Ratings

The corporate credit rating (i.e., the default risk rating) on Charter Communications Inc. (CCC+/Negative/--) is indicative of a relatively high probability of default. However, our detailed transaction-specific recovery analysis (see "Recovery Report: Charter Communications' Senior Secured Financing," published April 12, 2006 on RatingsDirect) determined that Charter's proposed $5.3 billion senior secured bank financing has excellent recovery prospects despite the low speculative-grade credit rating on the company. Not only did we assign a 'B' bank loan rating and a recovery rating of '1' (indicating a high expectation for full recovery of principal in the event of a payment default) to the borrower's loans, we also applied a 'B-' senior secured debt rating and a recovery rating of '1' to Charter's second-lien notes maturing in 2012 and 2014.

It is important to bear in mind that, while Charter's corporate structure is relatively complex, with debt at several intermediate holding companies, the bank debt borrower is Charter Communications Operating LLC, the direct parent of all of the material operating companies. The bank debt borrower is also a co-borrower of the second-lien notes, along with Charter Communications Operating Capital Corp. Therefore, while the parent company may have greater-than-average prospects for default, the bank debt and second-lien notes are structurally senior to almost all of Charter's remaining debt.

This structural seniority, particularly when combined with the upstream subsidiary guarantees and the pledged subsidiary collateral, offers lenders the prospect of recovery associated with senior secured debt. But structural analysis, while allowing us to appreciate how value would most likely be distributed among claimants given a default, is only part of the recovery equation.

In all of our recovery reports, we strive to detail the assumptions comprising our simulated default scenarios. These scenarios, in turn, enable us to have an opinion on borrower valuation that is unique to that borrower and to that specific simulated default scenario. In short, we believe that value results from our opinions regarding the timing and path to default. We do not expect value on a multiples or unit basis to be identical from one borrower to the next. In other words, two comparable firms within the same industry sector may have very different valuations depending on when and how we believe each firm might default.

The simulated default scenario for Charter contemplated a default in the near future and was primarily based on increased costs and marginal subscriber erosion. The default scenario was not based on general deterioration of the borrower's business or products. Nor was the simulated default grounded in a fundamental shift of the borrower's technology or a monumental change in the competitive landscape, though each of these two factors are potentially viable contributors to default. (Were we considering a simulated default scenario with a much longer time horizon, these other factors may have played a larger role.)

Consistent with the 'CCC+' corporate credit rating, Charter does not need to experience a substantial decline in unleveraged free cash flow before it reaches a point of payment default. Our default scenario contemplates the borrower reaching insolvency in 2007, when projected available funds plus free cash flow of $2.11 billion are insufficient to meet projected fixed charges of $2.16 million (the erosion of revolver availability due to prior-year drawdowns required to pay interest is a fundamental contributor to insolvency).

Given this scenario, along with our expectation that Charter would emerge from insolvency with its business model relatively unchanged, but with an improved capital structure, our discounted cash flow analysis (assuming a 2% perpetual growth rate) resulted in an expected emergence value of approximately $12.3 billion. This enterprise valuation roughly equated to a 7.2x emergence EBITDA multiple. Given a different scenario applied to a different borrower, the resultant enterprise value, market multiple, or unit value might have been different.

As market and credit conditions are dynamic, so too are the factors affecting both the simulated path to default and enterprise value. Therefore, a significant benefit of our recovery analysis is our ability to monitor the dynamic factors affecting recovery prospects and adjust our recovery expectations on the basis of these factors. For example, six months from now, growth rates and market multiples could decline substantially. If such a trend continued, we would most likely revise our valuation to reflect the market direction.