Our outlooks across the U.S. telecom and cable industry are a mixed bag for 2019, as some of the past year's negative trends will persist while offsetting factors in certain subsectors may even conditions out. Wireline companies--which are facing secular industry pressures and heightened competition--continue to lose voice lines to wireless substitution and broadband and commercial customers to cable providers. At the same time, the ongoing erosion of the pay-TV ecosystem has contributed to chronic video subscriber losses as consumers continue to migrate to over-the-top (OTT) video platforms.

Still, there are some bright spots. Service revenue and subscriber trends for U.S. wireless companies improved in 2018 since T-Mobile and Sprint scaled back their aggressive promotional activity in advance of the regulatory approval process for their proposed merger. A successful combination could prompt us to revise our industry outlook to stable from negative since reducing the number of nationwide carriers to three from four would alleviate competitive intensity. That said, credit quality improvement could be constrained by mature industry conditions, ongoing capital spending requirements, and spectrum license purchases. For the U.S. cable sector, our outlook is stable, bolstered by continued growth from broadband and commercial services despite fewer traditional pay-TV customers and potential competition from 5G fixed wireless. We also have a stable outlook for the telecom infrastructure segment, which comprises data center, fiber, and tower operators. These industries benefit from greater data and video consumption by residential, commercial, and mobile customers. Nonetheless, capital spending requirements to support growth are substantial and high leverage constrains free cash flow generation. As a result, we do not expect any improvement in key credit metrics in 2019.

On a broader scale, concerns about the health of the U.S. economy as it enters its 10th year of expansion and higher interest rates could prompt U.S. telecom and cable issuers to scale back investment and focus on debt reduction following several years of higher leverage to accommodate merger and acquisition (M&A) activity. For the most part, the telecom and cable industries are less vulnerable to changes in macroeconomic conditions since consumers are not likely to give up their mobile devices or broadband service. That said, an economic downturn could pressure residential average revenue per unit (ARPU) across various sectors and have a larger impact on business services.

U.S. Economic Outlook: Telecom And Cable Issuers Are More Leveraged This Time Around

For our telecom and cable ratings, we focus on economic indicators that we believe most correlate with consumer demand, including real GDP, unemployment, personal consumption expenditures, and housing starts (see table 1).

Table 1

Under our baseline assumption, S&P Global Ratings' economists see a 15%-20% risk of recession in the U.S. over the next 12 months. We expect real GDP growth of 2.9% in 2018 and 2.3% in 2019 and two rate hikes in 2019. We also expect that GDP growth will transition back to below 2% in 2020 and beyond as the boost from the recent tax reform legislation wanes and the cumulative monetary tightening begins to affect economic growth.

Additionally, credit risks are rising as the cycle continues to age--particularly in the corporate debt market, where debt and leverage have built up substantially. Although the U.S. telecom and cable sectors held up well during the 2008 financial crisis, we believe they could be less resilient under a more stressed scenario now given more mature industry conditions and technology changes (e.g. a shift to online video streaming services). Furthermore, these issuers carry more leverage than they did in 2008 because of M&A.

U.S. Telecom And Cable Rating Trends Are Increasingly Negative

About 90% of U.S. telecom and cable issuers are speculative grade, including almost 67% in the 'B' or 'CCC'/'CC' categories. In 2018, there were 21 downgrades and only four upgrades, which equates to a higher downgrade ratio than during the financial crisis. Furthermore, rating outlooks are increasingly negative; 25% of issuer credit ratings have a negative outlook compared to about 18% at the end of 2017. About 10% of telecom and cable issuers are now in the 'CCC'/'CC' categories compared to 4% at the end of 2017. Ratings in these categories largely reflect secular industry declines, intense competition, debt-financed M&A and, in some cases, refinancing risk.

We expect that competitive pressures, technology shifts, and some additional M&A could trigger more negative rating actions in 2019 even as some companies look to reduce leverage. In a rising interest rate environment and potentially weaker macroeconomic conditions, lower-rated issuers with high leverage and limited growth prospects will likely face refinancing risk, which could lead to potential downgrades and trigger more defaults over the next few years.

