The U.S. telecommunications and cable industry was full of surprises in 2022, but held up well relative to other corporate sectors. Wireless subscriber trends and service revenue growth were surprisingly strong while fixed wireless access (FWA) and fiber to the home (FTTH) began eating into cable broadband subscriber gains. However, credit metrics did not improve meaningfully for the incumbent telecom companies (telcos) because of elevated capital expenditures and some earnings pressure due to high inflation, supply chain challenges, and rising interest rates.

For the first time, high speed data (HSD) subscriber growth slowed dramatically for the incumbent cable providers because of intensifying competition from FWA and FTTH, broadband penetration reaching maturity, and lower customer move activity. Despite these negative trends, the cable operators continue to generate healthy FOCF and modest EBITDA growth, which kept credit metrics stable over the past year.

S&P Global Ratings believes the U.S. telecom and cable sector is well-positioned to withstand current inflationary pressures and a shallow recession in 2023 since consumers will continue to prioritize connectivity and issuers have been able to pass on higher costs to customers. We expect telecom operators will allocate cash flow to debt reduction and work to reach their leverage targets following several years of substantial debt issuance to fund mergers and acquisitions (M&A), spectrum purchases, and network upgrades. In cable, despite slowing broadband subscriber growth due to increased competition, we expect solid free cash flow generation and credit metrics to remain steady.

Against this backdrop, some of the key risks as we head into 2023 include:

• Macroeconomic headwinds: Despite the sector's resilience to macroeconomic pressures and our expectation for lower capital expenditures (capex), we believe persistently high inflation, a deeper-than-expected recession, and rising interest rates could constrain leverage improvement for U.S. wireless operators following their aggressive spending in recent spectrum auctions. These headwinds could also push up the cost per home passed, lower returns, and ultimately curtail FTTH deployments for the U.S. wireline operators in 2023, leading to delays in achieving their longer-term build targets. For the incumbent cable providers, a weaker economy may hurt small and mid-sized business (SMB) customers, typically accounting for about 15%-20% of their revenue, and drive lower-end consumers to switch to FWA.
• High interest rates could hurt low-rated issuers: We expect higher borrowing costs will have the greatest impact on issuers at the low end of the rating scale. Even though many of these companies took advantage of low interest rates over the last few years to refinance debt, many have significant exposure to floating interest rates, primarily consisting of bank loans. We believe depressed equity valuations and high financial leverage could ultimately render the weakest capital structures as unsustainable.
• Pressure to return money to shareholders: Lower stock prices and slowing subscriber growth may induce the larger US telecom and cable operators to return more money to shareholders via stock buybacks or dividends at the expense of debt reduction following a sustained period of low interest rates and massive debt issuance.
• Capex remains elevated: While we expect capex reductions for Verizon Communications Inc. and T-Mobile U.S. Inc., fiber builds for the wireline companies and AT&T Inc. will likely keep capex elevated for the sector has a whole. Cable companies are also increasing capital spending to upgrade their existing networks and expand into new markets.
• Convergence increases competitive intensity in wireless and cable: Growing competition in cable from FWA providers and FTTH will likely result in limited HSD customer growth while mature industry conditions and aggressive competition from the cable operators in mobile (which are bundling wireless service with in-home broadband) should constrain subscriber growth and margin expansion for the U.S. telcos.
• Enterprise demand: Within telecom and cable, business customers are most exposed to weaker economic conditions where demand for IT services typically declines as customers tighten budgets and decision making takes longer. Telcos that are most exposed to business services include AT&T (20% of revenue), Lumen Technologies Inc. (80% of pro forma revenue), and Frontier Communications Holdings LLC (45% of revenue).
• Accelerated video cord cutting: We estimate the pace of subscriber defections from traditional linear TV ecosystem picked up to about 10% in 2022 as pandemic restrictions eased, competing forms of entertainment re-emerged, and government subsidies rolled off. We expect the rate of cord-cutting will rise to around 12%-13% in 2023 as consumers become more price sensitive in a recessionary environment. However, we don't expect this trend to affect cable distributors' creditworthiness given that video is a low-margin business while satellite TV providers DISH DBS Corp. and DirecTV Entertainment Holdings LLC are heavily exposed to these secular headwinds.

Rating Trends

Rating trends skewed negative over the past year because of higher interest rates and weaker capital market and business conditions. In 2022, we downgraded 11 companies and upgraded eight. Within infrastructure, we loosened triggers for some infrastructure providers, including Equinix Inc., Crown Castle Inc., and SBA Communications Corp., reflecting the strong demand for data, ongoing capital spending needed to support carriers' network upgrades, long-term contracts, and high renewal rates. This view prompted upgrades for Crown Castle and SBA. In contrast, we lowered ratings on some wireline operators, including Lumen, Zayo Group Holdings Inc., and Consolidated Communications Holdings Inc., as well as cable providers Altice USA Inc. and Radiate Holdco LLC. The outlook bias is increasingly negative. About 19% of our ratings have a negative outlook or are on CreditWatch negative compared with 9% at year-end 2021.

