Your Call
Deregulation, technology gains, increasing competition, and the
growing use of third-party ? all factors that ensure telecoms
continues to attract the biggest chunk of global infrastructure
investment.
But despite rapid growth, telecom risk continues to rise due to reliance on large debt burdens for multi-year build-out of massive networks, growing system complexity, unstable prices, and tight credit. This increased risk profile has led to a rising number of bankruptcies in the sector, especially for competitive local exchange carriers (CLECs).
A continuing tightening of credit and the potential for slowdown in market demand would add to credit pressure and potential losses in the year ahead. While the sector will continue to grow, lenders are looking for strong credits in many of these transactions through a better allocation of risk or a lower risk profile.
Given the growing industry risk levels and renewed investor interest in credit quality, Standard & Poor's expects that sponsors will increase their use of traditional single asset project finance structures for long-term telecom investments. These structures help to limit recourse to the sponsor's balance sheet, enable joint ventures, attract large amounts of debt, and provide a lower level of credit risk.
Although many telecom deals employ non-recourse debt and are therefore considered projects, they often lack key structural features usually seen in traditional project financing that help mitigate some credit risks. These features include strict limitations on asset composition, activities, debt, and distributions, as well as substantial liquidity facilities.
A renewed interest in sector credit quality argues for greater use of true single asset project structures to mitigate risk.
Industry trends raise potential credit risks
The demand for telecom services is driven largely by the need for basic service in much of the developing world, the rapid growth in wireless communications, and customer needs for increasing transmission bandwidth and speed to support explosive growth of the Internet and new data applications.
Demand is strengthened by declining prices in key industry services ? switched access, long distance, and undersea cable capacity. Massive investment in the supply response has been aided by favorable developments in deregulation, continuing technology gains and the use of third-party debt.
Technology gains, however, can have negative credit effects on telecom deals by placing downward pressure on prices. For example, capacity prices on undersea fiber cables are declining at around 20% to 25% per year. These trends suggest that some telecom services have or could take on commodity characteristics, and thus associated credit risk profiles.
The considerable competition fired by industry change also can have adverse credit effects. Businesses have responded by entering into global partnerships and undertaking merger and acquisition activity, to extract value from perceived synergies, gain access to foreign markets, or establish a national or large cross-border presence.
Additional transaction risk stems from the growing size and complexity of telecom projects. Service providers are trying to build national networks over several years (to gain first mover advantages) which greatly increases construction risks.
Industry trends have certainly increased the supply of innovative telecom services, but the downside is a more risky environment in which many telecom companies are exposed to the increased potential for credit default and loss of principal. The recent bankruptcies of several satellite telecom deals such as Iridium and ICO Global Communications show the potential risks in the sector. Furthermore, in recent months, many CLECs, such as GST Telecommunications and Northpoint Communications, also succumbed to failed business plans as access to capital markets for required expansion dried up. The ability to attract capital and mitigate transaction risk is key for telecom project viability.
Project debt as a financing alternative
Many of the funding and market risks to telecom transactions can be addressed with single asset project finance structures. Project finance facilitates joint ventures, limits recourse to sponsors, can open access to a wider pool of investors, and may, with appropriate structural features, lower a transaction's risk profile and capital costs. Statistics from Capital DATA suggests that from 1994 through 2000, telecom project debt was about $209 billion, mostly in the form of bank loans. In the same period, the average project size rose to about $778 million for bank loans and about $100 million for capital market debt (see charts 1 and 2). Most of these transactions, however, likely involve only lightly structured corporate entities rather than true project finance structures in which asset composition, debt, activities, and equity distributions are restricted.
Many sponsors have not heavily structured these transactions due to regulatory and technological uncertainties, and also to take advantage of business opportunities that may arise. But, Standard & Poor's expects that the growing level of and a renewed lender focus on risk will lead sponsors to increasingly use single asset project finance structures to control transactions' credit risk.