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M&A Could Take A Back Seat To Debt Reduction In 2019

Following years of higher leverage to accommodate acquisitions, we expect U.S. telecom and cable providers will be more prudent in capital allocation decisions, especially as interest rates rise, although weaker economic conditions could curtail any meaningful improvement in credit quality. For this reason, we expect M&A activity to slow in 2019 and that large investment-grade issuers, in particular, will focus their attention on debt reduction and integrating recent transactions.

Last year was another active year for M&A, highlighted by a couple of high-profile deals. T-Mobile and Sprint agreed to merge in an all-stock transaction and Comcast Corp. announced that it would acquire pan-European entertainment and satellite pay-TV provider Sky PLC, along with an unsuccessful effort to acquire Twenty-First Century Fox Inc.AT&T Inc. also closed on its $85 billion acquisition of Time Warner Inc. (now Warner Media LLC) after a long regulatory approval process. In the aftermath, we expect leverage for all of these companies to rise: For T-Mobile, we expect pro forma adjusted debt to EBITDA (excluding the benefits of lease accounting) will increase to the mid- to high-4x area from about 3x on a standalone basis. For Comcast, we expect leverage to increase to around 3.6x from 2.3x as of Sept. 30, 2018, although we assume the company will reduce debt to EBITDA below 3x by 2020, which is our threshold for the current rating. And for AT&T, adjusted leverage rose to around 3.5x from 3.0x.

In the fixed-line industry, secular industry pressures and the need for scale to preserve margins and stabilize top line performance are the key drivers for consolidation. Still, acquisition opportunities are diminishing and market reception for these transactions has waned because of secular and competitive pressures and a history of poor results from M&A.

In wireless, the combination of T-Mobile and Sprint would leave few regional providers available for consolidation, none of which would improve economies of scale. We believe that a successful merger could promote much healthier market conditions since it could reduce overall competitive intensity. Furthermore, since the wireless industry is very scale-intensive, with massive capital spending requirements and an ongoing need for spectrum licenses to address capacity constraints, a merger would enable the New T-Mobile to better compete since it would potentially have a superior spectrum position relative to its peers and a larger subscriber base over which to spread costs.

In cable, we could see more consolidation among the small and mid-sized providers as rising programming expenses hurt video margins and competition from OTT services intensifies. These companies generally lack the scale and pricing power to negotiate programming contracts and can't pass through price increases without losing customers.

We believe that fiber providers will be an attractive asset for U.S. telecom and cable operators because of rising demand for data and video and the need for wireless backhaul capabilities as we enter the next iteration of wireless technology; however, high take-out multiples could limit potential deals. Cable providers are also acquiring fiber assets to better serve larger enterprise customers while tower operator Crown Castle has been acquiring fiber providers to bolster is small cell ambitions.

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5G Deployments Could Be More Risk Than Reward For U.S. Telcos

For U.S. telcos, we have a cautious view on 5G and believe that accelerated deployments could hurt balance sheets that are already stretched because of M&A, mature industry conditions, and competitive pressures. In our view, consumer adoption of mobile 5G could prove to be strong, akin to smartphone and LTE adoption; however, it's unclear if carriers can monetize improved performance. We question the propensity of consumers to spend more for faster data speeds on their mobile devices. Moreover, the real revenue opportunities to monetize 5G investments through Internet of Things (IoT) applications is likely five to 10 years away. At the same time, the acquisition of spectrum licenses and rising capital expenditures from the buildout or leasing of fiber and network deployments could raise debt levels at a time when leverage is already elevated. Specifically, the inherent high costs associated with small-cell network architecture could make deployments uneconomical and increase risks for wireless operators. According to a recent study by Deloitte & Touche, the U.S. needs to invest about $130 billion-$150 billion in fiber in the next five to seven years to support the growing demand for data and video. S&P Global Ratings estimates that U.S. telcos' investments in fiber to the node or to the home only represent about 40% of households in the U.S.--substantially less than other developed countries.

