More telcos may stop giving before it hurts

editor's corner

Large integrated telcos such as AT&T (NYSE:T) and Verizon Communications (NYSE:VZ) are considered stable, blue-chip stocks to most investors, but will they be able to retain that reputation as their landline networks continue to battle competition from cable companies and their wireless units invest billions to upgrade their networks?

It's no secret that growing competition and increasing capex pressures are impacting the bottom lines of mobile network operators. But Standard & Poor's Rating Services is expressing concern about how those stresses, combined with telcos' long history of paying out handsome dividends to investors, may impact their ability to repay debt and maintain or reduce leverage.

It's an interesting issue that directly impacts network investment. S&P notes that dividends at major telcos often consume 50 percent to 100 percent of free operating cash flow (FOCF). That's money that could be used for network buildouts and upgrades as well as to reduce debt but instead it goes into investors' pockets.

Investors don't need to panic yet, as S&P "does not expect financial policies of the large, publicly traded U.S. telecom companies to change in the near term." But the company is warning that "secular declines in the wireline industry and rising capital expenditures in wireless" could ultimately slam telco cash flows. In the near future, telcos may need to hold their purse strings tighter to conserve cash and slash their leverage if they want to maintain their financial credit ratings.

Credit ratings are critical issues for companies, just as they are for individuals, because they impact the cost of borrowing. Your FICO score can make the difference between your being able to buy the house of your dreams in your favorite neighborhood or a dilapidated one-bedroom condo down the road. That's because if you have a high credit rating, you'll get a much lower interest rate on a mortgage and, thus, lower payments. It works the same for corporations.

Everyone knows landline carriers are feeling financial pressures due to cutthroat competition from cable-TV providers and even wireless carriers. But the ever-expanding wireless sector is getting hit hard too. "Companies with large wireless operations also have significant near-term capital spending requirements to deploy fourth-generation (4G) networks, and margins are declining, at least in the short run, because of higher handset subsidies as smartphone penetration increases. These factors could hurt FOCF generation unless wireless carriers are able to grow revenue, which may be challenging as the industry matures," said S&P.

"The other major cost facing wireless providers is for additional spectrum, especially given the rapid increase in data traffic over wireless networks. Spectrum purchases could take the form of acquisitions, given that we do not expect significant U.S. government auctions of spectrum in the next few years," the firm added.

Sprint Nextel (NYSE:S) halted its dividend payouts in February 2008 as it hemorrhaged customers and isn't likely to restart those payouts anytime soon, given that it's quite busy borrowing to upgrade its network. On May 29, Sprint Nextel announced it entered into a new $1 billion credit facility with Deutsche Bank and a syndicate of other banks to finance equipment purchases from Ericsson (NASDAQ:ERIC) for Sprint's Network Vision project, which will cost $4 billion to $5 billion in total and should be largely complete by the end of 2013.

Earlier this year, Alaska Communications Systems Group slashed its dividend by more than 75 percent to $0.20 per share, S&P said. The operator's landline business is struggling, as all telcos' wireline units are, but ACS' wireless business is also engaged in an intense rivalry against GCI and AT&T Mobility, and Verizon Wireless is looking to enter the Alaskan wireless market in the next few years too. "These factors, coupled with higher capital spending to support the buildout of its long-term evolution (LTE) network, caused FOCF to decline over 30% in 2011," noted S&P.

The good news for blue-chip investors is that large U.S. mobile operators such as AT&T and Verizon will be wrapping up their LTE buildouts in 2013, meaning they should see future reductions in capex. But they still have lots of thorny issues to deal with in their wireline units and sticky pension obligations that will hang heavy over them for years to come.

A lot of pride and tradition is associated with large telcos' roles in the stock market, and leading operators are not likely to make changes to their dividend policies on a whim. But "pride goeth before hunger," and the heated competitive environment could certainly impact these telecom players' financial strategies sooner rather than later.-- Tammy

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