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Telefonica Gets a Debt Ratings Upgrade

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Fitch Ratings has upgraded Telefonica and its subsidiary O2's Long term Issuer Default ratings (IDRs) to 'A '(A minus) from 'BBB ', respectively. The agency has simultaneously upgraded Telefonica Finance USA's preference shares to 'BBB ' from 'BBB'. Telefonica's short term rating of F2 is affirmed.

The Outlook on Telefonica's Long-term IDR is revised to Stable from Positive following the upgrade.

"Today's upgrade of Telefonica reflects an operational and financial profile that Fitch regards is comfortably in line with an 'A-'(A minus) rating, with the company's scale, diversification, top-line growth and free cash flow all proving good in comparison to Deutsche Telecom and France Telecom, the two most comparable 'A-'(A minus)-rated incumbents in the European portfolio" says Stuart Reid, a Director in Fitch's European TMT team. "Fitch remains conscious of the degree to which Telefonica temporarily deviated from its financial policies in 2006 when O2 was acquired. However, de-leveraging since then and strong cash flow generation throughout make it difficult to constrain the rating on M&A risk indefinitely."

Telefonica's leverage metric (net debt plus cash commitments to EBITDA) which at the 9M08 stage was around 2.0x, at the bottom of the company's target range of 2.0-2.5x, was key to its upgrade. Fitch expects distributions and the settlement of announced M&A activity (primarily the company's increased stake in China NetCom/Unicom and the buy-in of minorities in Telefonica Chile) to increase leverage marginally by year-end, but the agency still expects the metric to remain at the low-end of the target range. On an un-adjusted basis (ie. excluding cash commitments), Fitch expects the metric to end the year at around 2.0x, which is consistent with an 'A-'(A minus) rating.

Added to the scale of the company's operations, with a retail telephony base (fixed plus mobile) of more than 232m access lines and solid free cash flow (EUR5.8bn before distributions for 9M08), Telefonica bares good comparison with its closest peers.

While telecom businesses generally are showing some sensitivity to economic conditions, Telefonica has so far shown a degree of resilience. Its domestic businesses in Spain are continuing to grow where its mobile business is notably outperforming strong competitors in the form of Vodafone ('A-'(A minus)/Stable Outlook) and Orange/France Telecom ('A-'(A minus)/Stable Outlook). Fitch acknowledges that a number of markets (such as Spain, the UK and Ireland) are facing major economic downturns while the potential for currency depreciation could affect the top line revenue growth of Telefonica's Latin American businesses. The agency considers however the company's diversity and strong cash flow provide Telefonica with flexibility for potential underperformance to planned targets, without materially undermining its financial metrics.

The key risk to the rating remains corporate strategy and M&A event risk. However, this is a risk that applies to most/many large scale industry leading issuers across diverse sectors. Fitch considers that in the face of a compelling strategic opportunity, stated financial policies are at risk of being subjugated, which proved to be the case at Telefonica with the O2 transaction. Telefonica has since that transaction however, consistently stated that it would only be interested in deals within its existing footprint. With the priority being the share it does not currently own in VIVO, its Brazilian joint venture, Portugal Telecom ('BBB'/Negative Outlook), its JV partner, remains in Fitch's view an unwilling seller, given the top-line growth that this asset contributes to its consolidated results. For the time being at least, Fitch also believes credit market conditions inhibit large scale telecom M&A deals given the refinancing risk of bridging any deal, or indeed the debt burden that might already reside in a potential target.

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