On Aug. 3, Standard & Poor's Ratings Services lowered its long-term corporate credit and senior unsecured debt ratings on AT&T (T) to BB+, below investment grade, from BBB. In addition, the short-term rating was lowered to B from A-3. The ratings downgrade reflects the company's continued challenging business risk profile due to the telecom industry's transformation and the resultant long-term impact on the company's financial profile, says analyst Rosemarie Kalinowski.
Standard & Poor's anticipates that competition will intensify from other large long-distance carriers, the regional Bell operating companies (RBOCs), and cable TV companies in the near-to-intermediate term, further affecting AT&T's weak operating margins. These factors are mitigated somewhat in the short term by AT&T's solid balance sheet and liquidity position.
The ratings were removed from CreditWatch, where they were placed with negative implications on April 28, 2004, due to continued weakening in the company's business risk profile as reflected in first-quarter 2004 results and the potential for steeper revenue declines and compressing operating margins. The outlook is negative. As of June 30, 2004, total debt outstanding was about $11.2 billion, unadjusted for operating leases and other postretirement employee benefits (OPEBs), or about $7.9 billion net of cash, restricted cash, and foreign currency fluctuation.
Competitive pricing pressures, wireless substitution, and more conservative capital spending by corporate customers have led to AT&T's more challenging business risk environment. The company's operating efficiency, measured by its operating margin, has demonstrated the effects of these challenges despite cost-reduction initiatives. The consolidated operating margin in the second quarter of 2004 was 4.6%, below the 11.7% level for the second quarter of 2003.
AT&T's Business segment, which represents about 75% of total revenue and was perceived to be the company's growth area, has been particularly affected by accelerated pricing pressure from competitors. Although AT&T has a dominant position in the Business enterprise segment, the company was required to reduce its price premium in order to stem market share loss. This action, in addition to continued pricing pressure, has resulted in the Business segment's operating margin weakening to 2.7% in the second quarter of 2004 from 9.3% in the second quarter of 2003. The intense pricing environment is not anticipated to improve over the next year.
The Consumer segment, which represents about 25% of total revenue and about 20% of EBITDA, has been under pressure over the past two years as the RBOCs obtained regulatory approval to provide long-distance services. In addition, regulatory decisions related to pricing of the unbundled network elements platform (UNE-P) has resulted in AT&T ceasing to market local services to new residential customers and to cease growing its consumer base.
Although the company has stated that it will continue to service its existing consumer base and selectively roll out voice over Internet protocol (VOIP) services to consumers, Standard & Poor's anticipates that the cash flow of this base could be challenged by expected increases in UNE-P rates, the aggressive marketing of the RBOCs, and the prospective telephony offerings of the cable TV companies. The Consumer segment has experienced annual mid-teen percentage declines in revenue due to competitive pricing pressure and wireless substitution, and this is not expected to abate over the near term. Due to these factors, this segment's operating margin declined to 11.9% in the second quarter of 2004, from 20.6% in the second quarter of 2003.
Although the rating is dominated by business risk pressure, AT&T has improved its balance sheet over the past two years via major asset sales and growth in free cash flow due to staff reductions, automation of system processes, and other cost-reduction measures. The company generated discretionary cash flow (after capital expenditures and dividends) of $1 billion in the first half of 2004 and $4.6 billion in fiscal 2003. Discretionary free cash flow is expected to be about $2 billion in 2004 and applied to debt reduction. In the second quarter of 2004, net debt to EBITDA was about 1.1; adjusted for operating leases and OPEBs, this ratio was about 1.5.
The company has a good short-term liquidity position. Its 2004 cash position should be sufficient to support the next five years of debt maturities. As of June 30, liquidity consisted of $2.5 billion of cash, $1.8 billion available under an unsecured $2 billion credit facility (net of letters of credit), and up to $1.2 billion available under a $1.35 billion accounts receivable securitization program. The bank facility, which matures in October 2004, has a one-year term out. Covenants under the credit facility and accounts receivable securitization program state that net debt to EBITDA cannot exceed 2.25 and that EBITDA interest coverage must be at least 3.5. The company has sufficient room under the covenants. There are no rating triggers or material adverse change clause in the two facilities. The company is expected to generate discretionary cash flow of more than $1 billion during the second half of 2004.
Outlook: The company's business risk profile is expected to continue to be challenged by competitors that can offer a more comprehensive bundled offering on the Consumer side, and by intense pricing pressure in the Business segment. Uncertainty exists as to the timing of price stabilization in the near term. Consequently, operating margins are expected to weaken further.
Generation of free cash flow at recent levels will depend on the status of the existing Consumer base, further cost reductions, and the degree of revenue decline in the Business segment. Visibility on price stabilization in the Business segment, maintenance of a good liquidity position, and keeping net debt leverage below 2 times (unadjusted for operating leases and OPEBs) are essential to sustaining the rating. From Standard & Poor's RatingsDirect