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Fitch Corrects Telefonica September 2016 Commentary
March 10, 2017 / 5:10 PM / 6 months ago

Fitch Corrects Telefonica September 2016 Commentary

(The following statement was released by the rating agency) LONDON, March 10 (Fitch) This commentary replaces the version published on 5 September 2016 to include the senior unsecured notes issued by Telefonica Participaciones, S.A.U in the full list of rating actions. There is no change to Telefonica SA's Long-Term Issuer Default Rating and senior unsecured rating of 'BBB/Stable'. The original rating action commentary with the correction is presented below. Fitch Ratings has downgraded Telefonica SA's Long-Term Issuer Default Rating (IDR) and senior unsecured rating to 'BBB' from 'BBB+'. The Outlook on the IDR is Stable. A full list of rating actions is available below. The rating downgrade reflects expectations that Telefonica is unlikely to reduce leverage on an organic basis during 2016 as we originally envisaged. This is due to higher-than-expected pressure on funds from operations (FFO) resulting from a combination of restructuring charges, FX depreciation and weaker performance in the group's Hispam division. We now expect FFO-adjusted net leverage is likely to peak end-2016 at 3.9x, or 0.4x higher than our previous forecast, before declining to 3.5x by 2018 as a result of growth in organic free cashflow. This leverage profile is more consistent with a 'BBB' rating. Fitch is also adjusting the rating sensitivity measures it applies to Telefonica to reflect the company's increased exposure to countries with a non-investment-grade rating. The increase has primarily been driven by the successive downgrades to Brazil's sovereign rating by Fitch over the past six months. The change implements tighter leverage metric thresholds that aim to maintain comparability of the company's rating with other diversified western European telecoms operators. The Stable Outlook reflects Telefonica's commitment to its medium-term leverage target and the strong competitive position of its operating subsidiaries. KEY RATING DRIVERS Well-Positioned Operating Subsidiaries Telefonica's ratings are supported by a portfolio of assets that are competitively well positioned and geographically well diversified across Europe and Latin America. The operator has a leading domestic market position, which drove about 47% of group operating free cash flow (EBITDA less capex on an underlying basis) in 2015. The Spanish operations underpin Telefonica's ratings and recent consolidation has improved market structure while the company's investments in network, content and bundled products sustain its competitive capability. Higher-Than-Expected Leverage Telefonica's 1H16 results indicate higher-than-expected pressure on FFO from three principal areas. Firstly, EUR650m-EUR700m annual cash restructuring costs in Spain over three years. These costs reduce Fitch's forecast 2016 operating free cash flow (FCF) by 9%. Secondly, adverse currency movements in Brazil and Hispam has led to a 10% fall in group organic EBITDA during 1H16 or EUR836m (based on Telefonica's reporting). We expect pressure from adverse currency movements in Latin America to improve during 2H16 however, this still represents a drag to our original 2016 estimates. Thirdly, competitive, regulatory and commercial cost pressures in Hispam. While the Hispam division continues to outperform its main competitors, the cost pressures have led to a contraction of 2.5 percentage points yoy in Hispam's 1H16 organic EBITDA margin. As a result of the lower FFO, Fitch now expects FFO-adjusted net leverage at YE2016 to increase to about 3.9x from 3.6x at end-2015. Previously, Fitch expected Telefonica's FFO-adjusted net leverage to decline to 3.5x during 2016 through organic cashflow generation and within 18-24 months. This, however, is unlikely to be achieved on an organic basis alone, given the group's trajectory. Organic Deleveraging Capacity Constrained Fitch expects FCF to increase over the next three to four years driven primarily by cost reduction in Europe, operating free cashflow growth in Spain, synergy extraction in Germany and Brazil, and a decline in capital expenditure as the intensity of fixed and mobile broadband network deployment reduces. Our base-case scenario envisages pre-dividend FCF margins expanding from 6% in 2016 to about 8% by 2018. This assumes revenue growth of less than 1% over 2017 and 2018. Dividends to shareholders are likely to consume 65%-70% of pre-dividend FCF over the next two years (assuming no change to Telefonica's dividend policy), leaving limited capacity to delever through organic cashflow generation alone. On this basis, the