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Rating Action:

Moody's changes PAETEC's rating outlook to Negative, downgrades liquidity rating to SGL2

Global Credit Research - 13 Sep 2010

Moody's places Cavalier Telephone Ratings Under Review for Possible Upgrade

New York, September 13, 2010 -- Moody's Investors Service changed the rating outlook on PAETEC Holding Corp.'s ("PAETEC") debt to negative from stable reflecting concerns about execution risk related to integration of the historically underperforming operations of Cavalier Telephone Corporation ("Cavalier"), which PAETEC has agreed to acquire for $460 million in cash. In addition, Moody's downgraded PAETEC's short term liquidity rating to SGL-2 from SGL-1, reflecting the moderately worsening proforma liquidity profile as PAETEC devotes its cash resources to integrate and turn around the Cavalier operations.

At the same time, Moody's has placed the debt of CavTel Holdings, an indirect wholly-owned subsidiary of Cavalier, on review for possible upgrade. The review for upgrade incorporates the benefits of PAETEC's stronger credit profile and the high perceived likelihood that the transaction will be completed as planned. The proposed transaction incorporates an expectation that Cavalier's existing rated debt will be repaid by PAETEC upon completion, after which Moody's anticipates it would raise Cavalier's debt ratings to at least the senior unsecured-equivalent level of PAETEC and immediately thereafter withdraw its ratings for Cavalier. Moody's notes that Cavalier will seek a waiver of potential covenant defaults under its credit agreement for the period between 3Q 2010 and closing of the transaction, for which we would expect the bank group to be accommodating.

PAETEC's B2 corporate family rating and the negative rating outlook reflect the Company's high leverage for its rating category and modest free cash flow, compounded by the challenge to turn around and integrate the acquired Cavalier properties amid the revenue declines at Cavalier's non-fiber businesses. The rating also reflects Moody's view that the operating environment for competitive local exchange carriers ("CLECs") will likely continue to be difficult. Moody's notes that PAETEC's revenues have stabilized after declining over the past 24 months as the economy is showing signs of a slow recovery. Moody's remains concerned, however, about the pace of the recovery and the relative softness in the company's Midwest markets in particular will challenge the Company's ability to grow revenues and delever over the next 12-18 months. Ratings continue to be supported, nonetheless, by PAETEC's operating scale as, proforma for the Cavalier acquisition, it will become the largest CLECs operator in the US, and benefits from the potential for the Company to drive its cost structure lower by migrating traffic onto its expanding fiber network and provide a platform for greater product diversity by utilizing its long-haul and metro fiber assets.

Proforma for the acquisition, we believe PAETEC's Moody's adjusted Debt/EBITDA leverage will rise to about 4.2x, from 4.1x at 6/30/10. These leverage levels are notably above the downgrade triggers previously indicated by Moody's, and the integration of Cavalier and the resulting synergies will likely take some time to take effect, especially in light of the ongoing turnaround of the operations put in place by Cavalier's management team. Both of the aforementioned factors contribute to the outlook revision to a negative bias.

Although PAETEC has been successful in integrating several CLECs in the past, the results achieved in the most recent McLeod USA acquisition took longer than expected. The challenge at Cavalier will be magnified by its higher concentration of residential and small business customers, relative to the core PAETEC target companies, which historically have been larger enterprises with 100 or more lines. Still, Moody's expects PAETEC to benefit from Cavalier's deep fiber network in the Northeast and Mid-Atlantic, as it stands to reduce its operating expense by moving more traffic onto its own network and colocation facilities.

The downgrade of PAETEC's liquidity rating to SGL-2 from SGL-1 reflects Moody's view that it should maintain good liquidity over the coming 12 months, as some of the company's liquidity will be utilized to integrate Cavalier. Moody's believes that proforma for the acquisition, PAETEC will have about $80 million in cash, which is down from the company's $124 million cash balance at 6/30/10, and expects PAETEC to have full access to its $50 million revolver. PAETEC's revolving credit facility includes a consolidated total net leverage covenant test set at 5.0x for the life of the credit facility. Based on Moody's expectations of the Company's operating performance, we estimate PAETEC has ample headroom under the leverage covenant. The Company's credit agreement includes an excess cash sweep requirement if leverage exceeds 2.5x. Although PAETEC has currently suspended selling wholesale fiber capacity, except in cases when it generates network revenues from customers, it could resume the fiber sales which could provide an alternative source of liquidity in times of stress.

Moody's could stabilize the rating outlook if PAETEC demonstrates progress in achieving targeted cost synergies and delivers stable revenue performance, such that its adjusted Debt/EBITDA leverage trends below 4.0x.

Downward rating pressure could develop if the company does not show improvement in its operating performance and adjusted Debt/EBITDA leverage remains elevated above 4.0x by year-end 2011 and there is an ongoing deterioration in free cash flow generation. Ratings could also come under pressure if changes in the competitive and/or regulatory environment threaten PAETEC's ability to sustain its EBITDA margins at current levels.

Upward rating consideration could be warranted if the Company maintains Debt-to-EBITDA leverage below 2.5x, either through better-than-expected operating performance or from debt reduction, and free cash flow-to-debt exceeds 10% on a sustainable basis. Ratings and/or the rating outlook may be revisited if competitive and regulatory dynamics lead to a greater degree of stability in the competitive telecommunications industry that could be driven by continuing consolidation. As a result, Moody's will look for signs of firmness in pricing terms, improving financial metrics, solid liquidity position, stability of cash flows, diminishing capital expenditures and growth through prudent acquisitions.

Moody's most recent rating action on PAETEC was on January 6, 2010 when Moody's assigned a B1 rating to the PAETEC's senior secured note issuance.

Moody's most recent rating action on CavTel Holdings LLC was on August 28, 2009 when Moody's downgraded CavTel, LLC's Corporate Family Rating to Caa2 and the Probability of Default Rating to Caa3, reflecting the rating agency's view of a heightened risk of default, as covenants in the company's senior secured credit facility were set to revert to original levels at the end of 2010.

The principal methodology used in rating PAETEC and Cavalier was Moody's Global Telecommunications Industry Methodology, published in December 2007 and available on www.moodys.com in the Rating Methodologies sub-directory under the Research & Ratings tab. Other methodologies and factors that may have been considered in the process of rating this issuer can also be found in the Rating Methodologies sub-directory on Moody's website.

PAETEC is a CLEC headquartered in Fairport, NY. The company generated nearly $1.6 billion in revenues in 2009.

Richmond, Virginia based Cavalier is a competitive local exchange carrier, which generated over $400 million in revenues in 2009.

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Please see ratings tab on the issuer/entity page on Moodys.com for the last rating action and the rating history.

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New York
Gerald Granovsky
VP - Senior Credit Officer
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

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

Moody's Investors Service
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Moody's changes PAETEC's rating outlook to Negative, downgrades liquidity rating to SGL2
No Related Data.
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