The coronavirus pandemic has wreaked havoc on the U.S. economy since early March. Many corporate issuers and sectors face depressed consumer demand due to ongoing restrictions and health and safety measures that are impeding on operations. The U.S. corporate default tally has reached a four-year high and S&P Global Ratings expects defaults will continue to rise for borrowers in the industries hardest hit by the pandemic and recession--especially if there's a significant pull-back in federal stimulus, much of which is designed to bolster the labor market (which, in turn, helps to prop up consumer spending).

Against this backdrop, we expect the U.S. wireless industry will hold up reasonably well relative to other corporate sectors. Mobile devices have become a necessity for most people and consumers are unlikely to rid themselves of wireless services, even in an economic downturn.

That said, if the pandemic causes an extended economic recession, much of the postpaid subscriber growth over the past couple of years could reverse itself, especially as companies reduce headcount to preserve margins, since a large portion of postpaid customer growth has come from the proliferation of second handsets as enterprises distribute smartphones and tablets to their employees for work. A partial mitigating factor is the potential for a more permanent work-from-home environment where mobile devices become more critical and increase demand for wireless data. At the same time, consumers could look to save money by moving to lower-margin prepaid plans or less-expensive postpaid plans, which could affect subscriber and service revenue trends.

Already, the industry--from a subscriber perspective--is mature and we believe there are few growth opportunities in the near-term. Longer-term, the Internet of Things (IoT) and enterprise applications could drive a new wave of revenue growth as 5G wireless technology becomes more prevalent. However, these opportunities will take several years to materialize.

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The New T-Mobile Is Off And Running

Since T-Mobile US Inc. and Sprint Corp. announced their plan to merge in April 2018, wireless industry service revenue growth has been positive while margins expanded due to low device upgrade rates. With the close of the merger in April 2020, investors are trying to determine what the impact will be on the sector. We believe the shift from four nationwide providers to three should lead to an easing in competitive intensity and discounting, especially as T-Mobile embarks on a massive integration. However, if T-Mobile is successful with its integration, we believe that competitive intensity could increase as the company will want to monetize its vast treasure trove of spectrum licenses, including the 2.5 GHz spectrum acquired from Sprint, which provides it with a competitive advantage versus its peers, especially as it deploys its 5G wireless network.

The industry outlook is further clouded by the sale of Sprint's prepaid business and spectrum to satellite TV operator DISH Network Corp., which plans to use its own spectrum to build out a nationwide network. At the same time, incumbent cable providers Comcast Corp., Altice USA Inc., and Charter Communications Inc. have launched their own wireless operations through mobile virtual network operator (MVNO) agreements. Combined, these cable operators have accumulated about 4.2 million mobile lines since launching over the past two years.

While T-Mobile has already announced some "uncarrier" initiatives, we would expect it to largely focus on the integration and building out Sprint's 2.5 GHz spectrum. As expected, its new unlimited plans are priced at a discount to Verizon Communications Inc. and AT&T Inc. although more aggressive pricing is targeted at lower-value postpaid customers while elite plans are generally offered at a more moderate discount to the larger incumbents. That said, solid execution during the integration is vital to T-Mobile's success and missteps could prompt it to scale back promotions in order to preserve margins.

Can DISH Be A Formidable Competitor?

DISH's ability to become a viable fourth nationwide wireless carrier in the U.S. is still highly uncertain, in our view. The company has a small prepaid customer base of around 9 million acquired by Sprint and a seven-year MVNO agreement with T-Mobile that will constrain cash flow generation in the near-term. Furthermore, the track record for MVNOs in the U.S. is poor at best, and these arrangements are almost never profitable given unfavorable wholesale economics. We also believe DISH's lack of experience in wireless could make it challenging to compete against established players such as AT&T and Verizon. Given these factors, we expect DISH's primary objective will be to capitalize on the proliferation of connected devices and new IoT opportunities likely to emerge with 5G technology, with limited exposure to traditional consumer wireless. That said, potential revenue opportunities, including enterprise private networks, augmented/virtual reality, and autonomous driving, are likely several years away, in our view.