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In 2023, we expect rating trends will continue to tilt negative across U.S. telecom and cable, although we anticipate rating actions will be concentrated among the lower-rated issuers with limited scale and pricing power where weaker macroeconomic conditions and rising interest rates will have the greatest impact. Many of these companies have capital structures with significant exposure to floating-rate debt that could depress cash flow and hurt liquidity while a higher rate environment could make it more difficult to refinance upcoming maturities at similar or affordable rates. Among U.S. wirelines, fiber providers, and data center operators, execution will be critical in their ongoing expansion where higher energy and labor costs, coupled with supply chain constraints, could hurt credit quality.

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Key Themes For 2023

U.S. telecom and cable are recession resistant but macroeconomic pressures will still constrain credit improvement

S&P Global economists expect the U.S. will fall into a shallow recession in the first half of 2023 with GDP declining 0.1% for the year following 1.8% growth in 2022. We also expect inflation to remain high on continued supply-chain disruptions with core CPI above the 2% target through the first quarter of 2024. Further, risks of a deeper recession are increasing.

Historically, U.S. telecom and cable has been fairly recession resistant and most consumer and business customers are unlikely to rid themselves of mobile and broadband service in the event of an economic downturn. Against this backdrop, we would expect the industry to hold up reasonably well relative to other corporate sectors but still not completely insulated from an economic deceleration. In wireless, with U.S. penetration levels above 100%, we expect some pressure on subscriber growth trends. This particularly applies to the business segment, as companies reduce headcount to preserve margins, since a large portion of postpaid customer additions over the last decade came from the proliferation of second devices as businesses distributed smartphones and tablets to employees because hybrid work became more prevalent.

In the consumer segment, customers may migrate to less expensive data plans or prepaid services during a recession. Switching activity will also likely increase with value providers, including T-Mobile and cable operators Comcast Corp. and Charter Communications Inc., being the most probable beneficiaries. The latter two are bundling mobile services with their broadband product via mobile virtual network operator (MVNO) agreements to keep churn low. We also expect bad debt expense and churn levels to increase in a recession scenario. In cable broadband, average revenue per user (ARPU) growth could slow as customers defer plans to upgrade to faster, more expensive speed tiers, while bad debt expense could also increase. Conversely, wireline companies that offer FTTH at a discounted price and FWA providers could benefit from increased switching activity in the broadband market as customers shop for less expensive HSD options.

Telcos are implementing price hikes and cost reduction measures to preserve margins

To offset inflationary cost pressures, both Verizon and AT&T implemented price increases on several legacy service plans. While these actions may bolster service revenue and ARPU, the potential impact on churn is uncertain, especially if economic conditions deteriorate in 2023.

The telcos are also executing cost reduction programs to combat inflation. AT&T is in the process of reducing expenses by about $6 billion and expects to achieve $4 billion of run rate savings in 2022 with more in 2023. Similarly, Verizon announced a new $2 billion to $3 billion expense reduction plan on the heels of completing a $10 billion cost cutting program. Wireline issuers with substantial FTTH opportunities are also looking to reduce expenditures as they embark on their buildouts. Frontier achieved its $250 million cost savings plan one year ahead of schedule and now expects to reach $400 million by 2024. Nonetheless, expense reduction initiatives may help preserve margins in the near term, but these companies will require substantial marketing expense and customer care to lure subscribers away from cable.

Higher energy costs will be a focus for data centers

Data centers consume vast amounts of power to run and cool servers in their facilities. For many rated retail colocation operators, this is the second-largest expense behind labor and typically accounts for about 25% of operating costs, on average. Rising power costs had a negative impact on profitability across the sector in 2022, with margins generally falling between 50 basis points (bps) and 200 bps. However, most operators have started to pass rising power costs on to their customers, or plan to shortly either through pass-throughs embedded in existing contracts or at contract renewal. Therefore, we believe we will see a modest improvement in margins in 2023 to the extent energy prices level off and companies see effects of implementing cost recovery mechanisms.

We believe the impact of rising power costs will vary by operator, depending on the nature of customer contracts, hedging strategies deployed, and competitive positioning. Wholesale providers, such as Digital Realty employ "metered power" contracts (84% of leased floor area) whereby power is a direct pass through to the customer so the impact to profitability is muted. Conversely, for retail colocation providers that do not have such contracts, there are often pass-through options embedded in customer contracts if power costs rise above a certain threshold (in addition to annual price escalators). Finally, most U.S. data centers have some form of a hedging program in place to deal with rising power costs, but specific hedging strategies vary by operator. Hedging ranges from short, seasonal contracts to longer-term purchase price agreements (PPAs).