Projects versus corporations
The differences between project and corporate finance transactions are important. Corporations generally rely on multiple assets in diverse regions and/or industries to repay moderate levels of debt that enjoy unsecured recourse to the company's assets. Projects, in contrast, are often highly leveraged with non-recourse debt and rely on a well-defined asset to manage high levels of debt by generating stable levels of cash flow. The project's single asset nature requires limitations on activities, additional debt, changes in contracts and distributions to equity, and liquidity reserves to support debt service in times of stress. Project structures also provide lenders with a more comprehensive security package.
Project criteria
Standard & Poor's assesses telecom project credit risk by through analysis of seven key project components:
? Markets and competitiveness;
? Regulation and competition;
? Technology and construction;
? Operations and marketing;
? Financial performance;
? Structural and legal; and
? Cross-border issues.
Markets and competitiveness
Markets
Standard & Poor's assesses a project's demand by examining key indicators whose overall importance depends on the study market. These indicators may include economic growth, sector growth (e.g. Internet data), the mix of residential and commercial customer bases, teledensity levels, and the ratio of incoming to outgoing calls (especially for emerging markets). Demographics are important in assessing the potential of population groups to afford service, but also help identify the size of upper income groups, which use more minutes of enhanced services.
For wireline projects, teledensity statistics measured in lines per 100 inhabitants and particularly measured in business districts indicate at least gross demand. A business concentration in the service area is favorable because they are the most lucrative customers and are often undereserved in voice telephony, data, and other high-speed application needs. The backlog for lines if accurate can indicate early demands ? especially in less-developed telecom markets with long waiting times for a telephone ? because these lines will produce the cash flow to fund the capital expenditures and working capital requirements that are greatest in the first years of a project.
Indicators for wireless projects involve a variation on wireline business risk factors, especially the concentration of businesses, which are prime wireless users. The availability of landline service, specifically the installation period for wired phones, can indicate wireless product demand.
Competitiveness
Competition growth, the general lack of long-term contracts and potentially declining prices all affect a project's competitive and credit position through its debt tenor. Standard & Poor's assesses the project's ability to compete based on service area competition, price, and volume forecasts. In general, more creditworthy projects are able to provide services at below market prices for a sustained period, without sacrificing customer service quality or system reliability.
Standard & Poor's assesses the authorized and unauthorized levels of competition in the service area. Some markets dominated by a monopoly provider may contain a level of, or potential for, material competition. Standard & Poor's assesses the strength of monopoly positions to determine if de juris monopolies actually translate into de facto market power, examines the presence of irregular competition, such as dial around or call back, and gauges the potential for new competition that may be enabled by regulatory acts or new technologies, such as development of wireless Internet access and 3G systems. Standard & Poor's examines the cost advantages of the parties under competition, and the extent of universal service obligations. Projects with considerable buildout requirements into potentially uneconomic areas may be less competitive than those that do not have such requirements?.
Standard & Poor's gauges the project's ability to sustain price and volume declines through the debt term without compromising customer service or product quality.
Regulation and competition
A project's regulatory environment usually presents credit implications, because it directly controls the level of competition and the project's operating regime. Standard & Poor's examines the regulatory goals for the project's service area, assesses how the regulator's tools may affect project cash flows, and studies the project's concession for performance requirements and limits to competition.
Regulatory goals vary between markets, but usually focus on expanding the availability of basic services, improving efficiency and lowering costs by introducing competition, or enabling the provision of higher value services. Regulatory tools may include rebalancing rates between residential and commercial users, controlling interconnection rules and prices, deciding on universal service obligations, controlling number portability and allowing carrier preselection, and adding requirements for third-party billing.
Concessions are reviewed for minimum coverage levels, buildout scopes and schedules, technology selections, and limits to competition. For a landline project, coverage may imply a specific minimum number of lines, but might also mandate the provision of service to minimum population clusters in certain geographic areas. The concession usually requires initial buildout in areas of pent-up demand, thus providing fairly good cash flow from the initial service area, but may require building out to increasingly remote areas, which could increase costs and delay completion. In addition, terms of coverage requirements and engineering concerns, including topography and the availability of antenna siting in urban areas, will also affect capital expenditures. Finally, the project's digital protocol might have operational implications for roaming into the service area of other operators that may be using analog, different frequencies, or different digital protocols.