While DISH already has a solid spectrum position of low- and mid-band spectrum, management also estimates that it will need $10 billion to deploy a 5G network, which could be daunting given its limited financial flexibility. As a result, its ability to compete against the larger incumbents will likely depend on finding a deep-pocketed partner while profitably expanding its base of business. Possible funding sources include the following:

• Strategic partner: Potential partners could include tech/ cloud companies such as Google or Amazon. These partners could also act as an anchor tenant.
• Leasing spectrum to T-Mobile: DISH is obligated to offer terms to T-Mobile to lease its 600 MHz spectrum, which could provide a source of high margin revenue to DISH.
• Private equity sponsor: DISH could sell a stake in its wireless business to a private equity sponsor.
• Cash flow from the satellite TV business: Notwithstanding the secular industry pressures as more consumers shift to over-the-top (OTT) video platforms, DISH DBS generates solid free operating cash flow (FOCF)of around $1 billion annually. However, we expect the company to apply the majority of this cash flow to debt reduction in order to maintain the sustainability of the DBS capital structure.
• New debt: Given its strong unencumbered spectrum position, DISH could use the wireless entity to add new debt to the capital structure, although consolidated financial leverage is already fairly elevated at around 5x.
• Equity: DISH has demonstrated its willingness in the past to issue equity or equity-linked notes.

Cable Operators May Struggle To Gain Traction In Wireless

Both Comcast and Charter launched their own wireless businesses using an MVNO agreement with Verizon with the goal of bundling mobile with their broadband and video services to reduce churn. More recently, Altice entered into the wireless market on the back of its MVNO agreement with T-Mobile (previously Sprint) and has been particularly aggressive on price. While competition from cable could ramp up over the next couple of years, the low margin profile of MVNO agreements in a very scale-intensive industry suggests that the impact on the wireless operators will be marginal at best and that cable providers will likely struggle to gain traction in the marketplace.

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All three cable operators have indicated that mobile will be profitable on a stand-alone basis shortly. We believe a path to profitability includes owning part of the network, particularly in high-traffic areas, thus avoiding the usage-based costs paid to wholesale providers. Charter and Comcast both purchased about $500 million of spectrum in the recently completed Citizens Broadband Radio Service (CBRS) auction and we believe this could be supplemented by purchasing more licenses in the upcoming C-Band auction.

COVID-19 Impact On Second Quarter 2020 Results

Our base-case forecast assumes U.S. wireless operations will be relatively stable in a recession because consumers are highly unlikely to disconnect their mobile devices. However, certain variables could affect results. In 2020, the pandemic has reduced foot traffic in stores, and many closed during the first half of the year, resulting in a decline in gross postpaid subscriber additions. At the same time, postpaid churn should be lower relative to historical trends since customers are less likely to change carriers with an overall negative net impact on postpaid net customer growth. Additionally, we expect lower equipment revenue as consumers are less likely to upgrade devices or switch carriers, although lower equipment revenue should also boost margins. Longer-term, higher levels of unemployment will likely increase churn in both the business and consumer segment as businesses disconnect laid-off employees and consumers seek out less-expensive plans or reduce the number of devices within existing plans. Still, we expect these factors to only have a modest impact on overall subscriber trends, depending on the severity of the recession.

Wireless results during the second quarter of 2020 were pretty much in line with our expectations. While store closures and weak economic conditions pressured gross subscriber additions, postpaid churn was at historic lows. At the same time, postpaid average revenue per user (ARPU) was hurt by lower roaming and waived fees. Service revenue was in line with our expectations as weaker subscriber growth and lower ARPU resulted in overall service revenue declines. Following several quarters of positive service revenue growth for the industry, Verizon's wireless service revenue declined 1.7% while AT&T's fell 1.1% from the year-ago period. T-Mobile's service revenue grew about 1.7%, constrained by revenue declines on the legacy Sprint network. Similarly, postpaid phone net adds were weak, with the big three adding about 275,000 customers compared to 1 million in the prior-year period. We expected equipment revenue to drop significantly during the quarter due to store closures but, surprisingly, equipment revenue showed mixed results across the different carriers. AT&T opened its stores faster than its peers and also adapted its distribution strategy to offer curbside pick-up while improving its digital capabilities. As a result, equipment revenue was essentially flat. Conversely, store closures had a more pronounced impact on Verizon's equipment revenue, which fell 20% from the year-ago period.

