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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
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
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
MOODY'S adopts all necessary measures so that the information it uses
in assigning a credit rating is of sufficient quality and from sources
MOODY'S considers to be reliable including, when appropriate,
independent third-party sources. However, MOODY'S
is not an auditor and cannot in every instance independently verify or
validate information received in the rating process.
Please see ratings tab on the issuer/entity page on Moodys.com
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The date on which some Credit Ratings were first released goes back to
a time before Moody's Investors Service's Credit Ratings were fully digitized
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Investors Service provides a date that it believes is the most reliable
and accurate based on the information that is available to it.
Please see the ratings disclosure page on our website www.moodys.com
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Please see the Credit Policy page on Moodys.com for the methodologies
used in determining ratings, further information on the meaning
of each rating category and the definition of default and recovery.
VP - Senior Credit Officer
Corporate Finance Group
Moody's Investors Service
Senior Vice President
Corporate Finance Group
Moody's Investors Service
Moody's Investors Service
Moody's changes PAETEC's rating outlook to Negative, downgrades liquidity rating to SGL2
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