Regarding limits to competition, important considerations include the level and term of service exclusivity granted to the project, and requirements for interconnection to would-be competitors. Real competition may hinge on interconnection terms, which if reasonably priced, may allow a new entrant to offer service before completing its own network by using the incumbent's network to jump-start its operations. Provisions for full service resale and the availability of unbundled network elements are also studied.
Standard & Poor's examines the regulator's track record with enforcement and interpretation of concessions provisions, and may request meetings with the regulator and/or other appropriate authorities.
Technology and construction
Technology
The project's choice of technology and its ability to redeploy new technologies are key credit quality factors. Projects can reduce risk profiles by using technology that is commercially proven and that matches the standard for the target market. Although some markets have multiple standards ? such as the U.S. wireless market ? a project's technology approach should ensure that it can capture an adequate market share through the debt tenor.
Standard & Poor's believes that projects can reduce their technology risk profile file by developing systems that can readily accommodate technology upgrades throughout the debt tenor at minimal cost. Although this approach is difficult for, say, a power project due to costly capital substitution, many telecom projects can readily upgrade with new transmission equipment. For example, capacity increases on undersea cable can be achieved by upgrading the laser and switching equipment on either end of the cable, a relatively straightforward task that is far less costly than laying another cable.
These capital upgrades require cash flow, which may be hard to earn because of growing competition and declining prices. Standard & Poor's believes projects can mitigate some technology risk by establishing at closing an adequate fund or funding commitments to technology updates.
Construction
Project finance transactions rely on the revenue earning potential of a single asset, so timely, proper and on budget construction are critical for project success. Standard & Poor's expects a project's construction program to include provisions to adequately mitigate construction-related risks by allocating risks to those parties that can best manage them.
The project's overall construction program should match the build-out provisions established in its concession or license agreement. Concession provisions often introduce at least two significant risks. First, a project could lose a concession if not built out on time. Second, permitting agreements may require build-out into hard-to-reach areas, which could increase costs.
Generally, experience suggests that more creditworthy projects will allocate the bulk of construction risk to experienced contractors, usually under fixed-price, date-certain engineering, procurement, and construction (EPC) contracts. If properly structured, these contracts can provide strong assurance to lenders that the project will be completed as forecast. Minimal provisions include liquidated damage penalties and bonus incentives for schedule and technical performance, strong completion tests, strict limits on change orders, progress-based payments, and adequate warranties. Appropriate budgets and contingency are also required.
Some projects can benefit from other arrangements, such as reimbursable cost contracts with lesser-known contractors, when costs are well defined and the scope of activity is limited. Regardless of the approach, Standard & Poor's examines each contractor's experience, ability to finance its construction operations, and ability to pay potential liquidated damages.
Operations and marketing
Standard & Poor's comprehensively reviews the telecom project's operations and marketing functions to determine if it has the resources to maintain system reliability and competitiveness through the debt tenor.
Operations
In general, telecom projects must maintain operational efficiency to remain competitive. Efficiency measures vary between projects, but include system reliability, expense per line, operating margins, and employees per line. Whatever measure is appropriate for a project, Standard & Poor's expects to see an improvement in the metric over time. Efficiency of operations in a monopoly environment may be of limited value in addressing credit quality, but given the trend toward competitive based regulatory systems, a project's ability to minimize cost and to provide higher value added services will improve credit strength.
Marketing
Standard & Poor's analyzes how the project will maximize revenues while minimizing bad debt, fraud, and churn rates. This analysis includes an examination of the experience of marketing management in delivering the project services given the resources available to them. The analysis will attempt to answer questions such as, how will the product be marketed, by an in-house sales force, agents, or resellers? How will credit be checked? Inadequate credit qualifications are a major cause of bad debt and associated churn. Is the bad debt policy aggressive enough to close the accounts within a reasonable timeframe? Standard & Poor's has seen operators take major write-offs for bad debts within the first year or two of operation due to improper bad debt policies.
