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Rating Action:

MOODY'S ASSIGNS A B1 SR IMPLIED RATING TO HAWAII TELCOM AND DOWNGRADES VERIZON HAWAII'S SR UNSEC NOTES TO B1. THE RATING OUTLOOK IS STABLE.

14 Apr 2005
MOODY'S ASSIGNS A B1 SR IMPLIED RATING TO HAWAII TELCOM AND DOWNGRADES VERIZON HAWAII'S SR UNSEC NOTES TO B1. THE RATING OUTLOOK IS STABLE.

Approximately $1.425 billion in debt affected.

New York, April 14, 2005 -- Moody's Investors Services assigned a B1 senior implied rating to Hawaiian Telcom Communications, Inc ("HI-Telco" or "the company"), a B1 to its proposed senior secured debt, a B3 to its proposed senior unsecured notes, and a Caa1 to its proposed senior subordinated notes. Moody's has downgraded the senior unsecured notes of Verizon Hawaii, to B1 from Baa1. Hawaiian Telcom, Inc, a wholly owned wireline operating subsidiary of HI-Telco, will assume these notes as part of the transaction. This action concludes Moody's rating review of Verizon Hawaii that was initiated on May 24, 2004, when The Carlyle Group announced it was undertaking a leveraged buyout (LBO) of Verizon Hawaii ("the transaction"). The rating outlook is stable.

Moody's has assigned the following ratings, as part of this rating action:

Hawaiian Telcom Communications, Inc.

Senior Implied -- B1

$175 million senior secured revolving credit facility -- B1

$300 million senior secured delayed draw term loan A -- B1

$400 million senior secured term loan B -- B1

$300 million senior unsecured notes due in 2013 -- B3

$250 million senior subordinated notes due in 2015 -- Caa1

Moody's also downgraded the following senior notes previously issued by Verizon Hawaii:

$150 million 7 3/8% senior notes due in 2006 to B1 from Baa1

$150 million 7% senior notes due in 2006 to B1 from Baa1

HI-Telco's B1 senior implied rating reflects high leverage and the significant business risk associated with the implementation of a new back office system, limited liquidity, and an increasingly competitive market place. Moody's also recognizes the inherit risk associated with the company's plans to improve margins while actively pursuing new product development. The senior implied rating is constrained by the company's operating margins, which are somewhat lower than comparable telecommunications companies.

As a result of the leveraged buyout (LBO) and investment necessary to establish new operating support systems, Moody's expects coverage metrics to be quite weak, especially in 2005 and 2006. Moody's is concerned that much higher fixed interest costs may limit HI-Telco's resources to respond to expanding challenges and to pursue growth opportunities, and could constrain the company's ability to withstand unexpected shortfalls as it builds out its new systems.

HI-Telco will lose access to Verizon's back office functions as a result of the LBO. While HI-Telco and Verizon have negotiated a nine-month Transition Service Agreement (TSA), with an optional 6-month extension, the scope of this substantial undertaking is fraught with operational risk. Moody's is concerned that the company's limited liquidity could quickly evaporate in the event that HI-Telco needs to extend the TSA beyond the 15-month optional contract life, or should competition expand faster than expected.

Limited liquidity also weakens the company's financial profile. At peak borrowing, Moody's rating anticipates that the company will have $40 million available under its revolving credit facility to fund any unexpected cost overruns.

HI-Telco has experienced 3.3% access line erosion in 2003 and 2004, mostly because of technology and wireless substitution. Cable competition is imminent and the primary cable provider in Hawaii has already made very significant inroads in residential high speed data with its cable modem product. HI-Telco's largest enterprise customers are particularly attractive to competition from other facility-based service providers because of the high geographical density, although the remoteness of its service territory somewhat limits the number of potential competitors.

The company's strong management team and ability to generate strong operating cash flow support the rating. Moody's estimates that HI-Telco will generate approximately $155 million a year in cash flow from operations beginning in 2006, after spending over $80 million to develop back office systems in 2005. The rating also assumes that the company will use free cash flow in 2006 to begin to meaningfully reduce leverage and improve liquidity.