We do not forecast a significant increase in customer churn related to rising data center rents because it is a consistent industry-wide issue. In fact, rising power costs could strengthen the case for enterprises to outsource to a more energy efficient purpose-built, third-party facility. Still, we recognize certain operators that compete more intensely on price--such as Cyxtera Technologies Inc., Dawn Acquisitions LLC, and other smaller operators--face more risk associated with cost pass throughs, particularly if power was unhedged. Conversely, we believe operators that have strong competitive positions and robust hedging strategies, such as Equinix, are better protected from the risk of customer defections from increased prices.

Business wireline trends will remain weak in 2023

Revenue from business customers has been in secular decline for a long period as they migrate to newer, less expensive networking technologies. We expect overall revenue and EBITDA in the business segment to decline around 5%-7% in 2023 since we estimate that about half of the larger telcos' business revenue base comes from legacy services, including Multiprotocol Label Switching (MPLS) and customers are accelerating their migration to newer technologies such as Software-Defined Wide Area Networks (SD-WAN). A worsening macroeconomic outlook could add to these pressures and telecom companies are already warning of delayed decision making and scaled-back IT budgets from corporate customers.

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Wireless subscriber trends should moderate in 2023, leading to slower service revenue growth

Over the last few years, investors have been expecting U.S. mobile subscriber trends to slow because of mature industry conditions and increasing competition from cable. That said, postpaid phone growth remained healthy in 2022 despite industry penetration levels above 100%. Strong postpaid customer net adds, coupled with rate increases on legacy plans and customers migrating to more expensive 5G rate plans will likely contribute to industry service revenue growth above 4% in 2022, surpassing the 3.8% service revenue growth in 2021.

However, we believe there are several headwinds as we enter 2023:

• We expect cable operators will be more aggressive in mobile as their in-home broadband business faces greater competitive pressures from fixed wireless and FTTH.
• Higher unemployment could push customers to move down market to lower-tier data plans or to prepaid services, hurting ARPU and service revenue growth trends.
• In the business segment, much of the device growth was driven by a proliferation of second handsets to employees, which could reverse if unemployment increases.
• While still highly uncertain, DISH Network Corp. could become a fourth nationwide provider of mobile services potentially further increasing industry price competition. The company deployed spectrum to 20% of the U.S. population and is committed to cover 70% by June 2023. It also entered into a 10-year MVNO agreement with AT&T, enabling it to delay its buildout into rural markets, which are more costly to deploy. However, we believe that a projected $10 billion of network buildout costs, its lack of scale as a mobile startup, and limited financial flexibility will likely constrain DISH's ability to compete.

For these reasons, we expect a deceleration of postpaid phone subscriber and service revenue growth for the U.S. wireless operators in 2023. We expect industry service revenue growth of around 2% in 2023, slower than the last two years, due to economic headwinds and increased competitive intensity, primarily from cable, which we forecast will take over 40% of postpaid net adds in 2023, up from around 30% in 2022. Additionally, we expect lower wholesale revenue will constrain T-Mobile's service revenue growth. A partial offset, at least for T-Mobile and Verizon, will be growth from FWA subscribers.

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Mid-band spectrum is critical for 5G deployments and T-Mobile has the lead

Through its merger with Sprint, T-Mobile acquired about 160 megahertz (MHz) of nationwide spectrum in the 2.5 gigahertz (GHz) band, giving it a material competitive advantage in the deployment of high-bandwidth mobile 5G applications. We view mid-band spectrum as critical in differentiating 5G network capabilities because it has better propagation than millimeter wave (mmWave) spectrum and superior throughput characteristics to low-band spectrum. Both Verizon and AT&T have been aggressive in acquiring mid-band spectrum licenses in the C-band auction and Auction 110 and have since closed the gap with T-Mobile. That said, both spent significant sums of money to acquire this spectrum, which pushed up leverage and reduced their financial flexibility. Verizon paid about $53 billion to acquire 161 MHz of nationwide spectrum in the C-band auction (including satellite incentive payments and relocation costs) while AT&T spent $27 billion and another $9 billion in Auction 110 to acquire about 120 MHz of nationwide spectrum in aggregate.

Notwithstanding their aggressive spending, Verizon and AT&T still lag T-Mobile in the deployment of mid-band spectrum licenses. T-Mobile covered about 260 million points of presence (POPs) with its mid-band spectrum at year-end 2022 and expects to reach 300 million POPs by 2023. In contrast, Verizon covered approximately 175 million POPs with its C-band licenses at year-end 2022 and expects to be over 250 million POPs by 2024. AT&T only covered about 130 million POPs at year-end 2022 and expects to reach 200 million POPs by 2023.

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5G FWA is a small revenue opportunity for U.S. telcos but are there others on the horizon?

As an early means to monetize their 5G wireless investments with new revenue streams, both Verizon and T-Mobile are offering in-home broadband service to customers over their mobile networks. Verizon expects to add about four to five million customers and cover 50 million homes with FWA. T-Mobile is targeting seven to eight million customers and currently covers about 40 million homes. However, their strategies are quite different. Verizon is targeting urban and suburban markets where it doesn't already offer its FTTH broadband service Fios, utilizing its C-band and mmWave spectrum resources. T-Mobile, on the other hand, is largely pursuing customers in rural markets where there is less data traffic and fewer competitors. We view this strategy more favorably given the competitive dynamics and limited broadband options, in some cases just DSL.