For those projects offering wireless services, a track record is vital to attain mid to high speculative-grade credit profiles. This experience can be gained simply over time or by joining with an experienced partner. Standard & Poor's has given at least one extra notch to a rating where the operator or its partner had operational experience.
Financial performance
Standard & Poor's reviews the project's financial projections, gauges the validity of key assumptions, examines financial robustness under stress scenarios, and may perform liquidity analysis. Standard & Poor's generally focuses on a cash basis, that is, it will assess the project's ability to pay debt based on operating cash. In appropriate cases, EBITDA measures are used.
Stress conditions are tailored for each project, but in general might include:
? An increase in operating costs;
? A decline in sales volumes;
? A decline in product prices;
? Loss of market share;
? Operation at less than base case capacity;
? Foreign exchange rates; and
? A combined downside case.
Standard & Poor's has established general debt service coverage ratio (DSCR) levels that project financings must demonstrate to achieve certain rating levels, but telecom industry trends of uncertain regulatory risk, competition, and price trends make such benchmarks harder to establish. Standard & Poor's expects that DSCR forecasts will need to be supplemented with additional analyses to gauge a project's financial merits.
Standard & Poor's determines if the project's debt amortization schedule matches potential risk presented to lenders over the debt tenor. Given the rapidly changing nature of competition and technology, Standard & Poor's believes that telecom projects can reduce their risk profiles by quickly amortizing debt.
Structural and legal issues
A project's transaction structure is important because it can provide the project with certain limited cash flow protection as well as a short-term safety net when difficulties arise.
Although legal and structural provisions alone cannot protect against inherent operating and financial performance weakness, an otherwise strong project may be rated lower due to legal and structural vulnerability of the transaction. Most telecom projects have no approachable cash flows until nearing completion and operation, whereupon revenues can be earned. Legal and security provisions need to be structured accordingly ? limiting flexibility in the development and construction phase and yet providing the project with appropriate flexibility over the long term.
The security package provided for lenders should include perfected, first priority interests in all material project assets, contracts, permits, licenses, and ownership interests. In the US and in many other countries, the inability to perfect a lien on telecom licenses creates a problem when structuring the security provisions. Transactions are viewed more favorably from a credit perspective when a license is closely bound to the investor's security package.
Cross-border issues
Standard & Poor's assesses the project's exposure to sovereign and foreign currency risks. Sovereign risks include potential activities of the host government that could affect the project's ability to operate and service debt, through exchange controls, changes in the operating and fiscal regime for the sector, and expropriation of assets. Projects issuing cross-border debt are usually limited to Standard & Poor's long-term foreign currency sovereign credit rating on the country where revenues are earned. Projects can achieve ratings higher than the sovereign in special cases where the product is strategic to the government, domestic demand is low, buyers are limited, and payment is made in hard currency. Most telecom projects lack these features.
Outlook for telecoms project finance
Many of the telecom transactions that Standard & Poor's has rated are start-up companies that employ non-recourse debt, have uncertain cash flow and high debt burdens, and may lack strong structural protections. As such, these transactions often have highly speculative credit profiles and are initially rated in the single ?B' category. Over time, a project can potentially improve its credit rating as it as completes buildout, gains market share, and demonstrates sustainable positive earnings.
To gain an initial rating in the ?BB' category, a project will generally have to quickly establish a revenue base with modest debt burdens, operate under a favorable regulatory regime, to maintain long-term competitiveness, and may require implied support from a strong, highly creditworthy parent. In addition, the project would require a much stronger structural makeup than is seen for most ?B' rated credit quality transactions, including limits on asset composition, activities, debt, and distributions.
It will prove a challenge for most telecom projects to obtain initial ratings in the investment-grade category without financial guarantees from investment-grade rated parents, solid structural features, and robust projected cash flows.
