The long-awaited, ‘ultimate’ consolidation in the telecommunications industry appears to have begun. This final merger wave was predicted as long ago as 2000, when Sprint and WorldCom proposed a combination. But when regulators nixed the deal, the pace of consolidation slowed. We have seen some activity in the wireless segment over the past few years but the transactions were not blockbusters involving top players. Cingular’s takeover of AT&T Wireless (AWE), which was announced about a year ago, has changed all that.
Several factors drove the Cingular/AWE deal. First, AWE was struggling to attract and hold on to subscribers, and its margins were weak. Ironically, AWE’s problems stemmed not from a headlong rush for subscriber growth, but rather from the company’s unsuccessful focus on profitability and free cashflow generation. But AWE was not very profitable, mainly because its network was not comparable with those of industry leaders such as Verizon. Second, Cingular was desperate for more growth. Its parents, SBC and BellSouth, had been losing wireline business. Recognizing that wireless was one of the few profitable growth areas available, they pursued the merger aggressively. Third, M&A activity picked up in 2004. After the leverage binge of the late 1990s, many companies were in no position to pursue acquisitions; now they have gotten their balance sheets back in shape.
Wireless mergers are attractive because they offer significant economies of scale. With network and back-office infrastructures firmly established, the addition of subscribers has led to improving margins. Verizon was one of the first operators to reach the holy grail of 40% margins. Sprint/Nextel and Cingular are on the same path—we expect both of them to get to that level shortly. In the meantime, capital spending has declined as the network builds are completed. The combination of higher operating income and lower capital expenditures has led to increased free cashflow. Cashflows should continue to grow as merger synergies lower the cost base and provide even better margins.
So what are the next deals and what should we expect in terms of the impact on credit profiles? We think the proposed Sprint/Nextel deal will be approved since the Federal Communications Commission has indicated, at least implicitly, that consolidation is not necessarily bad for customers. This is especially true in this case because Nextel has targeted mainly business users, while Sprint has pursued the consumer market.
The deal presents obvious synergies and the aforementioned economies of scale. However, integrating two incompatible technologies is likely to be challenging. As the combined entity initially will be running two networks coincidentally, cost savings are not likely to be substantial. In fact, higher costs would not be surprising. Nextel bondholders are clearly better off with the merger while Sprint bondholders may actually be slightly worse off depending on the progress of the assimilation process.
As the wireless operator with the lowest rate of subscriber turnover, or churn, and strong subscriber growth, Verizon does not need to do a deal. But Alltel would be an attractive target for Verizon, given Alltel’s concentration in rural markets, margins that are higher than most in the industry, and an existing reciprocal roaming agreement with Verizon. Most importantly, Alltel and Verizon share a common CDMA (code division multiple access) technology, suggesting a much smoother integration process than the Sprint/Nextel merger.
Although we view the Alltel acquisition of Western Wireless as a defensive move, we still think Alltel is vulnerable to a takeover. It will have a hard time competing against a strong lineup of national wireless operators that have four to five times as many subscribers. If a Verizon/Alltel transaction were to go through despite potential complications related to the disposal of Alltel’s wireline properties, the credit impact would be minimal because both companies are similarly rated. Spreads would be relatively unchanged under such a scenario.
Another possibility for Verizon would be a bid for Sprint, despite public comments to the contrary. Sprint would be attractive because of its similar technology, large subscriber base and huge amount of spectrum. Impediments to a deal would be the substantial cost of an acquisition and potential regulatory scrutiny: the combined entity would be 40% larger than its closest competitor and nearly four times the size of the third largest player.
A deal with Sprint would definitely affect Verizon’s credit profile. However, the impact would not be dramatic, even if Verizon was to use a significant amount of debt. Sprint bondholders would obviously benefit as the credit profile would probably have low single-A characteristics.
The impact on Vodafone, Verizon’s partner in Verizon Wireless, would be similar to Verizon. Despite remarks from Vodafone’s management that it has no desire to pursue an acquisition, we think Vodafone would support Verizon in a transaction that increases its presence in the still-growing US market. Consequently, Vodafone would be subject to a ratings downgrade were a Sprint deal to be consummated, but would see little impact with an Alltel deal.
On the wireline side, the most obvious possibility is a merger of SBC and BellSouth. Both firms are inextricably linked as a result of the Cingular partnership. Both are facing declines in access lines. Long-distance gains are helping the top line but the impact on margins is negative. But a merger would probably face a long approval process.
The regulators would express concerns that of the seven original Baby Bells, only three would remain, with one of them, Qwest, struggling mightily. SBC and BellSouth would likely argue that the cable operators are providing plenty of competition. And that could be a compelling argument, given that Comcast, Time Warner, and Cox are rapidly expanding their telephony penetration. Assuming a merger would eventually be approved—more likely than not, in our opinion—the impact for bondholders would be immaterial because the credit profiles are nearly identical and bonds are only trading a few basis points apart.
Rumors about AT&T as a potential target seem to have receded lately, possibly due to the fact that its stock has appreciated more than 35% from the lows reached in mid-August. AT&T has a top-flight long-haul network, but so did many start-ups that fell by the wayside during the crash of the early 2000s. The real value in AT&T is its extensive list of business customers. SBC, BellSouth and Verizon have made impressive inroads into the consumer side of the market, but have not enjoyed similar success with business customers.
A takeover of AT&T would send the acquirer to the top of the industry in one fell swoop. With a market capitalization of less than $15 billion, the cost would not be prohibitive. However, it is hard to imagine that the Bells would be very aggressive in pursuing a company that continues to experience contracting margins, with no improvement forthcoming in the near future. The credit profile of the regional Bell operating companies would also likely deteriorate, unless of course it was an all-equity deal, which is not likely. Considering that wireless and DSL (digital subscriber line) expansion appear to be higher priorities, the odds of such a deal are low—a comforting thought for bondholders.
Dave Novosel is a senior bond analyst at Gimme Credit