Exits from bankruptcies and recapitalizations have given U.S. wireline companies (telcos) a new lease on life. However, as they embark on aggressive fiber-to-the-home (FTTH) deployments, secular industry declines from legacy products--coupled with significant competition from cable broadband and lost subsidy revenue--could constrain top-line growth over the next several years. At the same time, high levels of capital expenditures and costs associated with FTTH builds will likely hurt telcos' credit quality in the near term, though our ratings already largely reflect this expectation for higher leverage and weaker free operating cash flow (FOCF).

In our view, the U.S. telcos ultimately have two options for the future:

• Investing in fiber, which contributes to higher capital intensity, reduced FOCF, and rising leverage in the near term. Achieving FTTH penetration of about 40% should help stabilize top lines and EBITDA in the longer term, though covering a footprint with FTTH can take several years, and reaching these penetration levels requires solid execution. Moreover, missteps can be costly and result in sustained top-line degradation and margin compression. That said, we believe there are opportunities to not only stem the loss of broadband subscribers to cable but also to take share. We view FTTH as superior to hybrid coaxial cable, though we don't believe most consumers would notice the difference in service quality. Therefore, we expect telcos to compete on price to some extent, at least in the near term, but upselling customers to faster data speeds could also drive higher average revenue per user (ARPU) over the longer term.
• Leave their existing copper-based infrastructure in place. By not investing in their networks, these issuers can generate healthy levels of FOCF in the near term and pay down debt. However, they will continue to lose broadband share to cable. Given the high percentage of fixed costs embedded in their base of business, revenue declines will result in even steeper EBITDA declines that could ultimately render their capital structures unsustainable.

Restructured balance sheets and third-party private investment have given wireline operators a new lease on life.  Two of the largest U.S. telcos--Windstream Holdings Inc. and Frontier Communications Holdings LLC--exited Chapter 11 bankruptcy over the past year, which enabled them to reduce their debt burdens materially. In addition, Consolidated Communications Holdings Inc. cut its dividend in April 2019 and allocated its excess cash flow to debt reduction, positioning itself to refinance its capital structure in September 2020. As part of the refinancing, it secured a $425 million equity investment from Searchlight Capital that enabled it to reduce reported debt to help fund its FTTH buildout. And Cincinnati Bell Inc.'s buyout by Macquarie Infrastructure Partners for $2.9 billion also allowed the company to lower its debt burden and invest in the business.

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Lumen Technologies Inc. recently announced two asset sales that should better position its business over the longer term: 1) about one-third of its mass markets segment (consumer and small and midsized business customers) to private equity sponsor Apollo Global Management Inc. for $7.5 billion and 2) its Latin American operations to private equity sponsor Stonepeak for $2.7 billion. We believe these transactions should bolster the company's longer-term business prospects and growth trajectory. This is because the mass markets segment is particularly challenged by secular industry declines of copper-based broadband and voice services, and the Latin America segment was not core to Lumen's operations. While the company is structuring these asset sales in a leverage-neutral manner, cash flow will weaken, as the company plans to invest a portion of the proceeds in the business by scaling its FTTH deployment in the remaining mass markets footprint without a corresponding dividend reduction (though the company has not made a final decision on the dividend).

Most U.S. telcos are now in a better position to ramp up their fiber investments to compete more effectively with incumbent cable providers. For example, both Frontier and Windstream had highly leveraged balance sheets, and their exits from bankruptcy substantially reduced their debt burdens. Equity investments from sponsors in Consolidated Communications and Cincinnati Bell demonstrate the longer-term value of fiber as the best conduit for transmitting data. That said, these companies' legacy residential business--including copper-based broadband service--is in secular decline or is losing share to cable. Similarly, their share of small and midsized business (SMB) customers has eroded as cable became the dominant provider in this market. Declines in legacy products imply that revenue and cash-flow stabilization will take several years, and the ability to do so is still highly uncertain.

