Rating Action Overview

• S&P Global Ratings recently completed a sector review and ranking exercise of rated cable operators, reflecting a more favorable view of rural providers and the industry overall given the increasing importance of high-speed internet whereby incumbent cable operators enjoy a sustainable competitive advantage in most markets.
• We rank Midcontinent Communications sixth on the list due to its solid operating metrics and favorable programming agreement with Comcast, which is partly offset by the company's above-average competitive overlap.
• We are raising all ratings on Midcontinent one notch, including the issuer credit rating to 'BB' from 'BB-', based on a more favorable view of the business.
• The stable outlook reflects Midcontinent's continued solid operational performance, which should enable it to reduce leverage by 0.4x turn a year on earnings growth of 5%-6% annually. However, potential acquisitions and dividends and the lack of a committed leverage target limit ratings upside over the next year.

Rating Action Rationale

The upgrade reflects Midcontinent's broadband competitive advantage, which we believe will continue to grow in importance as data consumption increases. Americans increasingly rely on fast internet connections to watch TV online, conduct virtual business meetings, interact socially, and educate remotely. While the pandemic will eventually end, we believe the shift toward higher-speed broadband will persist and COVID-19 served only to accelerate these inevitable trends. Importantly, we do not expect the competitive landscape to change significantly over the next three to five years given the high barrier to entry given the substantial capital investment needed to overbuild an incumbent network in these less dense markets where Midco operates. Therefore, as consumers demand more bandwidth, we expect Midco to continue to increase its broadband penetration levels while also benefitting from opportunities to raise prices as customers move to faster speed tiers.

We view favorably the mix shift toward broadband and away from traditional video. We believe the predictability in Midco's earnings and cash flow has improved significantly despite more concentration in a single service. Broadband profit margins are very high because the costs are fixed, and largely sunk. Furthermore, churn is low because the competing phone company offers far inferior speeds in the majority of Midco's footprint. In contrast, Midco faces direct competition from satellite TV providers, DISH and DirecTV, as well as a plethora of new online entrants for video service. Furthermore, video profit margins are under intense pressure from rising programming costs.

Midcontinent's partnership with Comcast positions the provider ahead of most small incumbent operators. The company's cost benefits from its video programming agreement with Comcast result in adjusted EBITDA margins of about 43%, which compare favorably among peers. Although this competitive advantage is moderating as the company increasingly deemphasizes video, we expect video to remain profitable over the next four years, which is better than most small operators. In addition, this strength partially offsets Midco's above-average competitive overlap with peers, wherein the company faces competitors capable of delivering comparable speeds in about 35%-40% of its footprint compared with the industry average of about 30%). Midco faces more competition that many peers because of the company's acquisition of WideOpenWest's Lawrence, Kansas assets in 2017, which overlap AT&T's FTTH service, and its decision to overbuild Cable One in parts of Fargo, N.D., in 2013.

We expect that leverage, currently in the high-3x area, could rise above 4x in the future for dividends or sizable acquisitions. Although the company has a leverage target range of 3x-3.5x, the company has shown a willingness to increase leverage above 4x for strategic opportunities and to support dividends. Midcontinent Media Inc. (MMI) and Comcast are equal partners in Midcontinent, and they periodically take a large dividend that levers the business to the mid- to high-4x area following a partnership extension. If the partnership were to dissolve, either owner could sell their 50% stake in the business to the other. Although there is no obligation of either party to purchase the other partner's interest, if Comcast were to sell its stake in Midco to MMI, leverage could increase to 6x or more if financed solely with debt. Still, we do not view this as a near-term risk given that the partnership was extended in 2019 and will likely be extended when it expires in 2026.

Outlook

The stable outlook reflects S&P Global Ratings' expectation that Midcontinent will benefit from strong growth from broadband and commercial services and that competitive dynamics in its territories will remain favorable relative to other incumbent cable operators, such that leverage declines to the mid-3x area from about 3.8x.

Downside scenario

We could lower the rating if the company completes a debt-financed acquisition or dividend that pushes leverage above 5x. Also, we could lower the rating if a more competitive environment resulted in the EBITDA margin declining to the mid-30% area, leading to debt leverage rising above 5x with little sign of improvement.

Upside scenario

Although unlikely, we could raise the rating if Midcontinent's leverage declined to below 4x and we believed that financial policy considerations would not lead to higher leverage.