Overall, we believe that capital expenditures (capex) and spectrum purchases are manageable; therefore, we don't anticipate taking any rating actions on U.S. wireless operators because of 5G deployments. However, these buildouts are also likely to reduce financial flexibility and could delay deleveraging for the U.S. telcos at a time when the credit cycle appears to be peaking. (See "The Future Of 5G: North American Telcos Race To 5G, Putting Balance Sheets At Risk," published Oct. 17, 2018.)

New Competition From 5G Fixed Wireless Could Pressure U.S. Cable Providers

Already, Verizon has started its deployment of 5G fixed wireless broadband service to four markets and plans to build out to about 31 million households (about one-quarter of total households) over several years--most of which will be in service areas where its fiber-based video product Fios doesn't exist. The company's target penetration rates of 20%-30% represent an opportunity of 6 million-9 million subscribers, or about 6%-10% of the overall wired broadband market. Similarly, T-Mobile is looking to compete in the 5G fixed wireless broadband market and plans to cover about 250 million points of presence (POPs) by 2024.

Since cable will likely have a comparable or better network, we believe that new wireless options will have to offer a compelling economic reason for customers to switch from cable. The potential exists for wireless pricing discounts given the cheaper last-mile deployment costs than cable, particularly if carriers are aiming to help subsidize necessary investments to support 5G mobile. Therefore, we believe the introduction of new wireless competition into more densely populated markets could result in some market share erosion for cable operators. On top of that, increasing competition could make it more difficult for cable providers to monetize increasing data usage, potentially putting pressure on margins, especially if there is a lower-priced option available.

Cable operators are employing different strategies in response to this threat based on financial resources, the size of their footprint, and their competitive landscape. The largest operators--such as Comcast, Charter Communications, and Altice USA--are all attempting to strengthen the bundle of services they offer by investing in improved video technology that allows for the easier content search and navigation while offering a wireless mobile service through mobile virtual network operator (MVNO) agreements with wireless carriers. We believe this is prudent considering that if cable operators become more reliant on broadband as a stand-alone product, the threat of 5G fixed wireless substitution could become magnified, particularly for cable operators in more densely populated regions where it will exist.

Strong Demand At Upcoming Spectrum Auctions Could Delay Credit Quality Improvement

Notwithstanding the desire to reduce leverage over the coming years, the extent of deleveraging will partly depend on how much spectrum wireless and cable operators purchase in the upcoming auctions.

The Federal Communications Commission (FCC) is currently auctioning off spectrum in the 28 gigahertz (GHz) band and will follow that with a 24 GHz auction early in 2019. We expect it will also conduct other auctions for millimeter (mm) Wave licenses, including the 37 GHz, 39 GHz, and 47 GHz bands, in the back half of 2019. Given the weaker propagation characteristics and need for cell-site densification to support this spectrum, we expect valuations and proceeds to be substantially lower than the previous broadcast incentive auction and advanced wireless services (AWS-3) auction. We currently estimate that gross proceeds from these auctions could be anywhere from $2 billion-$13 billion in total and therefore, will not have a material impact on financial leverage for the wireless carriers.

However, the FCC is also looking to make spectrum available between 3.7 GHz and 4.2 GHz (C-band), which is currently used by fixed satellite service providers, as well as spectrum in the 3.5 GHz band (Citizens Broadband Radio Service [CBRS]) available for 5G. For the CBRS spectrum, the FCC is looking to put forward about 150 megahertz (MHz) of spectrum in this band, although about 70 MHz would be released through auction while the remaining portion could be available for unlicensed use. The satellite providers that hold the C-band spectrum (mainly Intelsat and S.E.S.) have committed to make 200 MHz (including guard bands) available (up from the original 100 MHz) if the FCC adopts their market-based proposal. Over the coming months, the FCC will analyze comments and proceed to a final order likely in mid-2019. While we recognize that the FCC seems focused on moving aggressively to make spectrum available to promote 5G leadership, there are several uncertainties that remain to be resolved and could have a large impact on the outcome. This includes the format of any monetization process, the amount of spectrum made available, the band plan, technical hurdles to avoiding interference, clearing and reconfiguration costs, government involvement in the collection of proceeds through taxation or other means, and timing. Adding to the uncertainty, we also note that the National Association of Broadcasters, among others, have reiterated the importance of protecting incumbent C-Band users, as the C-Band is currently used primarily to broadcast video signals.