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5G Technology: Significant Investments But Little Return In The Near Term

U.S. wireless carriers are at work deploying 5G networks across the country. Already T-Mobile is using its 600 MHz spectrum and now covers about 250 million population equivalents (POPs) with 5G service. AT&T is also using its low-band spectrum and covers around 205 million POPs. That said, spectrum deployment strategies differ, which impacts user experience and download speeds. For example, while T-Mobile has deeper 5G coverage, its use of low-band spectrum diminishes performance, in our view. However, with the acquisition of Sprint and the purchase of some millimeter Wave (mmWave) spectrum, the company will create a "layer cake" that we expect will enhance coverage and speed. Verizon, in contrast, is using its vast quantity of mmWave spectrum to provide superior speeds in denser urban markets. However, in order provide good geographic coverage and fast data speeds, it will likely be an aggressive bidder in mid-band auctions to complement its low-band and high-band spectrum holdings. Similar to T-Mobile, AT&T is deploying much of its low-band spectrum to build out its 5G network but is supplementing it with mmWave spectrum in denser urban markets.

The result of each carrier's strategy is not surprising. According to OpenSignal, an independent mobile analytics company, Verizon's average 5G download speed is almost 500 megabits per second (Mbps) while AT&T's and T-Mobile's was 63 Mbps and 47 Mbps, respectively. Verizon's 5G experience is substantially better than the other providers given that it is using higher-band spectrum, which has better throughput characteristics. At the same time, its coverage is substantially smaller than its competitors', which are closer to nationwide coverage.

Our view on 5G and its impact on credit quality is largely unchanged. Cash outlays will likely be substantial, including the acquisition of spectrum licenses in mid-band auctions, and higher capital spending to build out these networks, including fiber builds and small cell densification.

At the same time, we believe returns on these investments will be slow to materialize. We question consumers' propensity to spend more for faster data speeds on their devices. The depth of the recession creates even more uncertainty around take rates for new 5G devices. Most of the IoT and enterprise opportunities are likely several years away. While 5G fixed wireless offers some potential to monetize investments at an early stage, the technology is still unproven and it will be challenging to take share from cable broadband, which can already provide 1 Gig service to its customers without line-of-sight or interference issues.

Capital Expenditures Should Remain Steady In 2020 But Could Spike Next Year

Notwithstanding the shutdown of the U.S. economy earlier in the year, we expect capital expenditures (capex) in 2020 to be essentially flat from 2019 levels. Verizon's capex should be about $500 million higher as it speeds its transition to 5G and works to add network capacity as business customers and schools look to enhance their virtual work models. Following a transition period, we expect T-Mobile's pro forma capex to be about 5%-10% higher than 2019 as the company deploys the 2.5 GHz spectrum acquired by Sprint and upgrades its network to 5G. Conversely, we expect AT&T's capex to decline around 5% in 2020 since most of the FirstNet build is almost complete.

That said, we expect capital spending to increase over the next couple of years as new mid-band spectrum is made available and companies upgrade their networks to accommodate the growing demand for mobile data and video. These capital outlays will also include spending to deploy fiber for wireless backhaul. Additionally, while longer-term capex synergies are meaningful for T-Mobile, the cost to achieve are also significant in the near-term, which could result in higher levels of capex in 2021 and 2022.

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Mid-Band Spectrum For 5G Comes Available In 2020 and 2021

With the completion of its merger with Sprint, T-Mobile has an abundance of low-band and mid-band spectrum, which will be a key element in its 5G deployment strategy. We expect both AT&T and Verizon will look to close the gap and be aggressive in the C-band auction. This auction, scheduled for December 2020, will offer 280 MHz of nationwide spectrum for the carriers and could be the most expensive auction since the AWS-3 auction in 2015. This, in turn, could push up leverage for both companies in what is already a difficult economic environment.

Over the last couple of years, Verizon has been focused on improving credit metrics to pre-Vodafone levels. Under our current base case forecast, we believe Verizon has capacity of around $10 billion-$15 billion for spectrum purchases, while still maintaining leverage at around 2.5x in 2021 due to its strong FOCF generation and modest EBITDA growth. However, its capacity is also dependent on the severity and length of the current recession, which could make results worse than our current base-case forecast. Conversely, AT&T's adjusted leverage is about 1x higher than that of Verizon and its absolute amount of debt remains elevated at about $169 billion gross and $152 billion of net debt. While AT&T also needs mid-band spectrum, balance sheet constraints are likely to limit its spending.

