in 2006. Therefore, it would appear likely that the aggregate access line erosion in 2006 will again reach a composite rate above 5% for wireline operators, with some slight moderation of this rate in rural markets, but it is likely there will be higher erosion than historical levels for those areas. However, it should be noted that Fitch expects that wireline operators will add approximately five million to six million additional DSL lines in 2006, increasing their market share of HSD end-users to nearly 45%. Therefore, the actual decline of total wireline connections will approximate 3%. This level of erosion, along with a moderately growing average revenue per user (ARPU), fueled by increased residential spending on bundled service offerings, allows for a more muted impact on financials.

Overall, data revenue growth should continue to be an important offset to traditional voice services. Data revenues represent approximately 24% of all wireline revenues according to Fitch estimates, and this source of growth should increase again in 2006 by a high single-digit amount due to increased DSL penetration as well as continued business demand for high-capacity circuits. Therefore, data services will continue to be a source of growth for wireline operations both in the mass and business markets.

In-region long distance has been a source of revenue growth for the incumbent local exchange carrier (ILEC) industry for the past couple years, but higher penetration rates and increasing pricing pressure are expected to significantly reduce the revenue growth of this service in 2006 to the low single digits.

For those operators reliant on universal service funding (USF) subsidies, 2006 is a time of uncertainty. The current USF plan expires in mid-2006, and while it is unlikely that funding will be reduced for eligible telecommunications carriers (ETCs), it is possible that exemptions to VoIP-based operators or movement to a primary carrier plan could damage the prospects of this important source of revenue.

Wireline operators did an excellent job of reducing costs in 2005 and maintaining or even improving EBITDA margins. In aggregate, Fitch expects that wireline margins could be slightly pressured in 2006 with additional cost savings only partially offsetting the continued decline of high-margin mature services such as circuit-switched voice and switched access. As a result, wireline EBITDA should be flat to slightly down in 2006. Wireline capital spending should be stable except in those cases where high-bandwidth interconnection, including video applications, to end-users are being implemented.

Wireless revenues should increase in the high single digit range in 2006 driven by lower net additions compared with a very robust 2005 and moderately lower ARPU. Fitch expects that gross subscriber additions peaked in 2005 and will likely fall in 2006. The next surge in gross additions will likely keep pace with the widespread adoption of 3G applications and appropriate handset devices, which Fitch expects in 2007. Net additions in 2005 are expected by Fitch to exceed 24 million, which is an 11% increase over that of 2004. Lower churn rates as well as an increased focus on the youth customer segment, wireless substitution, and data services have fueled strong net additions. Fitch expects that reseller and prepaid services will continue to become an increasing percentage of the total subscriber base due to the popularity of prepaid offerings and mobile virtual network offerings (MVNOs). As a result of strength in reseller and MVNO plans, along with a youth segment focus and success of family plans, ARPU will be pressured downward in 2006. In part providing an offset to the downward ARPU pressure is the success of data services. Fitch expects that by fourth-quarter 2005, data services will have an annualized run-rate of approximately $10 billion compared with $6 billion in fourth-quarter 2004. This pace of data services revenue growth should continue in 2006 as penetration of these services increase. Aggregate churn is expected to be relatively stable in 2006 with improvements in post-paid churn being offset by an increasing mix of higher churn, lower economic value users in the total subscriber base. Slowing gross additions along with integration improvement at Cingular and Sprint Nextel should allow EBITDA margins to continue to improve at a measured pace. Fitch expects that aggregate EBITDA margins for the industry should reach 33% in 2006. As a result of improving margins and continued revenue growth, EBITDA should increase in the high single digit range in 2006. Wireless capital spending is expected to increase in 2006 compared with 2005 with spending on 3G upgrades and network quality improvements as well as strong customer additions.

Fitch expects the Regional Bell Operating Companies (RBOCs) to have relatively stable ratings in 2006 after completing the review of Verizon for its acquisition of MCI. From a positive perspective, Verizon, SBC, and BellSouth have strong service portfolios, especially related to wireless, good scale, and solid balance sheets. From a negative perspective, these operators face significant cable MSO competition in the mass market that will require them to make high levels of re-investment into their networks to maintain their competition position. In the business market, SBC and Verizon face integration risks from their respective acquisitions of AT&T and MCI but also have significant revenue potential in expanding wireless into this space. In general, organic cash flow growth is expected to be flat to slightly up for these operators in 2006 based on strong wireless results. Furthermore, it appears that the RBOCs have completed debt reduction and will focus on returning more value to shareholders, so material debt reduction is not expected beyond any outstanding acquisition deleveraging.

For Pure-play wireless operators such as Sprint Nextel, Fitch has a more favorable rating outlook for 2006 than the industry in general, although this will not lead to widespread positive rating actions. While these carriers lack service diversity, they maintain a key wireless service provider position in the industry, which should face only modest changes in competitive pressure in 2006. Furthermore, growing demand for data services, including wireless broadband along with investment in improved network quality and 3G network upgrades, should provide them with good growth prospects, which should produce strong cash flow growth and a strengthening balance sheet.

Fitch believes rural local exchange carriers (RLECs) have a more negative rating outlook compared with the industry in general as there is increasing risk for weaker financial results due to competitive pressures, reliance on traditional wireline services, and the prospect of changing regulatory policies. Furthermore, many of these operators have been returning exceedingly large amounts of free cash flow to equity stakeholders in the form of dividends and share repurchases while maintaining current debt levels and minimum cash balances.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.