We believe that demand for these spectrum licenses (mid-band spectrum) will likely be strong and may help facilitate 5G deployments because they have stronger throughput characteristics than low-band spectrum but better propagation than very high-band spectrum. Based on auctions in other markets, we believe the price per MHz POP could be in the $0.10-$0.40 range in the U.S. The closest transaction in the U.S. for mid-band spectrum would be Sprint's acquisition of the 2.5 GHz spectrum from its remaining 50% stake in Clearwire Corp. that it didn't already own for about $0.30 per MHz POP. As a result, we estimate that proceeds from the sale of these spectrum licenses could be anywhere from $9 billion-$35 billion in aggregate.

Table 3

Overall, we expect that Verizon will be the most aggressive bidder of spectrum in future auctions since its current spectrum holdings are the lowest on a per-subscriber basis compared with other wireless providers, although its acquisition of StraightPath could limit its participation in the mmWave auctions. In contrast, we believe that AT&T will be less aggressive since it is working through the integration of Warner Media LLC while trying to navigate the secular industry pressures in several of its business lines and manage a massive $175 billion debt burden (as of Sept. 30, 2018). Also, its buildout of the First Responder Network Authority (FirstNet) will already give it access to a large swath of 700 MHz spectrum, which will facilitate the deployment of a 5G network. That said, since AT&T was unsuccessful in its bid for StraightPath, we believe it will be an active participant in upcoming mmWave auctions. Demand from the third-largest carrier T-Mobile will partially depend on whether or not it successfully acquires Sprint, which would give it an enviable spectrum position. Sprint owns a vast amount of spectrum in the 2.5 GHz band, which has very good throughput characteristics and could be valuable for 5G deployments, especially given the improvements in antenna technology. On a stand-alone basis, while Sprint could participate in these auctions, it is constrained by its highly leveraged balance sheet.

We do factor in spectrum purchases in our base-case forecasts for Verizon and AT&T but not T-Mobile given the uncertainty around the outcome of its proposed merger with Sprint and the fact that the rating is on CreditWatch. For Verizon, we believe the company could spend about $10 billion in upcoming auctions and still reduce leverage over the next couple of years, although its path to 2.5x adjusted leverage, which is our target for an upgrade, would depend on the timing of capital outlays. We believe that AT&T has some flexibility within its 'BBB' rating for spectrum purchases, although we do not factor in material spending.

We believe it is possible that cable providers could look to purchase spectrum in the future, as Comcast, Charter, and Altice USA have all launched or plan to launch a wireless service. Currently, these cable providers rely on wholesale agreements with either Verizon or Sprint to provide service. In our view, it could be beneficial for them to gain owners economics in certain markets by bringing more traffic onto their own networks and avoiding variable usage-based roaming costs to the wireless carriers. This could be achieved most efficiently through purchasing mid-band spectrum, such as 3.5 GHz or C-Band, though we have not included any spectrum purchases in our base-case projections for cable providers. Owning spectrum assets could also be leveraged when negotiating MVNOs with wireless operators. We believe Charter and Altice USA have flexibility within their current ratings and leverage targets to pull back on share repurchases to allow for spectrum purchases, if necessary. Conversely, Comcast has less flexibility to make spectrum purchases and still delever to our target leverage of below 3x within two years.