FTTH investments will yield broadband customer growth eventually but will also pressure cash flow in the near term.  We've estimated that U.S. telco FTTH penetration would reach about 45%-50% by 2028 from approximately 30% today (see "High-Speed Rivalry Between Cable And Telcos Enters New Phase As Infrastructure Proposal Raises Stakes For Broadband Providers," May 5, 2021). The biggest FTTH network expansion is from AT&T, which plans to cover about half of its footprint (30 million households) with fiber by 2025. Assuming telcos can achieve a penetration rate of 40%, this expansion could translate to about 25 million-27 million FTTH broadband subscribers. While some of these customers will come from cable, we believe that most will be migrations from their own digital subscriber lines (DSL) or fiber to the node (FTTN) broadband; the latter generally offers download speeds of 50 Mbps-100 Mbps, which is substantially slower than cable or FTTH. Furthermore, over time telcos should be able to increase ARPU by charging higher prices for faster Internet speeds.

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That said, building FTTH can be expensive: up to $1,000 per home passed. However, the buildout cost depends on several factors, including the company's existing fiber assets and infrastructure, the use of aerial versus buried fiber, and market density. Some telcos already use FTTN to provide broadband service; the last-mile connection is copper-based, thereby lowering the cost per passing relative to a greenfield build. For example, Consolidated has leveraged its near-net regional fiber network to keep its cost per passing substantially below historical norms at about $450. Windstream indicated that it could build FTTH for about $400-$500 per home passed. As part of Frontier's buildout plan, the company expects to spend $500-$600 per passing in its first wave, which includes the buildout of 700,000 homes by the end of 2021, leveraging its existing infrastructure and fiber assets. However, its second wave will expand FTTH to cover 6 million homes across its footprint by 2025 at an average cost of $900-$1,000 per home. These service areas are primarily copper-based, with little existing fiber infrastructure to leverage.

In addition to the build-out costs, we expect U.S. telcos to incur incremental labor and marketing expenses. This could pressure EBITDA margins, resulting in lower levels of FOCF over the next several years.

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We developed a hypothetical FTTH model for a wireline service provider. As part of the model, we assume that the company builds out FTTH to cover about 3 million potential customers over a six-year period. We also make the following assumptions:

• Broadband ARPU of $55, growing about 5% annually to reflect consumers migrating to faster-speed data plans over time.
• Construction capex per home passed of about $800, though this amount could vary depending on the aforementioned factors.
• The EBITDA margin starts off at of about 25%-30%, reflecting the initial labor and marketing expenses, increasing to the 50% area over the longer term, including a gross margin of about 90%-95%.
• Monthly churn of 1.75%.
• Long-term FTTH penetration of about 40%-45%.

As a result, we forecast that a wireline company can achieve breakeven free cash flow by around Year Six or Seven. However, during the initial deployment years, the outlook can be grim as revenue and EBITDA from legacy products outpace top-line growth from FTTH services while increased levels of investment activity burns cash, resulting in higher leverage. Ultimately, the ability to reduce leverage over the longer term depends on execution, including reaching target penetration levels and being able to offset declines in the legacy business.

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Leveraged balance sheets, high dividend payouts, and a lack of network investments caused the U.S. telcos to lose market share to cable.  Over the last decade, U.S. telcos have been losing broadband share to incumbent cable operators. Originally, the cable industry gained market share by focusing on its triple-play bundle of Internet, voice, and video services. However, as over-the-top (OTT) video became more prevalent, cable ceded video share to these streaming platforms, but this had been low-margin because of rising programing expenses. At the same time, more consumers shed their landline phones and migrated to their mobile devices for voice service. The cable providers upgraded their networks to DOCIS 3.1 to offer speeds of 1 gigabit per second (Gbps) and were able to take share from the telcos' copper-based DSL or FTTN broadband service. Because cable was able to offer significantly faster Internet speeds than the telcos, it increased its share to about 65% currently from 58% in 2015, while the telcos' share declined to approximately 28% from 37% over the same period.