Contact
Terry A. Pratt, Director, Corporate and Government Ratings, New York (212) 438-2080, e-mail terry_pratt@standardandpoors.com
Richard C. Siderman, Managing Director, Corporate and Government Ratings, New York (212) 438-7863, e-mail richard_siderman@standardandpoors.com
But despite rapid growth, telecom risk continues to rise due to reliance on large debt burdens for multi-year build-out of massive networks, growing system complexity, unstable prices, and tight credit. This increased risk profile has led to a rising number of bankruptcies in the sector, especially for competitive local exchange carriers (CLECs).
A continuing tightening of credit and the potential for slowdown in market demand would add to credit pressure and potential losses in the year ahead. While the sector will continue to grow, lenders are looking for strong credits in many of these transactions through a better allocation of risk or a lower risk profile.
Given the growing industry risk levels and renewed investor interest in credit quality, Standard & Poor's expects that sponsors will increase their use of traditional single asset project finance structures for long-term telecom investments. These structures help to limit recourse to the sponsor's balance sheet, enable joint ventures, attract large amounts of debt, and provide a lower level of credit risk.
Although many telecom deals employ non-recourse debt and are therefore considered projects, they often lack key structural features usually seen in traditional project financing that help mitigate some credit risks. These features include strict limitations on asset composition, activities, debt, and distributions, as well as substantial liquidity facilities.
A renewed interest in sector credit quality argues for greater use of true single asset project structures to mitigate risk.
Industry trends raise potential credit risks
The demand for telecom services is driven largely by the need for basic service in much of the developing world, the rapid growth in wireless communications, and customer needs for increasing transmission bandwidth and speed to support explosive growth of the Internet and new data applications.
Demand is strengthened by declining prices in key industry services ? switched access, long distance, and undersea cable capacity. Massive investment in the supply response has been aided by favorable developments in deregulation, continuing technology gains and the use of third-party debt.
Technology gains, however, can have negative credit effects on telecom deals by placing downward pressure on prices. For example, capacity prices on undersea fiber cables are declining at around 20% to 25% per year. These trends suggest that some telecom services have or could take on commodity characteristics, and thus associated credit risk profiles.
The considerable competition fired by industry change also can have adverse credit effects. Businesses have responded by entering into global partnerships and undertaking merger and acquisition activity, to extract value from perceived synergies, gain access to foreign markets, or establish a national or large cross-border presence.
Additional transaction risk stems from the growing size and complexity of telecom projects. Service providers are trying to build national networks over several years (to gain first mover advantages) which greatly increases construction risks.
Industry trends have certainly increased the supply of innovative telecom services, but the downside is a more risky environment in which many telecom companies are exposed to the increased potential for credit default and loss of principal. The recent bankruptcies of several satellite telecom deals such as Iridium and ICO Global Communications show the potential risks in the sector. Furthermore, in recent months, many CLECs, such as GST Telecommunications and Northpoint Communications, also succumbed to failed business plans as access to capital markets for required expansion dried up. The ability to attract capital and mitigate transaction risk is key for telecom project viability.
Project debt as a financing alternative
Many of the funding and market risks to telecom transactions can be addressed with single asset project finance structures. Project finance facilitates joint ventures, limits recourse to sponsors, can open access to a wider pool of investors, and may, with appropriate structural features, lower a transaction's risk profile and capital costs. Statistics from Capital DATA suggests that from 1994 through 2000, telecom project debt was about $209 billion, mostly in the form of bank loans. In the same period, the average project size rose to about $778 million for bank loans and about $100 million for capital market debt (see charts 1 and 2). Most of these transactions, however, likely involve only lightly structured corporate entities rather than true project finance structures in which asset composition, debt, activities, and equity distributions are restricted.
Many sponsors have not heavily structured these transactions due to regulatory and technological uncertainties, and also to take advantage of business opportunities that may arise. But, Standard & Poor's expects that the growing level of and a renewed lender focus on risk will lead sponsors to increasingly use single asset project finance structures to control transactions' credit risk.