Cord-Cutting Is Expected To Remain At A Relatively Stable Rate

Overall, we expect that traditional pay-TV distributors will lose subscribers at approximately 3.3% in 2019, which is slightly higher than the 3.0% rate we projected for 2019 at this time last year. Still, we are not forecasting a meaningful acceleration in cord-cutting because we believe that virtual multichannel video programming distributors (vMVPDs) were designed to primarily target customers who don't already subscribe to traditional cable TV as a way for media companies to add incremental customers. We believe the savings from cutting the cord may not be worth it for most consumers after factoring in the higher cost of broadband, lost content, and limitations on the number of streams permitted. Furthermore, for the subset of the population that find vMVPDs to be an attractive alternative to traditional TV, it is possible that most have signed up by now, as evidenced by the recent deceleration in growth of both Sling TV and DirecTV Now. Finally, we expect the savings gap to narrow as vMVPDs raise prices in the future, as most are currently operating at very slim profit margins or at a loss.

We believe cable providers are better positioned to manage the threat of cord-cutting because they also provide the required broadband service necessary for streaming services and can increase the cost of the high-margin, stand-alone broadband service. However, there is a significant variance between large cable providers and small cable companies in our forecast. We believe large cable providers will continue to invest in and promote their video product, increasingly to serve as a retention tool for their broadband services and resulting in only modest subscriber losses. Furthermore, large providers such as Comcast and Charter have greater scale, which gives them negotiating leverage with content providers and a greater cushion to absorb rising programming costs. Therefore, as vMVPDs raise prices in the future, those increases will likely outpace rate hikes for large cable providers and make them less appealing on a percentage basis in the intermediate term. At the other end of the spectrum, we believe small cable providers are more vulnerable given their tighter video margins and fewer financial resources to innovate.

The story is different for satellite TV providers because they do not have a true broadband product for delivering streaming alternatives. Therefore, the cost savings for consumers to switch to a vMVPD are more significant than cable. We believe DirecTV will fare better than Dish because it has premium content such as NFL Sunday Ticket that customers value and because it can bundle with fiber broadband in about 14 million homes.

For telco providers, it is a mixed bag. We had previously projected that AT&T would continue its intentional migration of video customers from U-Verse to DirecTV to free up internet capacity in its network. However, this trend did not come to fruition in 2018, which is the primary reason for the recent improvement in telco numbers and a deterioration in satellite subscriber trends.

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Capex Will Increase To Support Video And Data Demand

In the telecom industry, capital expenditures (capex) growth was slower than we expected in 2018 and several companies reduced their guidance throughout the year due to timing issues and network efficiencies. We still expect aggregate capex to increase around 3%-5% in 2019 driven by the wireless sector as 5G capex kicks in along with small cell and fiber deployments for network upgrades to support rising demand for wireless video and data. At the same time, we expect capex as a percentage of revenue to increase modestly in 2019. While we expect AT&T's capex to be relatively flat (albeit elevated) compared with 2018 levels, other wireless carriers will likely increase capital spending in 2019. Most of the growth will come from Verizon as it continues to build out fiber infrastructure and densify its network with small cells, partly to support its 5G fixed wireless build. On a stand-alone basis, we expect Sprint will continue to deploy its 2.5 GHz band and upgrade its network with massive multiple-input and multiple-output (MIMO) in anticipation of its 5G launch, while T-Mobile continues its buildout of the 600 MHz spectrum acquired in the broadcast incentive auction.

While wireline operators need to invest in fiber to improve their network capabilities and better compete with the cable operators, we assume capital expenditures will decline by about 2%-3% in 2019 as these companies look to preserve cash flow and strengthen their liquidity positions amid secular industry pressures.