group's FFO-adjusted net leverage is likely to decline to about 3.5x by 2018 supported by the conversion of EUR1.5bn mandatory convertible notes in 2017. Telefonica's target is to achieve a net debt to EBITDA ratio of 2.35x (based on its own leverage definition) by end-2017. The scenario is likely to require the use of asset sales and possibly the issuance of hybrid securities. To this extent the company has announced its intention to list a stake of at least 25% in Telxius, while also considering strategic options for O2 UK that will involve Telefonica maintaining a majority stake. Fitch does not include these events in its ratings until they are complete. FX Exposure on Leverage Telefonica's main FX exposure comes from its Latin American operations, which in 2015 comprised 42% of operating free cashflow (the proportion is lower when interest and tax is taken into account) but about 13% of net debt (as defined by the company). The mismatch in cash flow and net debt creates pressure on leverage metrics when there is significant and sustainable devaluation in currencies as there has been in 2H15 and 1H16. Revised Rating Sensitivities Fitch has tightened Telefonica's FFO-adjusted net leverage metric to achieve a 'BBB+' rating to 3.3x from 3.5x. The lower leverage threshold reflect the group's sizeable exposure to Brazil. Telefonica derived 21% of its EBITDA from Brazil in 1H16. Fitch has progressively downgraded the country's sovereign rating to 'BB'/Negative from 'BBB'/Negative over the past 12 months. The downgrade of Brazil's sovereign rating has significantly increased the proportion of Telefonica's group EBITDA that is generated from countries with non-investment-grade ratings, which Fitch estimates was about 26% in the past 12 months to 1H16 on an underlying basis. The proportion is significantly higher than Fitch's estimates for its immediate peer group of large, diversified western European telecoms operators, such as Deutsche Telekom (7%), Orange (12%) and Vodafone (10%). Telefonica's non-investment-grade exposure carries a relatively higher cash flow risk, which is now reflected in the tighter leverage rating sensitivities. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer are: - Reported revenue decline of 5% yoy in 2016 with 0.5%-1.0% growth a year thereafter. This assumes some improvement in FX rates in 2H16. - EBITDA margins increasing from 31% in 2016 to 32% by 2019. - Capex to sales ratio of 16.6% in 2016 declining to 15.3% by 2019. - Off-balance-sheet debt adjustment based on an operating lease multiple of 6.7x. The multiple is based on an estimated weighted average of the geographic dispersion of long-term operating leases. - Fitch's calculation of net debt assumes that the vast majority of the company's derivative financial assets and liabilities are related to FX hedges. - Telefonica's reported operating income before depreciation and amortisation (OIBDA) has been considered as EBITDA. RATING SENSITIVITIES Positive: Developments that may, individually or collectively, lead to positive rating action include: - FFO adjusted net leverage falling sustainably below 3.3x. - Improved competitive position in Telefonica's domestic and other key international markets combined with strong growth in pre-dividend FCF. Negative: Developments that may, individually or collectively, lead to negative rating action include: - FFO-adjusted net leverage trending above 3.8x on a sustained basis. - Pressure on FCF driven by EBITDA erosion, FX and capital repatriation constraints, higher capex and shareholder distribution, or significant underperformance in the core domestic and international markets. FULL LIST OF RATING ACTIONS Telefonica SA - Long-Term IDR: downgraded to 'BBB' from 'BBB+', Outlook Stable; - Senior unsecured: downgraded to 'BBB'/'F3' from 'BBB+'/'F2'; - Short-Term IDR: downgraded to 'F3' from 'F2'. Telefonica Europe B.V. / Telefonica Emisiones S.A.U / Telefonica Participaciones, S.A.U - Senior unsecured bonds: downgraded to 'BBB' from 'BBB+'; - Subordinated hybrid securities: downgraded to 'BB+' from 'BBB-'. Telefonica Finance USA LLC - Preference shares: downgraded to 'BB' from 'BB+'. Contact: Principal Analyst James Hollamby Associate Director +44 20 3530 1656 Supervisory Analyst Tajesh Tailor Director ++44 20 3530 1726 Fitch Ratings Limited 30 North Colonnade London E14 5GN Committee Chairperson Damien Chew, CFA Senior Director +44 20 3530 1424 Additional information is available on www.fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary. Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@fitchratings.com; Pilar Perez, Barcelona, Tel: +34 93 323 8414, Email: pilar.perez@fitchratings.com. 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