Projects versus corporations
The differences between project and corporate finance transactions are important. Corporations generally rely on multiple assets in diverse regions and/or industries to repay moderate levels of debt that enjoy unsecured recourse to the company's assets. Projects, in contrast, are often highly leveraged with non-recourse debt and rely on a well-defined asset to manage high levels of debt by generating stable levels of cash flow. The project's single asset nature requires limitations on activities, additional debt, changes in contracts and distributions to equity, and liquidity reserves to support debt service in times of stress. Project structures also provide lenders with a more comprehensive security package.
Project criteria
Standard & Poor's assesses telecom project credit risk by through analysis of seven key project components:
? Markets and competitiveness;
? Regulation and competition;
? Technology and construction;
? Operations and marketing;
? Financial performance;
? Structural and legal; and
? Cross-border issues.
Markets and competitiveness
Markets
Standard & Poor's assesses a project's demand by examining key indicators whose overall importance depends on the study market. These indicators may include economic growth, sector growth (e.g. Internet data), the mix of residential and commercial customer bases, teledensity levels, and the ratio of incoming to outgoing calls (especially for emerging markets). Demographics are important in assessing the potential of population groups to afford service, but also help identify the size of upper income groups, which use more minutes of enhanced services.
For wireline projects, teledensity statistics measured in lines per 100 inhabitants and particularly measured in business districts indicate at least gross demand. A business concentration in the service area is favorable because they are the most lucrative customers and are often undereserved in voice telephony, data, and other high-speed application needs. The backlog for lines if accurate can indicate early demands ? especially in less-developed telecom markets with long waiting times for a telephone ? because these lines will produce the cash flow to fund the capital expenditures and working capital requirements that are greatest in the first years of a project.
Indicators for wireless projects involve a variation on wireline business risk factors, especially the concentration of businesses, which are prime wireless users. The availability of landline service, specifically the installation period for wired phones, can indicate wireless product demand.
Competitiveness
Competition growth, the general lack of long-term contracts and potentially declining prices all affect a project's competitive and credit position through its debt tenor. Standard & Poor's assesses the project's ability to compete based on service area competition, price, and volume forecasts. In general, more creditworthy projects are able to provide services at below market prices for a sustained period, without sacrificing customer service quality or system reliability.
Standard & Poor's assesses the authorized and unauthorized levels of competition in the service area. Some markets dominated by a monopoly provider may contain a level of, or potential for, material competition. Standard & Poor's assesses the strength of monopoly positions to determine if de juris monopolies actually translate into de facto market power, examines the presence of irregular competition, such as dial around or call back, and gauges the potential for new competition that may be enabled by regulatory acts or new technologies, such as development of wireless Internet access and 3G systems. Standard & Poor's examines the cost advantages of the parties under competition, and the extent of universal service obligations. Projects with considerable buildout requirements into potentially uneconomic areas may be less competitive than those that do not have such requirements?.
Standard & Poor's gauges the project's ability to sustain price and volume declines through the debt term without compromising customer service or product quality.
Regulation and competition
A project's regulatory environment usually presents credit implications, because it directly controls the level of competition and the project's operating regime. Standard & Poor's examines the regulatory goals for the project's service area, assesses how the regulator's tools may affect project cash flows, and studies the project's concession for performance requirements and limits to competition.
Regulatory goals vary between markets, but usually focus on expanding the availability of basic services, improving efficiency and lowering costs by introducing competition, or enabling the provision of higher value services. Regulatory tools may include rebalancing rates between residential and commercial users, controlling interconnection rules and prices, deciding on universal service obligations, controlling number portability and allowing carrier preselection, and adding requirements for third-party billing.
Concessions are reviewed for minimum coverage levels, buildout scopes and schedules, technology selections, and limits to competition. For a landline project, coverage may imply a specific minimum number of lines, but might also mandate the provision of service to minimum population clusters in certain geographic areas. The concession usually requires initial buildout in areas of pent-up demand, thus providing fairly good cash flow from the initial service area, but may require building out to increasingly remote areas, which could increase costs and delay completion. In addition, terms of coverage requirements and engineering concerns, including topography and the availability of antenna siting in urban areas, will also affect capital expenditures. Finally, the project's digital protocol might have operational implications for roaming into the service area of other operators that may be using analog, different frequencies, or different digital protocols.
