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Baby Bells Core Lines Weaken


Vonage In Print News

Downgrades Toll For 3 Baby Bells As Core Lines Weaken

September 27, 2004

By Ken Brown and Aaron Lucchetti

Not long ago, telephone companies were considered utilities and their bonds were only slightly more risky than a passbook savings account.

Today, the phone companies' product is viewed as a commodity in an increasingly crowded industry, and their widely held bonds are getting less respect.

Sometime in the next week, Standard & Poor's, citing a deterioration in their core phone businesses, likely will lower its credit rating for the three biggest Baby Bell telephone companies: Verizon Communications Inc., SBC Communications Inc. and BellSouth Corp. Such a move would be the first time the ratings firm has acted against these three companies at once.



The market already anticipates a one-notch downgrade, bond investors say, but they add that the bonds would likely take a hit if the downgrade was more severe or if S&P continued to raise doubts about the companies' outlooks. If the bonds tumble, the Bells' stocks could follow, particularly if investors begin to worry about the companies' ability to pay their healthy dividends.

In 4 p.m. composite trading Friday on the New York Stock Exchange, Verizon's shares rose 17 cents to $40.31. SBC's stock climbed one cent to $26.05. BellSouth finished at $27.15, down 24 cents.

The potential downgrade highlights how significantly the business has changed for the nation's three largest local phone companies, which once had near monopolies in their regions. In the past few years, though, they have lost millions of local phone lines as people switch to wireless phones and Internet phone service provided by cable-television companies and upstart phone companies such as Vonage Holdings Corp. Five years ago, BellSouth was rated Triple-A, S&P's highest rating, while Verizon hasn't seen its rating cut in more than four years. Today, all three companies are rated A-plus, which lies in the middle of the investment-grade universe, but still puts the companies in the top 10% of those rated by S&P, a unit of McGraw-Hill Cos.

S&P, as well as Moody's Corp.'s Moody's Investors Service and Fimalac SA's Fitch Ratings, put grades on the bonds of thousands of companies, telling investors how likely they are to pay their interest and principle on time and in full. When a company's rating is lowered, the interest rate the company must pay to borrow generally goes up, making it more expensive to take on debt. A lower debt rating can also trigger a selloff in the company's shares, particularly now that stock investors have realized that the bond market often figures out a company's problems before they do.

Earlier this year, S&P said Verizon, SBC and BellSouth faced a "more challenging environment" and put the three companies on negative credit watch. "We're following the developments in the industry and saying this has transitioned to a higher-risk industry," says Richard Siderman, a managing director at S&P who runs the firm's telecommunications and cable-TV ratings group. Moody's separately downgraded the three companies for similar reasons in late 2002 and early 2003.

S&P said that SBC and BellSouth also could be downgraded because of the risks created by their $41 billion agreement in February to buy AT&T Wireless Services Inc., which they plan to merge into their jointly held wireless company, Cingular Wireless. One potential scenario, Mr. Siderman says, is that the ratings on all three Bells are lowered by a notch next week, but BellSouth and SBC would be kept on negative credit watch until their deal to buy AT&T Wireless closes, which is likely to occur next month. Then, if S&P believes the companies took on too much debt in the deal, it could downgrade them another notch. A downgrade could make it more expensive for the Bells to borrow money to do deals, slowing the long-hoped for consolidation in the telecom industry.

The Bells say S&P's actions are unwarranted and that their businesses and balance sheets are actually in better shape than they had been recently. "All of the financial risk issues that agencies have traditionally focused on are in some cases the strongest they have ever been," says William F. Heitmann, Verizon's senior vice president and treasurer.

The bond market disagrees, and has been demanding higher interest rates for Bell bonds. Late last week, for example, BellSouth bonds maturing in October 2031 yielded 6.06%, or 1.24 percentage points more than Treasury bonds of a similar duration, according to bond-data provider MarketAxess. At the beginning of the year, they yielded about 0.9 to one percentage point above Treasurys. Some Verizon bonds have performed better, but those maturing in December 2030 yielded 6.15%, or 1.34 percentage points above Treasurys last week, compared with a low in April of 1.18 percentage points over Treasurys. By comparison, bonds rated the same as Verizon and the other two Baby Bells last week yielded only about 1.09 percentage points over Treasurys, according to Lehman Brothers' credit index.

"The point is that the Bells' cash-cow business is shrinking," says Geoffrey Gwin, a New York hedge-fund manager who has sold short the bonds of BellSouth, betting that their value will decline. He says that the Baby Bells' bonds could be under pressure because "they're not going to be able to take out expenses at the same rate" as their core, highest profit-margin business "diminishes."

Angelo Manioudakis, a portfolio manager with OppenheimerFunds, uses cable lines provided by Cox Communications Inc. for his home phone line in Rhode Island. As a manager of a bond portfolio, he says customers like himself make him want to go light on the Baby Bell bonds.

"The business model has been under threat and I don't know how you reverse that," Mr. Manioudakis says. Even though the bonds' higher yields make them more attractive now, "we don't think they're a good buy. Over time, they're going to continue to deteriorate," he says. In a few years time, he expects that the industry's debt ratings will slip several notches into a range around Triple-B, the lowest investment-grade rating.

Representatives of SBC and BellSouth say a downgrade would be unwarranted since the companies' balance sheets have improved, their cash flows are strong and their overall business is solid. An SBC spokeswoman says the $8 billion to $10 billion the company will borrow to finance its acquisition of AT&T Wireless "is going to be a very good investment, despite the balance sheet impact it will have in the short-term."

Verizon's Mr. Heitmann questions the timing of S&P's move, and pointed out that Verizon had cut its debt by about $20 billion from a peak of about $62 billion at the end of 2001. He also said S&P's mandate is to focus on whether a company can repay its debt, not on a company's business strategy. "I, for one, see them drifting away from that perspective and starting to look more like equity analysts than they do debt analysts," Mr. Heitmann says.



 
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†AK and HI residents pay $29.95 shipping. ††Limited time offer. Valid for residents of the United States (&DC), 18 years or older, who open new accounts. Offer good while supplies last and only on new account activations. One kit per account/household. Offer cannot be combined with any other discounts, promotions or plans and is not applicable to past purchases. Good while supplies last. Allow up to 2 weeks for shipping. Other restrictions may apply.

1Unlimited calling and other services for all residential plans are based on normal residential, personal, non-commercial use. A combination of factors is used to determine abnormal use, including but not limited to: the number of unique numbers called, calls forwarded, minutes used and other factors. Subject to our Reasonable Use Policy and Terms of Service.

2Shipping and activation fees waived with 1-year agreement. An Early Termination Fee (with periodic pro-rated reductions) applies if service is terminated before the end of the first 12 months. Additional restrictions may apply. See Terms of Service for details.

HIGH SPEED INTERNET REQUIRED. †VALID FOR NEW LINES ONLY. RATES EXCLUDE INTERNET SERVICE, SURCHARGES, FEES AND TAXES. DEVICE MAY BE REFURBISHED. If you subscribe to plans with monthly minutes allotments, all call minutes placed from both from your home and registered ExtensionsTM phones will count toward your monthly minutes allotment. ExtensionsTM calls made from mobiles use airtime and may incur surcharges, depending on your mobile plan. Alarms, TTY and other systems may not be compatible. Vonage 911 service operates differently than traditional 911. See www.vonage.com/911 for details.

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