Early results have been positive with FWA taking a majority of the broadband net adds over the last few quarters. T-Mobile has been adding more than 500,000 customers over the last three quarters while Verizon recorded 363,000 net subscriber additions during the third quarter of 2022. The carriers combined have about 3.2 million FWA subscribers as of Sept. 30, 2022. That said, even though we believe there is a niche for FWA, especially as a replacement for copper-based broadband service or as a competitive threat for low-ARPU cable customers, we do not expect it to take meaningful share from cable broadband or FTTH service longer-term given the technology limitations.

The ability to monetize their 5G investments (spectrum and capex) will be challenging, in our view, and there are limited opportunities in the retail wireless market given its maturity, other than migrating customers to higher-rate plans or share gains in the SMB segment. Potential 5G IoT/enterprise revenue opportunities include virtual/augmented reality, driverless cars, machine-to-machine applications, smart cities, monitoring solutions, mobile edge computing, smart homes, private networks for enterprise customers, and health care. However, we believe these new revenue streams are likely at least several years away from making any meaningful contribution to revenue, if at all.

FWA will continue to weigh on cable subscriber growth rates in the near term, particularly in a recession

Intensifying competition from FWA combined with low move activity and maturing market conditions caused cable broadband subscriber growth to stall across the industry, with Charter and Comcast each reporting roughly 1.5% growth in the third quarter of 2022, year over year, while some smaller operators have reported modest declines. We project relatively flat subscriber trends across the industry in 2023, with scaled operators offsetting the impact from modest share losses to FWA by edging out of their existing footprints.

We expect FWA will continue gaining market share with discounted service relative to cable, appealing to more price-sensitive customers that may be willing to compromise on speed and/or reliability compared with a wired cable connection. We believe many of these households subscribe to copper-based services and historically had converted to cable when copper networks failed to meet their data requirements. Fixed wireless fills the gap between cable and copper, typically offering better speeds than copper at a lower price than cable. For example, Verizon offers 300 megabits per second (Mbps) in urban and suburban markets (with up to 1 gigabit per second (Gbps) in certain markets that use mmWave spectrum) and T-Mobile offers speeds of 30 Mbps-180 Mbps across a wider footprint, compared with most copper services that range from 10Mbps-50Mbps. Therefore, we expect some copper-based customers and certain lower-ARPU cable customers to convert to FWA over the next two to three years such that the mobile operators reach 11 million to 13 million subscribers.

To achieve these targets, wireless service providers will need to grow at similar rates compared with the third quarter of 2022. We believe these targets come with some risk as the business scales and managing churn becomes more important. We also believe cable operators could respond more aggressively from a marketing standpoint to highlight network advantages.

Longer term, we recognize limitations of FWA that may create a ceiling for the number of subscribers wireless players can garner. More specifically, fixed wireless is a poor use of spectrum resources compared with mobility, which can be monetized at an exponentially higher rate per bit. There is a clear trade-off between speeds offered to customers and the number of customers that can be served per cell site. To the extent a wireless carrier is spectrum-constrained, a single residential customer could crowd out the traffic of many mobile customers. This could confine fixed wireless to niche locations, such as suburbs with good spectrum resources but lower mobile demand. Therefore, we project the pace of FWA subscriber growth will begin to slow in 2024 and 2025 as wireless companies begin to run into capacity constraints and they prioritize the much more lucrative mobile customers.

We expect cable operators will remained disciplined in pricing, opting not to chase cheaper FWA offerings. In fact, most cable operators have announced rate increases recently. We believe this carries more risk in a recession, particularly for price-sensitive consumers, which could cause some modest churn for cable. Still, we also believe consumer behavior plays to cable's strength as rising data usage requires a fast, reliable internet connection. Therefore, we expect HSD ARPU will grow 2%-4% over the next few years from a combination of price increases and a continued migration toward faster speed tiers, largely consistent with recent trends.

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FTTH competition is intensifying and is a more viable longer-term threat to cable broadband

FTTH is the best technology available for data transmission and will present formidable competition for incumbent cable operators. We estimate U.S. wirelines expanded their FTTH service to around 6 million new homes in 2022 compared with 4.5 million in 2021 and now pass 37% of U.S. homes. We believe the allure of new technology, potential marketing challenges, and possibly lower FTTH price points will cause cable to lose some market share to FTTH in existing markets over time. Still, unlike FWA competition, which blanketed much of the country in a short time, fiber builds will be more gradual. We expect incremental FTTH to cover about 6%-7% of the country per year over the next three years, or 53%-55% of U.S. households by 2025. Therefore, we believe cable customer churn could increase moderately in these territories as the telcos market aggressively to grow their customer base.

