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Fitch Rates TalkTalk Telecom Group PLC IDR 'BB-'; Outlook Stable
January 10, 2017 / 10:34 AM / a year ago

Fitch Rates TalkTalk Telecom Group PLC IDR 'BB-'; Outlook Stable

(The following statement was released by the rating agency) LONDON, January 10 (Fitch) Fitch Ratings has assigned TalkTalk Telecom Group PLC a Long-Term Issuer Default Rating (IDR) of ‘BB-'/Stable Outlook. Fitch has also assigned an instrument rating of ‘BB- (EXP)'/‘RR4’ to the company’s proposed new unsecured notes. Proceeds from the issuance will be principally used to repay some of short-term borrowings under the existing revolving credit facilities. The final instrument rating is subject to the final documents conforming materially to the preliminary documentation reviewed. TalkTalk’s rating is supported by its sustainable market position as a niche “value-for-money” operator in the UK telecoms market. There are top-line growth opportunities from higher demand for data and greater product penetration. Future costs savings from its Making TalkTalk Simpler (MTTS) programme, dark fibre extension and a reduction in wholesale charges should gradually improve the company’s profitability over the next three years. However, its reliance on regulated BT wholesale products means TalkTalk’s profitability is below the sector average. TalkTalk has flexibility in balancing network investments and dividend distributions, but its weak FCF (post-dividend) profile is a constraining rating factor. KEY RATING DRIVERS Niche Value-for-Money Operator: The core strategy of TalkTalk of providing a value-for-money quad-play service differentiates it from the other fixed-line operators which have deep financial resources, high-quality network infrastructure, and in some cases, exclusive access to media content. We believe revenue growth from price increases is likely to be limited, given the company’s value-for-money pricing strategy. However, with the rollout of fibre, the convergence of bundled products and the expected improvements in the regulatory environment, we anticipate opportunities, especially in Corporate with growing demand in data, and On-net with higher product penetration. Favourable Regulatory Framework: The UK telecom regulator (Ofcom) has a history of strong and pro-competition regulation in curbing the incumbent’s market influence. The recent move to force a legal separation of Openreach from BT Group should gradually shift some of the market power towards operators like TalkTalk which rely on access to BT’s wholesale products. This should increase Openreach’s independence and sustain TalkTalk’s market position over the medium term. Nonetheless, the timing and the magnitude of future reductions in BT’s regulated wholesale prices remains uncertain. Flexible Financial Policy: TalkTalk has had to rely on external funding sources to maintain its liquidity profile, because of high capex requirements and regular dividend distributions. We do not anticipate TalkTalk will generate positive FCF in the financial year to March 2017 (FY17) given outflows for capex, working-capital movements and committed dividends of GBP150m. However, we believe TalkTalk has the flexibility to manage its financial policy to accommodate further investments including in Fibre-to-the-Premise (FTTP), and dividend distributions to maintain a neutral to positive FCF. Opportunistic bolt-on acquisitions and/or investments might result in FCF being temporarily negative and net leverage above its stated target. Below-Average but Improving Margins: TalkTalk’s profitability has been lower than the sector average with a last-twelve-month (LTM) EBITDA margin (Fitch adjusted) of 14.7% as of September 2016. The margin reflects TalkTalk’s business model that is underpinned by its regulated wholesale access to BT’s network, and a Mobile Virtual Network Operator (MVNO) agreement with Vodafone, later transferring to O2, and commercial arrangements with Sky. We believe there are opportunities for further cost savings driven by the MTTS initiative, extension of dark fibre and potential reduction in wholesale charges, although there remains an element of execution risk in the company’s plans to meet its financial targets. Cyberattack Drags Performance Temporarily: TalkTalk lost 95,000 customers (around 3% of its customer base) following the cyber-attack in October 2015 in which 15,000 customers had their bank account details stolen, which it has not recovered since. Immediately following the attack, the company incurred exceptional costs of around GBP42m including measures to bolster online and IT security. However, our view is that any long-lasting effects are limited given the mainly positive reception from customers to how the company dealt with the incident, with TalkTalk’s trust score with customers higher now than it was before the attacks. DERIVATION SUMMARY TalkTalk’s ‘BB-’ rating reflects its established market position as a value-for-money operator compared to BT Group Plc (BBB+/Stable), Sky Plc (BBB-/Stable) and Virgin Media Inc (BB-/Stable) which offer quad-play products with their respective differentiating niches. TalkTalk’s network coverage of 96% of the UK gives it better coverage than Virgin and Sky. TalkTalk’s financial structure is more conservative than Virgin Media, with a committed financial policy targeting a net debt/EBITDA ratio (as defined by TalkTalk) of 2.0x. However, the business model relies upon regulated wholesale access to BT’s network, leading to an EBITDA margin below average for network operators. To generate neutral to positive FCF (post-dividend), TalkTalk will have to balance investment in its network (including FTTP trials) with regular dividend distributions. No Country Ceiling, parent/subsidiary or operating environment aspects impact the rating. KEY ASSUMPTIONS Fitch’s key assumptions within the rating case for TalkTalk include: - revenue CAGR growth of 2.6% for FY17-FY19 driven by a stabilised broadband subscriber base and steady revenue growth in Corporate and On-net; - EBITDA margin improvement to 16.8% by FY19 driven by the benefits of the MTTS programme, extension of dark fibre and gross margin improvement from lower BT wholesale prices; - combined cash outflows for capex (including investments in FTT) and dividends of over GBP300m in FY17, and GBP250m to GBP300m thereafter; - exceptional items related to relocation to new site in Salford. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action Continued strong operational performance, accompanied by a financial policy track record in managing FTTP investments and dividend distributions, leading to: - positive FCF (pre-dividend) in high-single digits; - comfortable liquidity headroom; and - FFO adjusted net leverage sustainably below 3.3x. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action

A shift in financial policy weighted towards shareholder remuneration or a material deterioration in key performance indicators, leading to: - FCF (pre-dividend) in low single digits; - shrinking liquidity headroom; and - FFO adjusted net leverage sustainably above 3.8x. LIQUIDITY Pro forma for the refinancing, Fitch expects TalkTalk to improve its liquidity headroom under the existing revolving credit facilities and debtor securitisation. We view this level of liquidity as satisfactory. Contact: Primary Analyst Timothy Li Associate Director +44 20 3530 1386 Secondary Analyst Peter Wormald Analyst +44 20 3530 1357 Fitch Ratings 30N Colonnade E14 5GN, London Committee Chairperson Damien Chew, CFA Senior Director +44 20 3530 1424 Date of Relevant Rating Committee: 14, December, 2016. Summary of Financial Statement Adjustments - Debt related to operating leases was adjusted so that a multiple of 8x was used for property and 5x for network equipment. Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@fitchratings.com. 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 Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 21 Nov 2016) here Additional Disclosures Dodd-Frank Rating Information Disclosure Form here _id=1017355 Solicitation Status here Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE AT WWW.FITCHRATINGS.COM. 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