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Fitch Affirms JSC Silknet at 'B+'/Stable, Expands Downgrade Trigger
October 11, 2016 / 9:41 AM / a year ago

Fitch Affirms JSC Silknet at 'B+'/Stable, Expands Downgrade Trigger

(The following statement was released by the rating agency) MOSCOW, October 11 (Fitch) Fitch Ratings has affirmed JSC Silknet's Long-Term Issuer Default Rating (IDR) at 'B+' with a Stable Outlook. The agency also expanded the downgrade trigger to 3x funds from operations (FFO)-adjusted net leverage, from 2.5x, due to significantly lower FX risks after Silknet's successful refinancing of all its FX-denominated debt into local currency in September 2016. Silknet is the incumbent fixed-line telecoms operator in Georgia, holding sustainably strong market positions of above 40% in both fixed-voice and broadband services. Voice revenue is falling, but it has long-term growth prospects in broadband, and generates stable cash flow from a growing subscriber base. The lack of significant mobile operations is a strategic weakness, as is its small absolute scale - Silknet services fewer than 375,000 fixed lines and it generated GEL55m (about USD24m) EBITDA in 2015. Silknet's liquidity is weak as it relies on uncommitted facilities from its relationship bank to regularly re-finance its amortising debt, so far without disruption. Refinancing risk is mitigated by moderate leverage - we project it to remain at or below 2x FFO-adjusted net leverage (1.6x at end-2015). The company's corporate governance has been weak, but recent changes suggest it is on track to improve. KEY RATING DRIVERS Strong Incumbent Positions Outside Tbilisi Silknet benefits from its strong position as the incumbent fixed-line telecoms provider across most of Georgia's territory, with the notable exception of the capital, Tbilisi, and some other large cities. The company was relatively late to realise the potential of broadband services. Competitors have taken a significant broadband market share as they rolled out their own infrastructure and have been able to cherry-pick the most commercially attractive locations, typically in large cities. We expect Silknet to defend its market position. Its advantage of being able to offer almost nationwide ADSL coverage across its existing fixed-line franchise will be supported by significant investments in new fibre infrastructure. Competition is typically less intense outside large cities, and the lower-speed ADSL-based service remains competitive in those areas. The company's large fixed-line franchise and extensive copper infrastructure has allowed it to rapidly develop its broadband subscriber base despite its late start and become the largest broadband operator in Georgia. In June 2016 the company controlled 45% of fixed lines and 61% of fixed voice revenues in the country; its subscriber and revenue broadband market shares were 40% and 41%, respectively. Revenue Growth Challenges We expect Silknet's revenue growth to remain sluggish, at low- to mid-single-digit percentages. The traditional fixed-line voice segment is in structural decline, which is likely to continue. This segment accounted for 20% of Silknet's 2015 revenue, and its double-digit contraction significantly weighs on the total. Fixed-to-mobile substitution is likely to continue unabated, as customers can typically obtain better pricing options on mobile-to-mobile calls. Broadband and pay-TV services remain key growth drivers. However, their contribution is only likely to offset voice decline and keep revenue growth slightly positive. Subscriber broadband growth has significantly slowed in Georgia since 2014. Potential revenue growth from upselling bundled services and market share gains is likely to be limited, due to continued competition and relatively limited consumer purchasing power outside the large cities. Revenue growth in the Georgian telecoms market has slowed to single-digit percentages and we believe acceleration is unlikely. Revenue from the still-expanding broadband and pay-TV segments grew by only 2.7% yoy and 8.1% yoy, respectively, in 2Q16, compared with 18.0% yoy and 21.3% yoy growth, respectively, in 2Q15, according to data from the regulator. Slower organic growth may lead to intensified price competition, as smaller companies tend to become more disruptive if they are unable to achieve meaningful expansion of their subscriber base. Low GDP Per Capita Constrains Growth Relatively low GDP per capita of USD3,249 (at market exchange rates in 2015) in Georgia is likely to constrain revenue growth and efforts to increase an average telecom bill through offering premium-quality services at a higher price. The current moderate broadband subscriber penetration level of close to 50% of households in Georgia suggests some longer-term subscriber growth potential. However, year-on-year subscriber growth had already slowed to 6% at end-1H16, with revenue growth lagging behind due to price competition. Key urban areas have already been covered, while less populated areas are less affluent than the national average. Fibre Improving Competitiveness; Execution Risks The company's strategy of rapid fibre development will improve its competitive position. We believe Silknet's plans to achieve ARPU growth from the existing customer base may be more challenging. Silknet plans to continue to make significant fibre investments, which would allow it to achieve network quality parity with its key broadband competitors, which typically operate proprietary fibre networks. Silknet's ability to offer ADSL service on its legacy copper network give it the advantage of quick subscriber coverage, but fibre peers can offer higher-speed, better-quality broadband connections. Improving network quality will come at a price. There is a risk that investments may not be quickly recouped from higher, incremental revenue. The management considers the current ADSL customer base likely to migrate to a better-quality fibre service, and that customers are more likely to pay more for higher connection speeds, while increasingly taking up pay-TV that would further increase ARPUs. We believe some positive traction is likely; however, the mass market is extremely price sensitive in Georgia and competition remains intense. Size Limits Efficiency Gains, Funding Options The company's small absolute size is likely to be a drag on its efforts to improve profitability. It will also be a limiting factor for its