May 12, 2017 / 5:24 PM / 2 months ago

Fitch Affirms Solocal at 'B-'; Revises Outlook to Stable

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(The following statement was released by the rating agency) LONDON, May 12 (Fitch) Fitch Ratings has affirmed Solocal Group's Long-Term Issuer Default Rating (IDR) at 'B-' and the senior secured bond rating at 'B'/'RR3'. The Outlook is revised to Stable from Negative. The Long-Term IDR of 'B-' reflects the evolving business profile of the group with some competitive advantages, low monetisation, robust growth prospects in digital advertising and high operating leverage of the business. The rating case firmly assumes that management will achieve growth in terms of customer numbers and recurring EBITDA in the internet business. The group remains vulnerable to technical innovation across the web, competitive pressures in the industry and a turn in the cycle. KEY RATING DRIVERS Some Competitive Advantages: Solocal is able to update customers' data and content across the web in real time. Through its own media (59% audience reach) and mobile apps (47 million installed on handsets), Solocal can use cookies on desktops and broader functionality embedded into the apps to gather big data that provides a competitive edge to its online marketing business. Also, a lot of smaller businesses may not want to employ an advertising agency but are happy to discuss cheaper, local choices of digital advertising with their internet support provider. These are the products that cannot be easily replicated by competitors. Low Audience Monetisation: The value to customers is less obvious than for a market-leading online classified business. Therefore, the product offering requires more explaining and a bigger sales effort. Also, the average product value marketed by Solocal's clients is much lower than real estate in the case of rightmove or cars in the case of AutoTrader. Hence, the group's customers are more price-sensitive. While average revenue per advertiser (ARPA) is not calculated on a fully comparable basis (EUR84 for Solocal, GBP842 for rightmove, GBP1,526 for AutoTrader; all quoted per month), looking at revenues and cash flow generation of the three players reveals that Solocal has substantially lower monetisation. Robust Growth Prospects for Digital Advertising: Currently, 24% of Solocal's customers make use of the digital marketing products. Management is keen to increase penetration and capitalise on this cross-selling opportunity, where the group has proprietary data that allows it to profile internet users and, as a result, better target advertising to the right audience. Market commentators forecast growth for this market in France of around 10% per annum to 2020. This business is expected to deliver solid earnings growth (from a relatively small base). One should bear in mind that advertising revenues are cyclical and have high correlation with GDP. High Operating Leverage: Solocal reported headcount of 4,386 and staff expenses of EUR368.5 million (representing 45% of turnover) for 2016. The sales force alone comprises around 2,000 people. For an internet company, this represents a very high fixed-cost base. As a result, there is a concern that earnings could weaken quickly if: i) any product areas were affected by technological innovation across the web; ii) Solocal saw mounting competitive pressures due to new entrants or consolidation moves; or iii) economic conditions weakened (not expected in the near term). In order to make the business more resilient, management would have to evolve the business model to be more scalable (not only towards growth but also towards possible contraction). Prospect of Industry Consolidation: The internet business is very fragmented. In most cases, growth is key to develop meaningful earnings. Currently, there are too many players in a lot of the segments in which Solocal is active, limiting income for everyone. Consolidation would make a lot of sense to improve economies of scale and gain pricing power. The market participants that do not manage to participate in this process could be left behind and become less relevant. We note that there are internet companies out there that are better capitalised than Solocal. Validation of Business Plan Required: Assessing the business plan, Fitch has concluded that management has the means at its disposal to manage future refinancing risk, particularly if the group amortises part of the debt ahead of the maturity in 2022. As a result, a Long-Term IDR of 'B-' with a Stable Outlook is warranted. Our rating case reflects growth in terms of customer numbers and recurring EBITDA from the internet business. If management fails to deliver on these points, the business may become less relevant and Fitch may question the business model. DERIVATION SUMMARY Solocal Group offers a broad range of services to enhance customers' visibility on the web. This starts with creating and maintaining websites and their content, achieving better rankings on search engines (increasingly with a geographical focus), placing advertising links with the target audience, and offering transactional tools to complete bookings and payments. The group generates traffic from its own media platforms, including PagesJaunes and Mappy, as well as through partnerships with international players, including Google and Apple. Solocal's operations demonstrate weaker monetisation of audience reach and structurally higher costs than market-leading online classified businesses such as rightmove and AutoTrader. We consider that the current business profile limits Solocal Group to a 'B' category rating, while the online classified businesses with number-one or -two positions in their local markets can achieve 'BB' category ratings, assuming in both cases very little debt funding. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - 2017 EBITDA in the range of EUR210 million-215 million and mid-single digit growth in 2018; - an effective tax rate of 45% for purposes of the income statement, of which 85% is assumed to translate into cash tax; - restructuring cost that may be qualified as recurring and utilisation of provisions of around EUR15 million per annum; - these items are included in "Other Items Before FFO" in Fitch's presentation of the cash flow statement; - working-capital outflows of on average EUR5 million per annum; - EUR75 million of capital expenditure per annum over the medium term - note that this is a Fitch assumption; the company's guidance is for EUR60 million of capital expenditure per annum; - EUR37 million of non-operating/non-recurring cash-flow expenditure in 2017 (including costs related to the financial restructuring of EUR28 million), reflecting the group's communication regarding pro forma net debt as at end-December 2016 of EUR344 million, implying a reduction of cash balances of EUR37 million; - use of free cash flow to build up a cash balance that is under all circumstances sufficient to safeguard liquidity and pursue additional capital expenditure/growth opportunities (mostly of an organic nature); - no dividends over the rating horizon. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action - Above-market growth in the local search business with a visibly improving market position; - FFO adjusted gross leverage below 1.5x (forecast for FY17: 3.3x); - Material reduction in operating leverage. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action - Further declines in customer number and recurring EBITDA from the internet business; - Lack of growth momentum in the digital business over the next 24 months; - Free cash flow margin falling below 5% on a sustained basis; - Failure to maintain cost discipline across the organisation; - Weakening liquidity due to either operational issues or corporate activity; - Failure to make voluntary debt repayments over the five-year tenor of the reinstated bonds. LIQUIDITY Adequate Liquidity: Following completion of the debt restructuring, the group holds around EUR60 million of cash and is expected to generate positive free cash flow on an ongoing basis. Contact: Principal Analyst Peter Wormald Analyst +44 20 3530 1357 Supervisory Analyst Oliver Schuh Director +44 20 3530 1263 Fitch Ratings Ltd 30 North Colonnade London E14 5GN Committee Chairperson Paul Lund Senior Director +44 20 3530 1244 Summary of Financial Statement Adjustments - Operating leases were capitalised at 8x, in line with French jurisdiction. - Non-recurring items were stripped out in order to arrive at Fitch Operating EBITDA. - In the cash-flow statement, non-recurring items were moved out of Cash Flow from Operations (Fitch defined) and into Total Non-Operating/Non-Recurring Cash Flow, essentially requalifying them from operating to investment activity. - The debt was recorded at notional value, ignoring the issue premium. 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