Regarding limits to competition, important considerations include the level and term of service exclusivity granted to the project, and requirements for interconnection to would-be competitors. Real competition may hinge on interconnection terms, which if reasonably priced, may allow a new entrant to offer service before completing its own network by using the incumbent's network to jump-start its operations. Provisions for full service resale and the availability of unbundled network elements are also studied.
Standard & Poor's examines the regulator's track record with enforcement and interpretation of concessions provisions, and may request meetings with the regulator and/or other appropriate authorities.
Technology and construction
Technology
The project's choice of technology and its ability to redeploy new technologies are key credit quality factors. Projects can reduce risk profiles by using technology that is commercially proven and that matches the standard for the target market. Although some markets have multiple standards ? such as the U.S. wireless market ? a project's technology approach should ensure that it can capture an adequate market share through the debt tenor.
Standard & Poor's believes that projects can reduce their technology risk profile file by developing systems that can readily accommodate technology upgrades throughout the debt tenor at minimal cost. Although this approach is difficult for, say, a power project due to costly capital substitution, many telecom projects can readily upgrade with new transmission equipment. For example, capacity increases on undersea cable can be achieved by upgrading the laser and switching equipment on either end of the cable, a relatively straightforward task that is far less costly than laying another cable.
These capital upgrades require cash flow, which may be hard to earn because of growing competition and declining prices. Standard & Poor's believes projects can mitigate some technology risk by establishing at closing an adequate fund or funding commitments to technology updates.
Construction
Project finance transactions rely on the revenue earning potential of a single asset, so timely, proper and on budget construction are critical for project success. Standard & Poor's expects a project's construction program to include provisions to adequately mitigate construction-related risks by allocating risks to those parties that can best manage them.
The project's overall construction program should match the build-out provisions established in its concession or license agreement. Concession provisions often introduce at least two significant risks. First, a project could lose a concession if not built out on time. Second, permitting agreements may require build-out into hard-to-reach areas, which could increase costs.
Generally, experience suggests that more creditworthy projects will allocate the bulk of construction risk to experienced contractors, usually under fixed-price, date-certain engineering, procurement, and construction (EPC) contracts. If properly structured, these contracts can provide strong assurance to lenders that the project will be completed as forecast. Minimal provisions include liquidated damage penalties and bonus incentives for schedule and technical performance, strong completion tests, strict limits on change orders, progress-based payments, and adequate warranties. Appropriate budgets and contingency are also required.
Some projects can benefit from other arrangements, such as reimbursable cost contracts with lesser-known contractors, when costs are well defined and the scope of activity is limited. Regardless of the approach, Standard & Poor's examines each contractor's experience, ability to finance its construction operations, and ability to pay potential liquidated damages.
Operations and marketing
Standard & Poor's comprehensively reviews the telecom project's operations and marketing functions to determine if it has the resources to maintain system reliability and competitiveness through the debt tenor.
Operations
In general, telecom projects must maintain operational efficiency to remain competitive. Efficiency measures vary between projects, but include system reliability, expense per line, operating margins, and employees per line. Whatever measure is appropriate for a project, Standard & Poor's expects to see an improvement in the metric over time. Efficiency of operations in a monopoly environment may be of limited value in addressing credit quality, but given the trend toward competitive based regulatory systems, a project's ability to minimize cost and to provide higher value added services will improve credit strength.
Marketing
Standard & Poor's analyzes how the project will maximize revenues while minimizing bad debt, fraud, and churn rates. This analysis includes an examination of the experience of marketing management in delivering the project services given the resources available to them. The analysis will attempt to answer questions such as, how will the product be marketed, by an in-house sales force, agents, or resellers? How will credit be checked? Inadequate credit qualifications are a major cause of bad debt and associated churn. Is the bad debt policy aggressive enough to close the accounts within a reasonable timeframe? Standard & Poor's has seen operators take major write-offs for bad debts within the first year or two of operation due to improper bad debt policies.