funding options. Its small operational size of fewer than 375,000 fixed lines may hamper its ability to achieve economies of scale on a par with larger peers. Silknet's small scale may also hamper access to international financial markets. Mobile Lack a Strategic Disadvantage Silknet does not have any significant mobile operations, which we view as a strategic disadvantage. It may face more intense competition from Magticom, Georgia's only quad-play-enabled operator. Magticom, the largest mobile operator in the country, recently entered the fixed-line broadband segment by acquiring Caucasus Online, the second-largest broadband operator and Silknet's key rival. Silknet has a portfolio of mobile frequencies, including for LTE services, but organic mobile development would entail significant execution risks and be likely to weigh on financial results and leverage. The Georgian mobile market is highly competitive, with third entrant Vimpelcom struggling to stabilise its EBITDA margin at above 20% despite controlling almost 25% of the subscriber base - which does not leave many opportunities for a new potential entrant. Fitch would treat Silknet's acquisition of an existing mobile operator as an event risk. Gradual Margin Improvement Helped By Cost Optimisation Silknet intends to remain focused on cost optimisation, leading to gradual profitability improvement. It spun off some non-core service operations, including network repair and subscriber installations, into ServiceNet LLC in 2015. It concurrently entered into a long-term contract with ServiceNet, aiming to achieve a 5% cost saving on these services. The spin-off is likely to result in higher reported EBITDA and capex as some costs previously treated as operating may now be capitalised, but this should only have a minor impact on free cash flow. Evolving Corporate Governance Silknet is a subsidiary of Silk Road Group, a diversified group with assets in Georgia's transport, trading, real estate, retail and banking sectors. The group is ultimately majority controlled by Mr. Ramishvili, a Georgian-born individual, and two other individuals, through a number of holding companies. Silknet's corporate governance situation is evolving as the company is establishing formal procedures to increase transparency and introduce some checks on shareholders' access to the company's cash flows, with some important steps already taken. Silknet has a history of upstreaming cash to shareholders through large loans that were later set off against equity. It also effectively guaranteed some debt of its sister companies. The company expects these practices to be stopped. Silknet made amendments to its charter of incorporation in July 2016 to impose restrictions on dividend distributions and related-party transactions. We view these amendments as positive, although shareholders retain the ability to reverse most of them. Board practices are somewhat informal, with no independent directors. Moderate Leverage, Improving Cash-Flow Generation Leverage was moderate at 1.6x FFO-adjusted net leverage and 1.7x net debt/EBITDA at end-2015. We expect FFO-adjusted leverage to remain at or below 2x in the medium to long term. FFO was boosted in 2015 by significant one-off IRU proceeds, which are likely to decline. We therefore project FFO-adjusted net leverage to rise in 2016 but not to exceed 2x. Leverage may come under pressure from an ambitious investment programme unless accompanied by significant EBITDA growth from wider fibre take-up and improved market share. We project Silknet's pre-dividend cash flow to start gradually increasing, helped by an ongoing focus on improving cost efficiency, modest revenue growth and lower corporate profit tax in Georgia. We do not expect the company's capex to exceed 25% of revenue on average across 2016-2019. Modest FX Risks Silknet's FX risks are modest and primarily relate to operating expenses and capex, after the company successfully refinanced all its debt into domestic currency in September 2016 at the cost of paying slightly higher interest. In addition to equipment spare parts, which are almost entirely imported, most of its content and international interconnection costs, including for internet traffic, are foreign-currency denominated. We estimate that the proportion of Silknet's operating expenses in foreign currency is higher than for most of its international peers. Stretched Liquidity Silknet does not have sufficient liquidity to repay its amortising debt of slightly above GEL15m a year. The company heavily relies on Bank of Georgia (BB-/Stable), by far the largest creditor and key relationship bank, for refinancing. Silknet had a GEL217m credit line with this bank at end-2015, but this facility is uncommitted. High refinancing risk is somewhat mitigated by Silknet's moderate leverage. KEY ASSUMPTIONS Fitch's key assumptions within the rating case for Silknet include: - a significant reduction in cash flow from IRU, leading to weaker 2016 FFO than in 2015; - low- to mid-single-digit percentage organic revenue growth in 2016-2019; - low corporate profit tax after tax reforms in Georgia; - a sharp one-off improvement in the reported 2016 EBITDA margin, due to the spin-off of ServiceNet in 2015; and - capex at around 25% of revenues on average across 2016-2019. RATING SENSITIVITIES Positive: developments that may, individually or collectively, lead to positive rating action include: - improved FCF generation, alongside stable operating performance, comfortable liquidity and a track record of improved corporate governance. Negative: developments that may, individually or collectively, lead to negative rating action include: - leverage rising to and sustainably above 3x FFO-adjusted net leverage without a clear path for deleveraging; and - a rise in corporate governance risks due to, among other things, related-party transactions or upstreaming loans to shareholders. Contacts: Principal Analyst Slava Bunkov Director +7 495 956 9931 Supervisory Analyst Nikolai Lukashevich, CFA Senior Director +7 495 956 9968 Fitch Ratings CIS Ltd 26 Valovaya Street Moscow 115054 Committee Chairperson Damien Chew, CFA Senior Director +44 20 3530 1424 Media Relations: Julia Belskaya von Tell, Moscow, Tel: +7 495 956 9908, Email:; Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: Additional information is available on 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. 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