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Overall, we expect the cable industry to lose roughly three to four million broadband customers to incremental fiber builds by the end of 2025 (or about one million per year) based on the following assumptions:

• Successful FTTH deployments will achieve roughly 40% penetration, consistent with Verizon FioS markets (AT&T Fiber sits at about 37% penetration today).
• The telcos will be able to convert most existing legacy copper-based customers, which have penetration rates of about 15%-20%, to FTTH.
• Cable has an average penetration in these markets of about 60%-65% (assuming total broadband penetration in these markets is below national average of 87%).
• Cable penetration in these incremental markets would slip to about 50% (assuming in-home broadband penetration approaches 90%).

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However, we believe scaled cable operators are well positioned to defend against FTTH competition for the following reasons:

• Cable internet speeds will be comparable, with an affordable network upgrade path. Cable operators can currently offer 1 Gbps download speeds but are disadvantaged with slower upload capabilities relative to fiber. Incumbent operators are embarking on a network upgrade that will allow multi-gig speeds in both directions. We believe this is more than sufficient for almost every consumer for many years to come. While FTTH players may have a marketing advantage (playing off optical fiber versus hybrid fiber coaxial cable; HFC), we believe cable service will remain very competitive from a practical standpoint and it will be incumbent upon cable providers to educate consumers on the merits of their offerings.
• Larger cable players can offer a differentiated broadband service. Comcast developed best-in-class content aggregation software, dubbed Xumo, which it now offers to Charter via a joint venture (it can also license this technology to other out of footprint cable providers). Xumo allows for seamless search and navigation across different streaming platforms, which is appealing to broadband-only customers that have several subscriptions to different apps.
• Scaled cable operators can offer more affordable traditional linear video when bundled with broadband. Large cable operators still benefit from scale when negotiating with programmers and can offer a more affordable video package than fiber competitors. Although this service is in secular decline and cord cutting is accelerating, more than 50% of U.S. households still subscribe to traditional video.
• There will be a natural floor on how aggressive FTTH price discounts can be given these competitors will need to achieve relatively high penetration and ARPU to justify substantial capital investments.

Further, we believe there are some opportunities for cable to continue growing broadband subscribers through the Rural Digital Opportunity Fund (RDOF), edge out activity, fiber rebuilds, and eventually the $42 billion Broadband Access Equity and Deployment (BEAD) rural broadband funding in markets where there isn't FTTH competition.

Cable's wireless service can serve as a defensive tool against FTTH

We expect cable providers will increasingly utilize mobile offerings to retain and attract broadband customers. We believe having access to capex-light variable cost MVNO agreements provides significant flexibility to price aggressively. This is particularly true, in our view, considering that cable operators are not running mobile segments to maximize standalone profitability but rather as a broadband retention tool, with a view toward maximizing total EBITDA per household.

Most importantly, we believe cable operators will be able to match, or exceed, any discount on broadband offered by a FTTH competitor. This is because the average household spends about 3x as much on wireless services compared with in-home internet and we believe there is a limit to how aggressive FTTH discounts can be given the capital intensity required. AT&T is building fiber most aggressively and we believe it will be reluctant to heavily discount wireless when bundled with fiber, given that wireless is its core business and is very capital intensive. However, Comcast or Charter only need to break even on wireless to be successful if it allows them to retain a broadband customer. Furthermore, we believe cable operators will be able to offer even lower prices as they deploy CBRS spectrum and offload more traffic onto their own networks.

Interestingly, cable operators that have not yet launched a mobile service have fared worse than Comcast and Charter. In fact, several smaller operators lost broadband subscribers in 2022. The National Content & Technology Cooperative (NCTC) is crafting MVNO deals that will enable its membership of smaller cable providers to enter the mobile market as well in 2023. We believe this will help these operators stabilize broadband trends in markets where they face incremental FTTH competition. However, we believe the lack of scale does make them somewhat more vulnerable than larger players that can offer more affordable triple-play bundles and a more differentiated broadband service.

U.S. wireline operators face near-term operational and macroeconomic headwinds with their FTTH builds

U.S. wireline operators that are deploying FTTH face substantial return on capital hurdles because fiber requires significant upfront investments. Ultimately, we believe FTTH will need to discount its internet service to attract new customers but the capital-intensive nature of fiber limits pricing flexibility to some degree. We believe this is especially true considering that the clearest pathway to adequate returns on FTTH investments is to monetize demand for faster internet by growing ARPU over time. Higher interest costs will likely make it even more challenging to execute on their business plans and meet these return thresholds.

Some U.S. wireline operators faced rough patches in 2022, including supply chain constraints and a tight labor market. For example, Lumen announced during its third-quarter 2022 conference call that it would likely miss its target for 1 million homes enabled by the end of 2022, citing supply chain, labor, and permitting issues. We believe the slower build pace is partly due to its later start relative to peers. That said, Telephone & Data Systems Inc. (TDS) management pointed to similar factors when it warned that it would miss its build target of 160,000 homes in 2022 and instead, would probably reach about 120,000 homes by year end.