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Despite recent recapitalizations, telcos still face significant secular headwinds from legacy services and regulatory subsidies, which we expect to decline materially in 2022.  These services include copper-based broadband (DSL), landline voice, and video, all of which are in secular decline. Revenue from landline voice service has been eroding for over a decade, primarily due to wireless substitution. The loss of video customers is a more recent phenomenon as more consumers cut the cord in favor of streaming options, including Netflix and Hulu. Revenue declines from voice and video services are significant, falling by over 10% annually for the U.S. telcos and while margins for landline voice is high, video profitability is low due to their lack of scale, which is particularly important in negotiating programming contracts. The outlier is Cincinnati Bell, which already benefits from its FTTH deployment that began in 2009. Ongoing edge-out activity has enabled the company to maintain relatively stable revenue for voice and video services.

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Furthermore, revenue from legacy products still outweighs contributions from fiber-broadband, and it will likely take three to five years before fiber-based revenue outpaces declines in legacy services so that overall revenue and cash flow are increasing. For example, while AT&T's broadband revenue accounts for about 70% of its consumer wireline segment, we estimate that fiber-based broadband service contributes around one-third of the total. In the case of Consolidated, we estimate that FTTH broadband revenue is only about 25% of its consumer revenue and about 10% of total revenue. However, its existing fiber assets--especially in the Northern New England markets--enable it to provide faster speeds because only the last-mile connection is copper based. In addition, its presence in less-competitive rural markets limits share losses to cable relative to its peers.

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Lost CAF II revenue will be another headwind.  U.S. wireline issuers historically derived a portion of their revenue from U.S. government subsidies to provide broadband service to underserved markets under the Connect America Fund (CAF II). However, CAF II subsidy reimbursements will stop in 2022 and will be replaced by the Rural Digital Opportunity Fund (RDOF). Most wireline operators did not win significant funds from RDOF, as bidding was aggressive and dominated by fixed wireless providers and incumbent cable provider Charter Communications Inc. According to the FCC, about 85% of the auction winners will deliver 1 Gbps speeds to their addressable market. However, we expect some of the fixed wireless providers to use a combination of FTTH and fixed wireless to offer broadband service. For example, LTD Broadband, the largest winner in the auction, promised to provide 1 Gbps and will lay fiber when necessary to achieve it.

This loss of subsidy revenue creates another challenge for U.S. telcos because subsidy revenue is 100% margin to the carriers and will exacerbate EBITDA declines in 2022. However, this will be partly offset by a reduction in capital expenditures.

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Enterprise customers have lower churn and a higher ARPU, but lower-priced new technologies will extend revenue declines.  AT&T, Verizon, and Lumen derive a significant portion of their revenue from larger enterprise customers, while the smaller wireline telcos have more regional and smaller business customers, including universities and hospital systems. Even though cable has a dominant market share among SMB customers, it is also moving up market, targeting larger business customers. However, we still believe wireline companies face somewhat less risk among larger enterprise customers because the cable operators are limited by their residential network architecture and their ability to attract larger, nationwide customers.

U.S. telcos benefited from COVID-19 to some degree because of increased demand for bandwidth, voice, and collaboration from enterprise customers. That said, business wireline continues to be pressured by secular industry declines and competition. And, the outlook remains uncertain as the Delta variant pushes out the return to offices and because of supply chain issues. Even as pandemic-related pressures subside and IT spending increases, revenue declines are likely to continue as customers accelerate their migration away from legacy multi-protocol label switching (MPLS) to cloud-based technologies--such as software-defined wide area networks (SD-WAN). Cloud-based networking solutions pose a threat to the industry because they are more flexible, open, and cheaper than traditional WAN technologies.