Company Description

Midcontinent provides video, voice, and data services to residential customers in SMB markets in Kansas, Minnesota, North Dakota, South Dakota, and Wisconsin. Its network is DOCSIS 3.1-capable in 90% of its footprint, enabling 1 million bits per second (Gbps) data speeds to its customer base. As of Sept. 30, 2020, its networks passed about 836,000 homes and served about 413,000 data subscribers and 173,000 basic video subscribers. The company was founded in 1931 and is an equal partnership between MMI and Comcast.

Our Base-Case Scenario

• U.S. GDP growth of 4.2% in 2021 and 3.0% in 2022. However, we believe company revenue growth is more directly tied to industry factors such as broadband demand and over-the-top (OTT) video competition than macroeconomic issues.
• Residential broadband subscribers increase by about 5%-6% while average revenue per unit (ARPU) increases by about 3%-4% as customers opt for faster internet speeds to support their increasing data consumption.
• Residential video subscribers decline by about 7%-8% because of maturing product conditions and competitive pressures from cable overbuilders and OTT offerings. This is partially offset by higher video ARPU, leading to 3%-4% video revenue declines.
• Telephone subscribers decline 3%-4% primarily due to a 5%-7% decline in residential voice due to wireless substitution partially offset by flat growth in commercial voice.
• EBITDA margin increase to the 44% area from around 43% in 2020 due to a continued mix shift to higher-margin broadband from lower-margin video. The margins also benefit from the programming agreement with Comcast.
• Capital expenditures remain elevated in the 20%-22% area as a percent of revenue in 2021 driven by the Connect America Fund Phase II (CAF II) fixed wireless build and greenfield opportunities.
• About $40 million-$45 million in partnership tax distributions in 2021. Although Midco does not pay taxes, the company makes distributions to the partners for the tax liability of the owners (MMI and Comcast) of the partnership. We treat these tax distributions as akin to operating outflows and incorporate these outflows in our free operating cash flow (FOCF) metrics.

Based on these assumptions, we arrive at the following credit metrics in 2021:

• Adjusted debt to EBITDA of 3.3x-3.5x in 2021, decreasing to 2.9x-3.1x in 2022;
• Funds from operations (FFO) to debt of 23%-24%, increasing to 26%-28% in 2022; and
• FOCF to debt of 5%-6% in 2021, increasing to 8%-9% in 2022.

Liquidity

We view Midcontinent's liquidity as adequate based on our expectation that sources will exceed uses by about 2.8x, and net sources will remain positive even if EBITDA declines 15%. We believe the company has sound bank relations but that its access to capital is more limited than larger, more diversified telecom peers.

Principal liquidity sources

• Approximately $8 million of cash and short-term investments as of Sept. 30, 2020;
• Approximately $210 million of availability on the $300 million revolving credit facility due 2024; and
• Forecasted FFO of about $180 million to $200 million over the next 12 months.

Principal liquidity uses

• Capital expenditures of about $130 million to $150 million over the next 12 months; and
• Debt amortization of about $6 million over the next 12 months.

Covenants

The revolver has a maximum senior secured leverage covenant of 4.5x, which does not step down. We expect the company to maintain at least a 30% EBITDA cushion over the next 12 months.

Ratings Score Snapshot

Issuer Credit Rating: BB/Stable/--

Business risk: Satisfactory

• Country risk: Very low
• Industry risk: Intermediate
• Competitive position: Satisfactory

Financial risk: Significant

• Cash flow/leverage: Significant

Anchor: bb+

Modifiers

• Diversification/portfolio effect: Neutral (no impact)
• Capital structure: Neutral (no impact)
• Financial policy: Negative (-1 notch)
• Liquidity: Adequate (no impact)
• Management and governance: Fair (no impact)
• Comparable rating analysis: Neutral (no impact)

Stand-alone credit profile: bb

Related Criteria

• General Criteria: Group Rating Methodology, July 1, 2019
• Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments, April 1, 2019
• General Criteria: Methodology For Linking Long-Term And Short-Term Ratings, April 7, 2017
• Criteria | Corporates | General: Recovery Rating Criteria For Speculative-Grade Corporate Issuers, Dec. 7, 2016
• Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Dec. 16, 2014
• Criteria | Corporates | Industrials: Key Credit Factors For The Telecommunications And Cable Industry, June 22, 2014
• Criteria | Corporates | General: Corporate Methodology, Nov. 19, 2013
• General Criteria: Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013
• General Criteria: Methodology: Industry Risk, Nov. 19, 2013
• General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities, Nov. 13, 2012
• General Criteria: Principles Of Credit Ratings, Feb. 16, 2011

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