While our forecasts do not assume any meaningful FTTH buildout delays in 2023, we believe there are some potential headwinds if global supply chain, labor, and inflationary pressures persist. At the same time, since most of these issuers are in the speculative grade category, have significant exposure to floating-rate debt, and are generating negative FOCF, they depend on accommodative credit market conditions. Higher interest costs may force the wirelines to scale back their capex to conserve cash flow but not investing will leave their legacy copper-based broadband service exposed to ongoing market share losses. On the other hand, if capex remains elevated, FOCF deficits could be greater than anticipated over the next year, putting the most leveraged capital structures in a vulnerable position.

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Massive government subsidies will spur rural broadband investments

The $42 billion BEAD rural broadband funding program is set to begin awarding subsidies in 2023. The program aims to make broadband available to all unserved locations in the U.S. Unserved is defined as lacking reliable internet at speeds of less than 25 Mbps downstream and 3 Mbps upstream, which may include certain copper-based telco markets (but no existing cable markets).

The National Telecommunications and Information Administration (NTIA) has indicated that it will prioritize FTTH broadband when awarding contracts. Rules for the program call for individual states to establish selection criteria and other rules for awarding funding, but those rules most conform to guidelines established by the NTIA. This includes the following when there is more than 1 funding application for an area:

• The provider must, absent a waiver, cover no less than 25% of the project cost.
• Providers committing to provide the most affordable total price to the customer for symmetrical GB service should be prioritized.
• Providers demonstrating compliance with federal labor and employment laws or that have no track record but commit to doing so should be prioritized.
• Prioritizing providers that commit to completing deployments in advance of the four-year deadline (as a secondary criterion).

It is unclear which providers will be awarded government subsidies, but there will undoubtedly be many interested parties. We believe wireline telecom operators may be awarded subsidies in certain markets where there is an existing copper plant that can be more affordably upgraded to FTTH than greenfield builds. Conversely, cable providers may have an advantage when bidding given significant scale and deployment experience, which could reduce costs and execution risk. We have not incorporated incremental capital spending or associated growth into our models yet. However, we believe this represents upside for cable operators (given that funds will not be awarded to overbuild their footprint) while it presents both an opportunity and a threat to incumbent telcos.

Determining the exact rural locations that don't already have access to high-speed internet has been a critical undertaking that the FCC has been working on. The FCC released the new broadband maps in November 2022. The NTIA has encouraged disputes to the accuracy of the map by January 2023 and the FCC has set a March 31, 2023, deadline for filing revised availability data. We believe this sets the stage for awards to begin in the second half of 2023, with funds potentially starting to flow in 2024.

Capital allocation decisions are in the spotlight as stock market prices weigh on shareholder returns

U.S. telcos are currently in the middle of a massive investment cycle and the first priority for capital allocation in 2023 will be network investment. Wireline companies are deploying FTTH while wireless service providers are building out their mid-band spectrum acquired in recent auctions. Similarly, we expect cable capex to rise as these operators upgrade their networks for offer faster Internet speeds. With leverage already elevated, we expect the U.S. telcos to allocate any excess cash flow toward debt reduction as they work towards their stated leverage targets. However, given capital market conditions and currently low stock prices, we are already seeing some hints that U.S. telecom providers will look to improve shareholder returns through stock buybacks or delay their plans to reduce leverage. While we expect the larger cable operators to allocate more money to capital expenditures, we also assume excess cash flow will go to shareholder returns rather than debt reduction. Some examples include:

• AT&T said that it expects to achieve its net leverage target of 2.5x by 2025. Previously, management indicated it would reach its leverage target in 2023. We believe this is likely the resulted of an extended investment cycle (rather than shareholder returns) for FTTH deployments that will keep capex elevated, at around $24 billion annually, for an extended period, which will limit leverage reduction.
• American Tower said on its 2022 third-quarter conference call that it expects to opportunistically restart its share buyback program, although this will be partially offset by an additional $570 million investment from Stonepeak in its data center business.
• In March 2022, Verizon stated it would consider share repurchases once it achieves its net leverage of 2.25x. Investors largely did not anticipate stock buybacks until it reached its net unsecured debt to EBITDA target of 1.75x-2.0x. We believe there is some risk that Verizon could start buying back stock at a higher leverage threshold, although we view this scenario as less likely.
• In September 2022, T-Mobile announced a 12-month $14 billion share repurchase program, although this scenario was already factored into our base-case forecast.
• In September 2022, Comcast announced it would increase its share repurchase authorization to $20 billion, having bought back $9 billion in 2022. Still, this was in line with our expectations as the company will operate around 2.4x leverage.

