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Verizon Dials Up More Risk with MCI

On Feb. 14, 2005, Standard & Poor's Ratings Services placed its long-term ratings of New York City-based Verizon Communications (VZ) and affiliates on CreditWatch with negative implications, following the company's announcement of its plan to acquire MCI (MCIP). In the event of a downgrade, Verizon's long-term corporate credit rating (currently at A+) would not fall lower than A. Accordingly, the A-1 short-term rating on financing arms Verizon Global Funding and Verizon Network Funding were affirmed. An aggregate of approximately $39 billion of Verizon debt is affected.

At the same time, S&P placed its ratings of Ashburn (Va.)-based MCI, including the B+ corporate credit rating, on CreditWatch with positive implications. The action affects approximately $6 billion of MCI debt.

The acquisition proposal values MCI at about $9 billion. Under its terms, MCI shareholders will receive about $5 billion of Verizon stock and just under $2 billion in cash. At closing, Verizon will assume about $4 billion of net MCI debt, which is elevated by the cash payment that will be made to MCI shareholders. The consideration is subject to adjustment if MCI's contingent bankruptcy and tax-related liabilities exceed $1.725 billion at closing.

DIFFERENT THAN SBC. The acquisition requires approval by MCI shareholders and a number of regulatory bodies, and it will take about a year to close.

The negative CreditWatch listing for the Verizon ratings reflects the potential for weaker financial parameters at the company, as well as a possible weakening of Verizon's overall business-risk position. The initial financial impact on Verizon won't be significant, given MCI's large cash position and the relative size of the companies. Accordingly, the CreditWatch placement incorporates concerns regarding prospects for material cash generation at MCI over the next few years.

S&P recently affirmed its ratings on SBC Communications (SBC), after it announced its planned merger with AT&T (T). To some extent, this was because SBC has more capacity than Verizon to absorb such an acquisition, given that it's rated a notch lower than Verizon. More important, the SBC affirmation recognized that AT&T, despite its significant business challenges, is still expected to generate good cash flow from its enterprise segment for a number of years.

CHANGE OF STRATEGY? In contrast, MCI has a materially smaller presence in the enterprise segment and fewer local points of presence (POPs), which means it faces higher access costs than AT&T. However, S&P expects the regional Bells, including Verizon, to increase their marketing efforts in the large-business segment. By purchasing MCI's network and its expertise, Verizon could mitigate some of the risk it might otherwise have incurred had it decided to more aggressively pursue the enterprise segment on its own. Also, Verizon's extensive network in its local-service territory should enable it to somewhat reduce MCI's access costs.

The positive CreditWatch listing for the MCI ratings reflects its potential acquisition by a much more creditworthy entity. If Verizon does not guarantee the MCI obligations, then the extent of a potential MCI upgrade will depend on a number of factors, including where the MCI debt will reside within the Verizon corporate structure. If the MCI debt resides at a Verizon subsidiary and is nonrecourse to Verizon, S&P would have to determine the strategic value of MCI to Verizon and what degree of support Verizon would give to the MCI debt.

In resolving the CreditWatch listings, S&P will examine how the MCI purchase alters Verizon's strategy to expand in the enterprise and international segments, as well as the likelihood for and magnitude of operating synergies. From Standard & Poor's Ratings Services

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