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Rating Action:

MOODY'S DOWNGRADES THE A2 SENIOR UNSECURED DEBT RATING OF VERIZON NEW YORK TO Baa2

20 Apr 2004
MOODY'S DOWNGRADES THE A2 SENIOR UNSECURED DEBT RATING OF VERIZON NEW YORK TO Baa2

APPROXIMATELY $3.1 BILLION IN DEBT AFFECTED

New York, April 20, 2004 -- Moody's Investors Service downgraded Verizon New York's ("VZ-NY" or the "company") senior unsecured debt rating to Baa2 from A2. The ratings outlook is stable. This action concludes the review for downgrade that began on October 27, 2003.

The downgrade reflects Moody's belief that: 1) rapidly expanding competition, particularly from cable MSOs will increasingly erode the free cash flow generating capacity of the company's traditional wireline operations; 2) UNE-P rate hikes and/or price increases, if implemented, are unlikely to stem inherently strong competitive pressures in the medium term; 3) VZ-NY faces regulatory strain stemming from its failure to meet requisite service quality standards; 4) VZ-NY has a largely static cost structure, which impedes cost reduction efforts; and 5) VZ-NY's credit metrics will remain weak for at least the next few years.

VZ-NY faces rapidly expanding competition in its service areas from cable MSOs (e.g. Cablevision, Time Warner) who, because of their relatively deep relationships with consumers, are a formidable threat. VZ-NY derives roughly two-thirds of its revenues from consumers. In addition, technology substitution (e.g. e-mail, instant messaging, wireless telephony), and CLECs using both UNE and facilities-based competition will exacerbate access line losses, and revenue and cash flow declines.

While the company has actively lobbied for both retail (basic exchange) rate and UNE-P line price increases, Moody's believes that such rate relief, if implemented, would be fleeting, and that competitive pressures would negate potential longer-term benefits. However, a UNE-P price increase could encourage facilities-based competition.

VZ-NY faces significant regulatory exposure as the New York State Public Service Commission (NYSPSC) set rates, including those by which the company leases portions of its networks to competitors (i.e. UNE-P and UNE-L) and monitors service quality. Because of poor service quality, (VZ-NY has missed two out five service quality standards), the NYSPSC suspended pricing flexibility in May 2003. This constraint, if not reversed, will further hinder the company's ability to compete effectively. Additionally, the NYSPSC may fine VZ-NY $40 million (refundable to those customers impacted by poor service quality) pursuant to its failure to meet all five quality standards.

A largely static labor cost structure characterizes the company's New York market. Union arbitration agreements prevent VZ-NY from reducing workforce levels quickly and achieving meaningful cost efficiencies. Unions have the right to challenge layoffs through the contractual arbitration process under the labor contracts. In July 2003, an arbitrator ordered the company to re-hire 2,300 employees that had been previously eliminated. We also note that while wage rates in New York remain high, the company has had some success reducing wage costs through targeted headcount reductions (primarily, incentivized early retirement packages), increasing repair and installation dispatch productivity, and reducing field technician overtime. We expect these cost reduction activities to continue throughout 2004 and 2005.

The company's credit metrics have deteriorated rapidly over the past several years, as a result of access line losses and a relatively high cost structure. From 2001 through 2003, access lines declined an average 4.2% per year, while revenues declined 4.5% per year. EBITDA margins have gone from well over 35% in 2002 to just under 23% in 2003 (as adjusted for non-recurring charges). Interest coverage has declined from 7.7x in 2002 to 4.8x in 2003 while total leverage (total debt to EBITDA) has increased from 2.4x to 3.6x over the same period. Improvements in these metrics will be slow and challenging. Moody's believes that the company's ability to generate material free cash flow over the next few years is quite limited amid declining operating cash flow and a limited ability to reduce capital spending further, given increasing competition from cable MSOs and service quality issues.

The rating also recognizes that the company may divest non-performing assets and utilize the proceeds to reduce external debt, which is currently $3.1 billion and represents about one-half of total company debt. Debt due to affiliates (i.e. intra-company debt) is about $3 billion. We also expect that over the next few years, the company will be substituting external debt for intra-company debt -- a modest credit positive all other things being equal.

We recognize that VZ-NY has strengthened its balance sheet somewhat over the last year. Moody's notes that during 2003, the company reduced net debt by roughly $450 million though they accomplished much of this via capex cuts (about $367 million). Moody's believes that VZ-NY's future capital expenditures will be on par with that recorded in 2003, though it may actually increase as a percentage of revenues, and will be used to address network quality issues, and for stepped-up broadband, data and enterprise investment in response to increasing competition and recovering business demand.

Moody's acknowledges the steps the company has taken to preserve cash flow by cutting its dividend to the parent, Verizon Communications. We also anticipate that the company will significantly reduce, or eliminate, its dividend to Verizon Communications as a means of sustaining positive free cash flow. Free cash flow for 2003 was $284 million. Given the likelihood that revenues will continue to slide because of access line losses (not giving effect for material regulatory relief) and that much of the company's cost structure is fixed, we expect free cash flow to be lower in 2004 -- despite anticipated dividend cuts.

The stable outlook reflects our view that: 1) competition will exacerbate; 2) any regulatory relief is likely to be short-lived; and 3) the company's ability to control its costs may be limited; however we do not believe such issues will be sufficient to impact the Baa2 rating over the next twelve to eighteen months. Moody's also expects that Verizon Communications will support VZ-NY's balance sheet via dividends cuts, and the replacement of external debt with intra-company subordinated debt.

Verizon New York, one of Verizon Communications' sixteen local telephone operating companies, provides local and long distance service by means of 11.2 million access lines in New York as well as a small portion of Connecticut.

Verizon New York's parent, Verizon Communications (A2, senior unsecured), provides domestic and international wireline and wireless communications services and is headquartered in New York, NY.

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

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

No Related Data.
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