December 19, 2016 / 5:34 PM / 7 months ago

Fitch Places Sky on Rating Watch Positive; Potential 1-Notch Upgrade

16 Min Read

(The following statement was released by the rating agency) LONDON, December 19 (Fitch) Fitch Ratings has placed Sky plc's (Sky) Long-Term Issuer Default (IDR) and senior unsecured ratings of 'BBB-' on Rating Watch Positive (RWP), following this week's announcement by 21st Century Fox, Inc. (FOX; BBB+/Stable) that it intends to acquire the roughly 61% interest in the pan-European pay-TV operator that it does not currently own. Assuming the transaction goes ahead, we expect strong strategic and operational links with Sky's higher-rated parent as per Fitch parent-subsidiary (PSL) methodology. However, legal ties in terms of direct support for subsidiary debt are less certain as it is not yet clear how FOX intends to fund its subsidiary over the medium term. We do not assume a parent guarantee or cross default into FOX's debt. We therefore do not expect rating support from FOX to be strong enough to equalise the ratings. This means the upgrade, upon a successful transaction, may be limited to only one notch. The RWP will be resolved when the outcome of the transaction is finalised. KEY RATING DRIVERS Potential Ownership by Stronger Parent FOX has made a 100% cash offer of GBP10.75 a share for Sky's outstanding publicly held equity, representing a total cash offer of GBP11.7bn and a 36% premium to the share price on 8 December 2016. Fitch makes no assumption over the likelihood of the offer being successful, but notes the offer has the unanimous support of Sky's Independent board committee. The offer remains subject to Sky shareholder vote and regulatory approvals. Assuming the transaction goes ahead, Fitch will view Sky's ratings in the context of its ownership by a stronger parent and as part of an enlarged, more diversified FOX group. Following the announcement of the transaction, Fitch has affirmed FOX's IDR at 'BBB+/Stable' (for more details refer to Fitch's rating action commentary 'Fitch Affirms FOX's 'BBB+' IDR Following Sky Acquisition Announcement; Outlook Stable' dated 16 December 2016 on www.fitchratings.com) Fitch to Apply PSL If the transaction goes ahead, Fitch will rate Sky using its PSL methodology. With FOX the stronger-rated entity the criteria allow rating uplift closer to the parent based on legal, strategic and operational ties. Fitch believes strategic links will be strong given the importance placed by FOX on owning the pan-European pay-TV operator and the perceived benefits in scale and diversification in content ownership, business platform and geography. Operationally Fitch would expect Sky to continue to be managed largely independently and to remain focused on its existing strategy. The potential for direct operational or cost synergies is somewhat limited. Legal ties in terms of direct support for subsidiary debt are uncertain as it is not yet clear how FOX intends to fund Sky over the medium term. We do not assume a parent guarantee or cross default into the parent debt. On this basis, we could rate Sky one notch lower than FOX once this transaction is complete. Given FOX's current rating of 'BBB+', this would lead to an upgrade of Sky's rating to 'BBB'. Sky's Standalone Fundamentals Sky's standalone ratings take into account the TV operator's leading market position and consistent delivery of strong operating results in the company's core operations. In a competitive UK telecommunications market, the company has established a strong brand, market-leading content and service quality and a competitive triple-play offer; and is soon to launch a mobile offer. Its German and Italian businesses offer diversification and solid growth potential, although Fitch expects operating cash flows to remain concentrated around its core UK and Ireland business in the medium term. Against these strengths Sky's leverage remains high at a forecast 3.3x for the financial year ending June 2017 in our rating case, leaving no headroom against a downgrade threshold of 3.2x. Leverage pressures are expected to remain, given a sizeable increase in English Premier League costs from FY17 and the new Bundesliga contract effective from FY18, along with a significant FX-related increase in debt due to sterling weakness and 74% of its debt being denominated in euros at FYE16 (after the effects of derivative hedging). Non- cash impact of FX movements on debt in FY16 was GBP918m. DERIVATION SUMMARY Sky's broader peer group includes telcos such as BT Group (BBB+/Stable), KPN (BBB/Stable) and TDC (BBB-/Stable); sub-investment grade cable operators such as Virgin Media and Telenet; both 'BB-'/Stable and media conglomerate, Vivendi (BBB/Stable). Sky's business model is nonetheless quite idiosyncratic given the company's position as the leading pay-TV provider in the UK; a premium content-led business model and attendant exposure to content rights inflation. We regard Sky as very well-positioned in the UK pay-TV market, and that management understand well the need to provide a complete communications offering in this market given its expansion into telecoms services. Its revenue growth remains stronger than most of the telcos but margins face ongoing pressure from rights inflation and its business model and cash flow is potentially more challenged than the telcos and cable operators. This results in a standalone rating at the lower end of the investment grade range. KEY ASSUMPTIONS Fitch's key assumptions within the rating case for Sky on a standalone basis include:- - Low to mid -single digit revenue growth approaching 5% in 2017, before falling to around 4% through 2019 - Adjusted EBITDA margin of 16-17% in FY17 due to increased English Premier League costs. - Margins of 17%-17.5% in 2018 and 2019 given cost savings and scale economies in Germany and Italy. - Group capex to remain at around 7% of sales. - Single- digit dividend growth through FY18. RATING SENSITIVITIES Future developments that may, individually or collectively, lead to negative rating action on Sky's standalone rating include: -Funds from operations (FFO) net leverage that is expected to remain consistently above 3.2x (including transponder costs). - Expectations that free cash flow margin will be consistently below 4%. - Material deterioration in Sky's operating environment and key performance indicators; including the impact of content rights inflation, material weakening in reported churn, average revenue per user or evidence that over-the-top video services is becoming a more significant threat to its traditional pay-TV business. Near-term variables including the outcome of the UK's EU referendum, given the likely impact on FX-related debt, as well as the upcoming Bundesliga auction will be monitored closely. Future developments that may, individually or collectively, lead to positive standalone rating action include: -FFO net leverage that is expected to remain consistently below 2.7x (including transponder costs). - Free cash flow margin consistently in high single digits. - Evidence of the ongoing resilience of the company's operating environment and core pay-TV business. LIQUIDITY Strong Liquidity At end-June 2016 Sky reported balance sheet cash of GBP2.1bn and had an undrawn GBP1bn revolving credit facility due 2021. Contact: Principal Analyst Joe Howes Analyst +44 20 3530 1382 Supervisory Analyst Stuart Reid Senior Director +44 20 3530 1085 Fitch Ratings Limited 30 North Colonnade London E14 5GN Committee Chairperson Damien Chew, CFA Senior Director +44 20 3530 1424 Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@fitchratings.com. Summary of Financial Statement Adjustments for the period ended June 2016:- - Leases: Fitch has adjusted debt by adding 8x yearly operating lease expense related to long term assets; 5x estimated transponder lease expenses: in aggregate approximately GBP1.8bn of lease adjusted debt was added to FY16 reported debt. 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. Applicable Criteria Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016) here Parent and Subsidiary Rating Linkage (pub. 31 Aug 2016) here Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 21 Nov 2016) here Additional Disclosures Solicitation Status here Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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