In the cable industry, we expect capital spending to increase 2%-3% in 2019 as most operators continue to invest in their networks for greater bandwidth capacity, faster broadband speeds, and more advanced video services. Several operators, including Comcast and Charter, plan to lay fiber deeper into their networks and add more optical nodes to enhance performance. Still, most cable operators have upgraded the electronics in their hybrid-fiber-coaxial (HFC) networks to DOCSIS 3.1 by now, enabling speeds up to 1 billion bits per second (Gbps). While this will likely spur the replacement of non-compatible customer premise equipment in the coming years, we expect capex as a percentage of revenue to decline modestly in 2019. Longer-term, we believe that speeds of 10 Gbps are possible through Full Duplex DOCSIS with only modest incremental investments. In our view, this will allow the cable industry to maintain its competitive advantage over legacy telecom networks and potentially reduce future operating expenses while also positioning itself to offer broadband speeds superior to future 5G fixed wireless.

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Sector Outlooks

Cable Industry: Stable Outlook

The outlook for the U.S. cable industry remains stable, reflecting our view that continued growth in high-margin broadband and commercial services will more than offset video declines over the next two years since cable's broadband moat provides a very powerful pricing counterbalance. Overall, we expect total cable revenue growth of about 4% in 2019, with average margins remaining relatively flat around 39%.

We believe cable companies can continue to increase high-margin broadband revenue for the next two to three years through a combination of subscriber growth and higher prices. We also think cable can continue to take market share from telecom providers offering slower digital subscriber line (DSL) and fiber-to-the-node (FTTN) services, but the number of opportunities is shrinking. We expect that the total number of broadband homes will increase by 1%-2% per year from a combination of new home builds and increasing penetration. Currently, only 80% of U.S. households pay for fixed broadband connections and we expect this number to gradually increase and surpass the peak of 88% that pay-TV reached in 2010 given the importance of internet and the potential for future government support. In our view, cable providers will continue to benefit from customers migrating to higher-priced, faster-speed tiers as data usage increases exponentially, providing good visibility into revenue growth over the next few years.

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However, longer-term growth in cable broadband revenue will depend on the industry's ability to successfully monetize rising data consumption. Two major issues, specifically broadband competition from 5G fixed wireless and the longer-term threat of government regulation could deter the industry's ability to increase broadband revenue in three to five years, but the realization of both issues is still highly uncertain. For starters, fixed wireless technology has yet to be demonstrated at scale, raising questions about its reliability and commercial success. Secondly, T-Mobile's aggressive fixed wireless plans largely hinge on regulatory approval of its acquisition of Sprint. On the regulatory side, net neutrality remains controversial, and Title II classification (which opens the door to price regulation) could be restored under a future Democratic administration. While the sector will benefit from a relatively benign regulatory environment for at least the next two years, we do not expect substantial changes in monetization practices for cable providers without permanent legislation around Title II and net neutrality. This includes paid prioritization of traffic or interconnection fees with commercial players such as Netflix.

Wireless Industry: Negative Outlook

Despite better service revenue trends over the past few quarters, our outlook for the U.S. wireless industry remains negative because the sector is mature and remains highly competitive. T-Mobile and Sprint have scaled back promotional activity while they await the outcome of the regulatory approval process for their proposed merger, which we believe has resulted in a more benign competitive environment and stronger operating trends for the industry overall. If the transaction is approved, our outlook could change to stable from negative because we believe a three-player market would substantially reduce competitive intensity, resulting in lower levels of churn and perhaps higher ARPU longer term. However, this positive development would be partly constrained by our expectation for greater capital spending and more spectrum license acquisitions for 5G deployments, which could hurt overall credit quality improvement.

We expect revenue growth for the industry will be about 3%-4% in 2018, substantially better that our previous base-case forecast of revenue declines in the low-single-digit percent area. For 2019, we expect total wireless revenue to increase around 1%-3% based on modest postpaid subscriber growth due to increased penetration of second handsets, assuming competitive pressures continue to abate. ARPU stabilization, coupled with lower upgrade rates and less promotional activity, should help improve margins to the 38% area (excluding the benefits of lease accounting for T-Mobile and Sprint). The unknown is the entrance of larger cable providers into the wireless market through their MVNO agreements with Verizon (Comcast and Charter) and Sprint (Altice), which could incite incremental pricing pressure in the industry.