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Total spending in the CBRS auction was in line with our expectations at about $4.6 billion. Verizon was the top spender, acquiring licenses for about $1.9 billion, which was not surprising given their need for mid-band spectrum. T-Mobile and AT&T remained on the sidelines. While the spectrum may have been attractive to AT&T, we believe it is more interested in the C-Band auction since there was only 70 MHz available (and a 40 MHz cap for each carrier) in total for the CBRS auction while the C-Band will offer 280 MHz uncapped. T-Mobile was an unlikely spender since it recently acquired Sprint. At the same time, we were somewhat surprised that DISH spent $913 million in the auction given the aggressive buildout requirements of its current spectrum holdings and existing balance sheet constraints. Charter and Comcast spent about $925 million in total with most of the spending in key locations where they could offload traffic while improving the economics of their respective wireless businesses.

For the C-Band auction, we expect proceeds to be anywhere from $14 billion to $32 billion, which is a fairly wide range because much will depend on the economy and issuer financial flexibility. However, with 280 MHz of contiguous spectrum and good coverage characteristics, we expect Verizon to be particularly aggressive in this auction while AT&T might take a more measured approach. We expect limited participation from T-Mobile given its abundance of mid-band spectrum but it may be opportunistic in certain geographic areas. We also expect the cable providers to be aggressive bidders in certain regions.

AT&T Looks To Differentiate Its Wireless Product

AT&T has been trying to differentiate itself in the marketplace by cross selling its Warner Media content to its mobile customer base. Some of AT&T's unlimited wireless plans include its streaming product HBO Max for free, although this product has not driven any meaningful subscriber growth to date. While HBO Max offers a vast array of content from both HBO and Warner Bros., over the near term, new programming will be delayed by the production shutdown in Hollywood, which could hurt subscriber and revenue trends. At the same time, non-HBO customers may not be willing to move to AT&T wireless just for the additional content provided by Warner Bros, although existing HBO Max customers may switch to benefit from bundled discounting.

Further hindering its ambition is the fact that both T-Mobile and Verizon offer their own content to customers through licensing agreements with Netflix and Disney, respectively. T-Mobile offers Netflix for free to customers if they have two or more lines and subscribe to an unlimited data plan. Similarly, Verizon offers a one-year promotion of Disney+ to both Verizon wireless and Fios customers for free.

As a result of these factors, there is a high degree of uncertainty as to whether AT&T can truly differentiate itself in the marketplace with content. We consider Verizon the industry leader with the most high-margin postpaid customers while T-Mobile now has an enviable spectrum position and the marketing prowess to take share, especially in the lucrative business-to-business segment. This leaves AT&T stuck in the middle. While its mobile business has been relatively stable over the last couple of years, investments in HBO Max may not drive incremental returns in the wireless segment longer-term.

Wireless Operations Should Support Issuer Credit Quality In The Near Term

Despite the coronavirus pandemic and current recession, wireless operations should provide some degree of stability for credit quality relative to other corporate sectors given its recurring, subscription-based revenue model. Verizon derives about 70% of its revenue from its wireless operations while all of T-Mobile's business comes from mobile services. In contrast, AT&T diversified its base of business into linear video and media through acquisitions over the last five years, and now only 40% of its revenue is from wireless services.

That said, there is still a lot of uncertainty with respect to competition. While moving to a three-player market from four should improve competitive intensity, T-Mobile has a lot of spectrum resources to capture share and will likely compete on price to do so. Additionally, new wireless players in DISH, Comcast, Charter, and Altice could result in more aggressive price-based competition that ultimately constrains growth and margin improvement for the wireless carriers. Furthermore, the industry is mature, very scale-intensive, and has ongoing capital spending and spectrum requirements to support the growing demand for data over these networks. Overall, we believe the industry will remain relatively stable from a competitive standpoint over the next couple of years, although pockets of risk still exist, including the ongoing recession.

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