For those projects offering wireless services, a track record is vital to attain mid to high speculative-grade credit profiles. This experience can be gained simply over time or by joining with an experienced partner. Standard & Poor's has given at least one extra notch to a rating where the operator or its partner had operational experience.
Financial performance
Standard & Poor's reviews the project's financial projections, gauges the validity of key assumptions, examines financial robustness under stress scenarios, and may perform liquidity analysis. Standard & Poor's generally focuses on a cash basis, that is, it will assess the project's ability to pay debt based on operating cash. In appropriate cases, EBITDA measures are used.
Stress conditions are tailored for each project, but in general might include:
? An increase in operating costs;
? A decline in sales volumes;
? A decline in product prices;
? Loss of market share;
? Operation at less than base case capacity;
? Foreign exchange rates; and
? A combined downside case.
Standard & Poor's has established general debt service coverage ratio (DSCR) levels that project financings must demonstrate to achieve certain rating levels, but telecom industry trends of uncertain regulatory risk, competition, and price trends make such benchmarks harder to establish. Standard & Poor's expects that DSCR forecasts will need to be supplemented with additional analyses to gauge a project's financial merits.
Standard & Poor's determines if the project's debt amortization schedule matches potential risk presented to lenders over the debt tenor. Given the rapidly changing nature of competition and technology, Standard & Poor's believes that telecom projects can reduce their risk profiles by quickly amortizing debt.
Structural and legal issues
A project's transaction structure is important because it can provide the project with certain limited cash flow protection as well as a short-term safety net when difficulties arise.
Although legal and structural provisions alone cannot protect against inherent operating and financial performance weakness, an otherwise strong project may be rated lower due to legal and structural vulnerability of the transaction. Most telecom projects have no approachable cash flows until nearing completion and operation, whereupon revenues can be earned. Legal and security provisions need to be structured accordingly ? limiting flexibility in the development and construction phase and yet providing the project with appropriate flexibility over the long term.
The security package provided for lenders should include perfected, first priority interests in all material project assets, contracts, permits, licenses, and ownership interests. In the US and in many other countries, the inability to perfect a lien on telecom licenses creates a problem when structuring the security provisions. Transactions are viewed more favorably from a credit perspective when a license is closely bound to the investor's security package.
Cross-border issues
Standard & Poor's assesses the project's exposure to sovereign and foreign currency risks. Sovereign risks include potential activities of the host government that could affect the project's ability to operate and service debt, through exchange controls, changes in the operating and fiscal regime for the sector, and expropriation of assets. Projects issuing cross-border debt are usually limited to Standard & Poor's long-term foreign currency sovereign credit rating on the country where revenues are earned. Projects can achieve ratings higher than the sovereign in special cases where the product is strategic to the government, domestic demand is low, buyers are limited, and payment is made in hard currency. Most telecom projects lack these features.
Outlook for telecoms project finance
Many of the telecom transactions that Standard & Poor's has rated are start-up companies that employ non-recourse debt, have uncertain cash flow and high debt burdens, and may lack strong structural protections. As such, these transactions often have highly speculative credit profiles and are initially rated in the single ?B' category. Over time, a project can potentially improve its credit rating as it as completes buildout, gains market share, and demonstrates sustainable positive earnings.
To gain an initial rating in the ?BB' category, a project will generally have to quickly establish a revenue base with modest debt burdens, operate under a favorable regulatory regime, to maintain long-term competitiveness, and may require implied support from a strong, highly creditworthy parent. In addition, the project would require a much stronger structural makeup than is seen for most ?B' rated credit quality transactions, including limits on asset composition, activities, debt, and distributions.
It will prove a challenge for most telecom projects to obtain initial ratings in the investment-grade category without financial guarantees from investment-grade rated parents, solid structural features, and robust projected cash flows.
Contact
Terry A. Pratt, Director, Corporate and Government Ratings, New York (212) 438-2080, e-mail terry_pratt@standardandpoors.com
Richard C. Siderman, Managing Director, Corporate and Government Ratings, New York (212) 438-7863, e-mail richard_siderman@standardandpoors.com
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