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Qwest Trashes Junk Rating

Light Reading
News Analysis
Light Reading
5/23/2002

Does Qwest Communications International Inc. (NYSE: Q) really deserve the junk status its credit rating received from Standard & Poors after the market closed yesterday?

That’s the hot topic on Wall Street today, as at least one analyst has followed suit and downgraded the company’s price target, while others insist the junk status doesn’t make any sense, pointing out that the country’s fourth largest telecom company is less leveraged than many other carriers that have not been downgraded.

Qwest, of course, leans toward the latter interpretation. On a conference call this morning, Qwest CEO Joe Nacchio responded with disbelief to S&P’s decision (see Qwest Complains to S&P ). “I’m a bit surprised and disappointed,” he said, saying he didn’t think S&P had based the new credit rating on new information. “We’re unclear on what prompted S&P to take the action they did.”

He said the downgrade would have some effect on the company, triggering financial covenants in $1 billion worth of older Qwest bonds.

Later in the morning, S&P had its own conference call to defend its decision to lower Qwest’s long-term credit rating from a triple B minus to a double B plus. BB+ is the highest junk grade, but S&P warned that if Qwest’s situation doesn’t improve, it might cut the rating further. “This reflects the continued weakness in the overall economy that continues to threaten the company’s viability,” said S&P credit analyst Catherine Cosentino.

In the Q&A at the end of the call, several observers indignantly accused S&P of just “adding noise” to an already difficult situation. Deutsche Telekom AG (NYSE: DT) and KPNQwest NV (Nasdaq/Amsterdam: KQIP) were pulled out as examples of telecoms that are in worse shape, but that haven’t been cut to junk bond status (see KPNQwest Ready to Kick the Bucket?).

Qwest is the second large carrier to see its credit rating reduced to junk this month. Telecom giant WorldCom Inc. (Nasdaq: WCOM) was downgraded to junk status on May 10 (see WorldCom's Junk Status Fuels Fears).

What separates Qwest from many of the other companies in this space, according to Cosentino, are the many external problems that threaten to further erode investor confidence in the company. These include a long line of pending investor lawsuits and an ongoing SEC investigation into many of the company’s accounting practices, such as engaging in capacity swaps, or indefeasible rights of use (IRUs), with companies like Global Crossing Ltd. (NYSE: GX) and Enron. These issues, she says, have the potential to demand a significant amount of management attention -- attention much needed to conduct company business in a hard-hit market.

Nacchio, however, says that the notion that management was being distracted is not true: “We may have to work a little harder, and we may have to work a little longer, but we are not distracted from running this business…”

Qwest is relying on the sale of non-core assets, which it claims will go for more than $10 billion, to help reduce its current $26.2 billion debt load (see Qwest Posts Loss, Preps Asset Sales and Qwest Gets Yellow Pages Bids). On the conference call, Nacchio said that the company had entered the second bidding round for its QwestDex Yellow Pages business, with only six bidders left in the game. He said the company should decide on a buyer by the end of June.

Standard & Poors says that its BB+ rating relies on the fact that Qwest in fact manages to sell its directories business for about $8 billion. There is, however, a risk that this won’t happen, S&P says, due to the state regulatory approval required in several of the states involved. If Qwest is unable to unload the directories business over the next couple of months, “its ability to meet debt to operating cash flow bank covenant when it tightens to 4 times in the fourth quarter of this year would be in jeopardy,” the company says. And if that happens, S&P will probably cut its credit rating again.

Nacchio, however, claims the regulatory approvals should go through over the next couple of months, and says that Qwest expects to be cash-flow positive by the end of the current quarter. He says the company has sufficient cash on hand to retire any debt that matures in 2002.

In wake of the junk rating, Qwest stock declined slightly in afternoon trading today, falling 9 cents (1.79%) to $4.94.

Analysts seem to be divided over whether or not the junk rating will really affect investor confidence. Jack Grubman of Salomon Smith Barney issued a note today downgrading his Qwest price target to $5 from $8, and raising the risk rating for the company. In the note, Grubman writes that while the sale of the directories business will help lower Qwest’s debt load, it will also result in a dramatic decline in free cash flow.

Sanford C. Bernstein & Co. Inc. analyst, Jeff Halpern, however, says there is no reason to believe that the downgrade will lead to a great decline in Qwest’s stock price. “There is no statistical relationship between credit downgrades and future stock performance,” he says, referring to a study carried out by Bernstein's strategy group a few months ago.

The S&P junk rating wasn’t the only bit of bad news for Qwest today. Netherlands-based KPNQwest announced this morning that it was seeking protection from its creditors under Dutch law, and that its supervisory board had resigned (see KPNQwest Supervisors Resign). Qwest, which holds a 40 percent stake in the company, will probably be left empty-handed.

On the Qwest conference call, Nacchio said that the smaller company’s bankruptcy should not cause interruptions to Qwest customers that are connected to the KPNQwest network. “We will take all steps possible to minimize the risks to Qwest and to our customers,” he said.

— Eugénie Larson, Reporter, Light Reading
http://www.lightreading.com

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