Longer term, we have a favorable view of the industry assuming that wireless companies are able to monetize their investments in 5G from growth in IoT, which comprises internet-connected devices, vehicles, buildings, and "smart" devices.

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Wireline Industry: Negative Outlook

Our outlook for the U.S. wireline industry is negative. Revenue continues to fall because of secular industry declines and aggressive competition. These factors contributed to multinotch downgrades and limited access to the capital markets, as evidenced by wider bond spreads for larger regional wireline companies Frontier Communications Corp. and Windstream Holdings Inc. While these issuers have been active in pushing out debt maturities, we believe they have less financial flexibility to address longer-term obligations unless they can dramatically improve operating and financial performance. CenturyLink, the largest pure wireline company in the U.S., is benefitting from cost synergies from its acquisition of Level 3, which has enabled it to grow EBITDA and expand margins. However, revenue had declined more than expected because the company has shifted away from less profitable products and services, which could result in lower EBITDA longer term unless it can stabilize the top line.

For 2019, we expect low- to mid-single-digit percent revenue declines in the wireline industry, modestly better than 2018 but still weak. In the consumer segment, these issuers continue to lose broadband customers to cable operators, which have a superior broadband product. Similarly, in the small and midsize business (SMB) segment, cable operators continue to take market share from the incumbent phone companies and are expanding their capabilities through network upgrades. While cable is targeting larger business customers, we still believe wireline companies face less risk in the enterprise segment. That's because this category is less likely to churn than smaller business customers and isn't subject to significant competition from cable. Still, we believe that new cloud-based technologies such as software-defined wide area networks (SD-WAN), which are used to connect enterprise networks, could pose a new threat to the industry since they are more flexible, open, and cheaper than traditional WAN technologies. Despite the realization of cost synergies from recent acquisitions, we expect margin compression over the next couple of years due to revenue declines and negative operating leverage.

Overall, wireline issuers face a difficult dilemma. They need to allocate capital to fiber deployments to better compete with cable but at the same time, they have limited financial flexibility and need to use free operating cash flow for debt reduction in the face declining earnings.

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Telecom Infrastructure Industry: Stable Outlook

Data centers:  We have a generally favorable view of the data center industry's demand characteristics, supported by increased IT outsourcing, data growth, and greater application complexity. We believe enterprise growth will continue as roughly 60% of applications still reside on-premises, leaving substantial runway for growth in third-party data centers because businesses can realize improvements in efficiency, reliability, and physical security by outsourcing to a dedicated facility. Furthermore, as hybrid IT data center solutions become more prevalent--utilizing a combination of colocation, managed services, and private/public cloud services--we expect enterprises will increasingly need to employ services that can quickly connect various IT environments.

We also believe that cloud service providers (CSPs) will continue to expand rapidly in third-party data centers, which can build faster and more cost-effectively given well-stablished supply chains. CSPs also find value in the interconnection to networks and enterprises offered by third-party data centers, which are difficult to replicate in-house.

Finally, we expect data center operators to benefit from the edging out of data, as mobile video and new IoT applications create a need for data to reside closer to the end user for low latency and optimal performance. We expect this trend to accelerate over the next several years with the growth of IoT. We believe operators in Tier II and III markets could benefit from this; however, these providers tend to have a larger concentration with SMB customers that are more susceptible to churn in an economic downturn.

Overall, we assume healthy demand for data center solutions will result in solid revenue growth for the sector in 2019. However, not all data centers are created equal and we believe scaled providers like Equinix will benefit the most, as they are able to offer greater interconnection services that enable organic growth at the high-end of the sector range of about 10% in 2019. We believe that providers that do not offer as much interconnection and rely more on managed services as an add-on to help differentiate will experience weaker growth and could be more susceptible to pricing pressure. For example, at the lower end of the spectrum we forecast Flexential to grow at about 3%-4%, particularly because it has had some integration problems after nearly doubling in size. We project that most other rated data centers in the telecom space will grow revenue in the mid- to high-single-digit range in 2019. However, we do not expect significant improvement in credit metrics over the next year given the industry's substantial capital spending requirements and M&A activities, which are often funded with debt.