Sector Outlooks

As recession fears mount, the U.S. wireless sector will benefit from the growing importance of connectivity while lower capex should support modest credit improvement

U.S. wireless providers are poised to withstand a deteriorating macroeconomic environment and high interest rates as consumer and business customers prioritize connectivity. While earnings growth may be weak due to cost pressures and competition, lower capex should enable modest leverage improvement in 2023.

The U.S. wireless market remains very competitive with cable making inroads into telcos' market share. We expect industry service revenue growth to slow to around 2% in 2023 from around 4% in 2022 due to aggressive competition and weaker subscriber growth, despite rate hikes that passed along higher costs to customers. Further, all the carriers are offering aggressive promotions to upgrade subscribers to 5G handsets and higher-tier data plans, which hurts near-term profitability. However, while capex will likely remain above historical levels as mobile operators build out their 5G networks, we expect it to decline in 2023 relative to 2022, as mid-band investments wind down. As such, we expect free cash flow generation to improve in 2023, which will drive moderate leverage reduction.

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High interest costs and capex are likely to weigh on credit quality for U.S. wirelines

While the longer-term outlook for U.S. wirelines is more favorable, near-term headwinds could have a more damaging impact on credit metrics. In the consumer business, building out FTTH across their footprint became more challenging in 2022 due to rising labor costs and supply chain constraints. Fiber returns on investment were good when the cost of capital was low, but this may not be the case as interest rates rise and valuations decline. Many of these companies are not fully funded for their build plan, which means they will need to access capital markets at some point over the next couple of years. The higher cost of capital and a weakening economy could prompt some to scale back FTTH deployments to conserve cash flow. That said, not building fiber is a lost opportunity that increases the risk of declining revenue and cash flow as they lose copper-based broadband customers to cable.

Similarly, business wireline services face secular industry pressures and technology shifts as these customers migrate to less expensive networking technologies. Large enterprise customers are focused on accelerating their digital transformation to reduce expenses in the face of a deteriorating economic conditions. This trend will extend revenue and EBITDA declines for U.S. wirelines over the next several years. The SMB segment represents a lower percent of its revenue base than it did 10 years ago due to market share losses to cable, but it is also at risk in an economic downturn since many of these customers will scale back operations or go out of business altogether.

Leverage for the wireline sector increased in 2022 due to the loss of Connect American Fund Phase II (CAF II)subsidy revenue, secular industry pressures, and elevated capex, although this was largely incorporated in our base-case forecast. In 2023, we expect some improvement in revenue trends as fiber-based broadband penetration increases. However, we do not expect that to translate into EBITDA stability until 2024 to 2025, at the earliest, because of marketing expense, capitalized labor costs, and other expenses associated with the fiber builds. Further, we believe it will likely take several years before leverage stabilizes and starts to improve but the timing will largely depend the timing of free cash flow improvement, access to capital, interest costs, and the alleviation of supply chain pressures.

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Capital spending in the telecom sector should moderate in 2023

We expect total U.S. telco capex will decline about 10% in 2023 but remain significantly above historical levels. We base our forecast on the following factors:

• With much of the C-band spend complete, we expect Verizon's capex to decline by around $5 billion in 2023.
• As T-Mobile achieves network synergies from its acquisition of Sprint, we expect the company to realize procurement savings and greater 5G deployment efficiencies, which should result in an approximate $2 billion to $3 billion decline in capex in 2023.
• Conversely, we expect elevated levels of capex from wireline operators Lumen, Frontier, Consolidated, Ziply Fiber (NW Fiber), and TDS.
• We also expect AT&T's capex to remain steady at around $24 billion.

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Chart 15

Competitive pressure is increasing for cable operators but modest earnings growth is still attainable

We expect broadband subscriber trends will remain pressured in 2023 as FWA continues to garner most of the industry net adds, with gradually intensifying FTTH competition. However, we believe the industry will be able to achieve low-single-digit annual EBITDA growth for the foreseeable future driven by the following:

• We believe there is room for HSD ARPU growth in the low-single digits as customers migrate to faster speeds given rising data consumption averaging around 30% per year. On average, roughly 20% of cable households subscribe to the most expensive 1GB tier, which we expect will rise over time. Furthermore, many operators have started to raise broadband prices to combat inflation, which should bolster ARPU. However, we believe this carries more risk, particularly in a recessionary environment where FWA players are marketing discounted internet service.
• Government subsidies could accelerate footprint edge outs into areas where there isn't FTTH competition. This network investment should be able to offset the loss of market share in duopoly markets, particularly considering cable should get very high penetration in new, less competitive markets.
• We expect that with greater scale, and migration of traffic on-network, wireless can provide modest EBITDA growth over time.
• We expect cable players will continue to take market share, particularly for SMBs. However, growth could stall in a recession in 2023.

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We expect cable capex will accelerate over the next two to three years

We view network investments favorably because most cable operators will fund these investments with cash from operations, providing a path toward future earnings growth. Comcast and Charter currently operate at their stated leverage targets so increased capital spending will likely come at the expense of share repurchases. However, for certain highly leveraged operators that have experienced operational challenges, such as Altice USA and Radiate, there is less financial flexibility to make these investments so the tradeoff for limited near-term cash generation (and leverage reduction) in exchange for earnings growth is more nuanced.