The extensive experience and good track record of the operating management team and the involvement of prominent local investors also support the ratings. The financial sponsors have presented a comprehensive operational plan to drive revenue and earnings growth. The plan includes adding local focus to the company's marketing strategy, expanding product offerings to include branded wireless services, growing DSL penetration, expanding market coverage of small businesses, and significantly improving the overall cost structure. Moody's believes that these factors, coupled with the eventual cost and strategic benefits from an entirely new back office system, offer significant potential to offset access line decline and improve margins. The company benefits from a unique ability to bundle branded services. As the incumbent with 92% market share, HI-Telco will be able to offer local, long distance, data, and wireless services under the same brand. In addition, the rating incorporates the financial protection afforded by the restriction on the company's ability to pay dividends until debt falls to 65% of capitalization, per the Hawaiian PUC order. The rating assumes that The Carlyle Group will contribute as least $425 million to the venture at closing in the form of common stock.

Moody's senior implied rating also assumes that the company will be able to switch to its own back office systems within nine months of closing, and as a result, improve its EBITDA margins to at least 35% over the intermediate term. The B1 rating also incorporates Moody's assumption that the company will use free cash flow to substantially reduce leverage, over the next several years.

The rating outlook for HI-Telco is stable. The stable rating outlook reflects Moody's belief that the company's strategic plans to pursue greater LD and DSL penetration and add branded wireless services to its product bundle should provide sufficient growth opportunities to offset the negative impact of traditional wireline access line loss.

Extending the TSA beyond nine months will not only increase costs and impede the company's ability to reduce leverage, but will also delay the company's ability to market bundled services. The failure to implement a complete and fully-functioning back-office system by the TSA termination date will likely lead to a rating downgrade. The ratings are likely to improve if: 1) the successful implementation of a back office system results in significant margin improvement, 2) the wireless strategy drives revenue and earnings growth, and 3) the company uses free cash flow to reduce leverage such that free cash flow exceeds 15% of adjusted debt.

HI-Telco's liquidity is adequate at best. The wireline segment produces strong operating cash flow, which we believe is sufficient to fund the increased interest burden associated with the LBO and maintenance capital expenditures. To supplement its liquidity, the company will enter into a $175 million revolving credit facility that will mature in 2012. Although the company is still finalizing the terms of the facility, Moody's assumes that the covenants will be set at a level such that the company will be fully able to access the facility despite potential operational shortfalls or unforeseen capital needs. Moody's expects the company to draw $135 million under the revolver to finance its back office buildout. Upon completion of this investment, Moody's expects the company to quickly reduce debt through operating cash flow and restore the availability under the facility. In the meantime, Moody's is concerned that the $40 million peak revolver availability only provides a modest cushion, should the back office buildout prove to be significantly more expensive than anticipated, particularly given cost escalation clauses in the transition services agreement with Verizon.

The Carlyle Group will issue the new LBO-related debt at HI-Telco, an intermediate holding company. Both the parent company and the operating companies will guarantee each class of debt on a basis consistent with its effective seniority. Secured debt will benefit from secured guarantees in the same way subordinated debt will benefit from subordinated guarantees. Moody's expects that the guarantees will unconditionally cover both interest and principal on a joint-and-several basis.

Also as part of the transaction, Hawaiian Telcom, Inc., the wireline operating subsidiary, will assume the existing Verizon Hawaii debt. Moody's notes that the indenture governing this debt includes a negative pledge that covers the issuance of secured debt. In the event that the obligor provides security, the holder of these notes will also benefit from the same security package. Moody's expects that post-LBO these notes will rank pari passu with all other secured debt in the capital structure.

Moody's does not notch the senior secured debt at the Parent company, nor the Verizon Hawaii-assumed debt, above the senior implied rating. Secured debt, measured in its totality ($400 million term loan, $300 million existing Verizon Hawaii bonds, and $135 million anticipated revolver borrowings), will comprise about 60% of total debt. This constitutes risk that is substantially the same as that of the company as a whole, and therefore is rated at the senior implied level. Moody's rates the senior unsecured and senior subordinated debt two and three notches below the senior implied rating, respectively, to reflect their effective subordination.

Verizon Hawaii, a wholly owned subsidiary of Verizon Communications, Inc., is an incumbent telecommunication service provider servicing approximately 690K access lines. Moody's expects Hawaiian Telcom Communication, Inc. to acquire Verizon Hawaii through an LBO sponsored by The Carlyle Group. The new company will be headquartered in Honolulu, Hawaii.

New York
Dennis Saputo
Senior Vice President
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Julia Turner
Managing Director
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

No Related Data.
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