Fiber providers:  Despite mixed results for U.S. fiber-centric providers in 2018, we have a favorable view of the industry based on rising market demand for bandwidth. Demand continues to be driven by mobile data and video consumption, enterprise IT outsourcing to data centers and the cloud, wireless backhaul and carrier network densification via small cells, migration of media content to OTT, and connected devices. We expect organic revenue for the larger providers (Zayo, GTT Communications, and Cogent Communications Group) to grow about 4%-5% in 2018, slightly worse than our previous base-case forecast of growth in the 5%-7% range, largely due to slower revenue growth for GTT following its acquisition of London-based Interoute Communications. Additionally, Zayo's revenue trends have been sluggish because of weaker-than-expected bookings. For 2019, we expect organic revenue for the industry to remain steady in the mid-single-digit percent area.

Weaker overall performance in 2018 largely reflects a mix of softer bookings and installation trends and elevated churn. Large-scale M&A also weighed on the results of GTT, the second-largest fiber provider we rate, following its acquisitions of declining revenue businesses, notably Interoute, which it purchased for $2.4 billion in mid-2018. That said, fiber industry fundamentals remain sound, in our view, although declining prices for IP transit and price-based competition from internet service providers remain key themes in the sector.

We view Zayo's plan to separate into two public companies as a modest credit positive. The spin-off would separate much of the company's lit services businesses and competitive local exchange businesses from its fiber solutions, colocation, and wavelength businesses. We view this favorably because Zayo would retain the higher-margin businesses associated with dark fiber and mobile infrastructure services that have healthier secular trends and better revenue visibility. That said, these benefits are somewhat offset by reduced product and customer diversification as the company shifts its focus to pure fiber infrastructure services, which support its planned REIT conversion.

Tower operators:  Tower operators are poised to benefit from favorable demand conditions in U.S. and international wireless markets, reflecting continued network investment from wireless operators to accommodate greater demand for mobile data. We expect organic revenue growth for the industry to be around 5%-6% in 2018, slightly better than our previous base-case forecast of 4%-5% growth. For 2019, we expect organic revenue growth to remain steady in the 5%-6% area due to greater capital spending by the U.S. wireless providers. This view is supported by AT&T's FirstNet build, Sprint's deployment of its 2.5 GHz spectrum, and T-Mobile's buildout of its spectrum in the 600 MHz band, among other network initiatives.

While demand fundamentals remain intact in international markets, we believe risks to performance are heightened due to industry consolidation, political uncertainty, bankruptcies, and currency fluctuations. In India, for example, we expect ongoing industry consolidation and elevated tenant churn to remain a significant drag on American Tower's international results over the near term. At the same time, we are uncertain whether new political leadership in Brazil and Mexico will be able to sustain improved economic conditions in those markets, where both American Tower and SBA Communications have significant tower operations.

We expect small cells to make up an increasing share of carriers' network investment plans driven by 4G densification and 5G buildouts, though zoning and other regulatory approvals are an impediment to speedier deployment. Given its significant holdings of dense metro fiber, we believe Crown Castle is best positioned to profit from network densification. The small cell industry is expected to grow at a compound annual growth rate of around 35% through 2022, according to S&P Global Market Intelligence.

We believe the impact of a merger between T-Mobile and Sprint would be manageable for all three rated U.S. tower operators given that only about 4%-6% of their revenue is at risk to site decommissions from overlapping sites, the lease contracts are non-cancellable with multiyear average remaining terms, and we expect some offset from additional network investment. Further, we believe the health of the U.S. wireless industry could benefit from less competition in a three-player market. Still, American Tower is least exposed to a potential merger, in our view, with less than 20% of its revenue coming from the two wireless companies. In contrast, Crown Castle and SBA each derive about one-third of their revenue from T-Mobile and Sprint in aggregate.

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