Cable providers are taking different approaches to upgrading their existing networks, largely to protect existing market share, while also providing a path to long-term ARPU growth through significantly faster internet speeds. These different strategies will influence the timing and amount of capex and network capabilities in certain markets, but the trend is toward multi-gig download speeds and at least gigabit upload speeds. We believe upgrades to the existing HFC plant can largely be completed within historical capital spending envelopes of low-teens percent of revenue, on average (whereas conversion to FTTH will cost significantly more). For example:

• Comcast will be upgrading its HFC plant using mid-splits and eventually Full duplex DOCSIS 4.0 that will enable multi-gig symmetrical speeds (up to 10Gbps download speeds) across more than 85% of its footprint by 2025. Management has indicated the all-in network upgrade cost per home passed is under $200, which we estimate can be completed for about 11% of revenue per year.
• Charter will be upgrading its HFC plant using a three-stage approach using a combination of high-splits and DOCSIS 4.0, at an average cost of $100 per home passed ($5.5 billion total over three years). This will enable the entire footprint to have up to 1Gbps upload speeds, with 35% of its footprint capable of download speeds of up to 10Gbps; 50% up to 5Gbps; and 15% up to 2 Gbps by 2025. We estimate this equates to roughly 12% of revenues per year (excluding line extensions).
• Altice USA is targeting conversion of its cable plant to FTTH across 6.5 million passings (about 65% of its footprint) by 2025 at an average cost of about $500 per passing (not including the customer drop), which will keep capex-to-revenue elevated in the low-20% area for the next two to three years before normalizing to the low-teens area in 2026.

The larger, and more uncertain, component of future capital spending will come from footprint expansion into rural markets, which will be very capital intensive. We expect much of this expansion will be subsidized through the following two major federal programs (among other smaller programs):

• BEAD: $42 billion rural broadband initiative that has yet to be awarded. We expect funds to begin flowing in 2024 and continue for about five years.
• RDOF: Up to a $20 billion federal program that has awarded $9 billion to a variety of industry participants in Phase 1.

We believe this footprint expansion will help drive subscriber growth over time. Cable expansion into rural markets could drive mid-teens rates of return because there is little competition so customer penetration will be higher (we estimate above 70% in many cases). However, our projections only include rural capital expenditures that have been announced and does not include any investments related to BEAD. More specifically:

• Charter has committed to invest $5 billion that will cover about 1 million homes over five years through the RDOF program ($1.2 billion will be subsidized). In 2023, footprint expansion will cost about $4 billion for Charter, consisting mostly of subsidized rural construction initiatives, bringing total capex-to-revenue to about 20% for the next two to three years.
• Comcast did not participate in the RDOF program so it has lower near-term capital intensity than Charter.

Therefore, we believe there is potential for capex to increase significantly in 2024 and beyond depending on the amount of BEAD subsidies awarded to operators. However, to the extent that these investments continue in lieu of share repurchases--such that financial leverage does not increase--we would view them favorably. Under our current operating assumptions, we have the following plug for share repurchases that provides flexibility for operators to make investments in the business and maintain target leverage:

• Charter: $5 billion per year in 2024-2026 to keep leverage at, or slightly below, 4.5x.
• Comcast: $10 billion per year in 2024-2026 (excluding any proceeds from Hulu put)

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We expect cable operators to manage capital allocation decisions to preserve credit quality

Most cable providers still have financial flexibility from FOCF generation combined with modest EBITDA growth. We project that, on average, incumbent cable operators can reduce leverage by about 0.2x-0.3x per year. This deleveraging ability is lower than it has been in recent years (at least 0.5x) due to slowing earnings growth, higher capital spending, and rising interest rates. Therefore, management teams may need to scale back on shareholder returns to maintain appropriate credit metrics for the existing ratings.

To the extent that business prospects weaken, such that EBITDA growth turns sustainably negative, we could re-evaluate our rating triggers. Therefore, we will be closely monitoring operating metrics such as HSD subscriber trends, HSD ARPU growth, and EBITDA per home passed.

Related Research

• Credit FAQ: Stretched Balance Sheets Leave Little Headroom For U.S. Wireless Carriers Amid Macroeconomic Headwinds, Aug. 12, 2022
• Credit FAQ: How U.S. Data Centers Are Navigating Inflation And Recession Risks, July 21, 2022
• Credit FAQ: Stepped-Up Competition Will Slow U.S. Cable Companies' Growth, June 29, 2022
• U.S. Tower Operators Poised To Benefit From 5G, But Credit Risk Looms With M&A And Expansion, May 20, 2022
• Credit FAQ: Calculating Leverage For Selected U.S. Telecommunications And Cable Companies (2022 Update), April 22, 2022
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