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Stabilizing revenue and cash flow is a top priority, but credit metrics will likely weaken over the next couple of years.  For U.S. telcos, headwinds from legacy products and lost subsidy revenue will likely result in ongoing revenue and EBITDA declines over the next couple of years. At the same time, investments in FTTH will constrain FOCF generation, resulting in higher leverage. However, we believe this is the only viable path for wirelines. Not making these investments would ultimately lead to EBITDA declines that outpace FOCF, resulting in unsustainable capital structures. While credit metrics are likely to deteriorate in the near term, the longer-term benefits of FTTH deployments are material because we view fiber as the best conduit for transmitting data. In addition to potential share gains, offering faster Internet speeds should translate into higher ARPU that helps top-line performance. Capital spending requirements will vary by market and will depend on the presence of existing fiber infrastructure. At the same time, solid execution during the buildout phase is critical and will ultimately determine if the telcos can reduce leverage in the longer term.

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Lumen.  Our current base-case forecast for Lumen assumes little deleveraging over the next couple of years due to the loss of about $500 million of annual CAF II revenue. While this will be offset by lower capital spending, we believe that EBITDA declines will offset any discretionary cash flow, resulting in little deleveraging. That said, the company recently announced two asset sales, including the sale of a portion of its consumer/SMB business to Apollo. While the multiples were surprisingly high, the company announced it would structure the transactions in a leverage-neutral manner. Some of the proceeds will be used for debt repayment, and the remainder will be used to accelerate investment in FTTH in its remaining markets. However, the company has not revised its $1.1 billion annual dividend. If left in place, the lost cash flow from the asset sales--coupled with higher capex--could pressure its discretionary cash flow, which could result in higher near-term leverage. Ultimately, the ability to reduce leverage over the longer term will depend on an improved earnings trajectory, which could be challenging in the face of secular industry pressures.

Frontier.  Following its emergence from Chapter 11 bankruptcy, Frontier has greater financial flexibility to invest in its network with FTTH upgrades. We expect leverage to be about 3.5x in 2021, though accelerated investments in FTTH--coupled with lost CAF II revenue and declines in legacy products--will push leverage to the high-4x area over the next couple of years. At the same time, we expect FOCF to be negative through at least 2025.

Consolidated Communications.  In conjunction with refinancing its capital structure, Consolidated secured a $425 million equity investment from Searchlight Capital, which improved its financial flexibility to invest in the business. In December 2020, the company announced its plan to expand its network FTTH build to cover about 75% of its addressable homes. However, unlike many of its peers, Consolidated will utilize its existing fiber infrastructure to build out fiber to the premise and reduce the construction cost per homes passed. The company estimates that its FTTH investments in the Northern New England market will cost about $450 per home passed. We expect FOCF to be negative through 2024 and for leverage to peak in the low- to mid-5x area.

Windstream.  Similar to Frontier, Windstream has emerged from Chapter 11 bankruptcy, substantially reducing its debt burden. It will use its improved financial flexibility to invest in network upgrades. However, as part of its settlement with real estate investment trust Uniti Group Inc., Windstream will receive about $1.75 billion over a 10-year period to help fund the network investment, which should limit the impact on its free cash flow burn. Therefore, our current base-case forecast assumes that Windstream's FOCF will be essentially breakeven over the next several years and that adjusted debt to EBITDA will in the low-to mid-4x area.

Telephone and Data Systems.  TDS covers about 39% of its wireline footprint with 1 Gig-capable FTTH and plans to reach 50% of its footprint. Unlike its peers, TDS has always had a conservative financial policy, with low leverage and a long-dated maturity profile. Consistent with this policy, the company issued two hybrid securities totaling $1.1 billion to mitigate the impact of the network upgrade (as well as spending in spectrum auctions) on its balance sheet. We ascribe intermediate equity credit (50% debt/50% equity) to these securities. As a result, we expect adjusted leverage to increase modestly--to the high-2x area--over the next couple of years from 2.5x in 2020, though we expect FOCF to be negative through 2022.

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