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Fitch Affirms Telefonica at 'A-' on Vivo Acquisition

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Fitch Ratings has affirmed Telefonica's and its subsidiary O2's Long term Issuer Default ratings (IDRs) at 'A ' respectively, following the announced acquisition of Portugal Telecom's stake in Vivo, Brazil's leading mobile operator, for EUR7.5 billion.

The agency has also affirmed the senior unsecured rating of bonds issued by Telefonica Europe at 'A-' and Telefonica Finance USA's preference shares at 'BBB-' and Telefonica's Short-term IDR at 'F2'. The Outlooks on Telefonica's and O2's Long-term IDRs are Stable.

"Today's affirmation reflects the strategic logic and relatively limited impact the transaction has on financial leverage, which is turn a function of the sheer scale of Telefonica's operations," says Stuart Reid, a Senior Director in Fitch's European TMT team. "Net debt/ EBITDA is likely to step up to around 2.3x -2.4x as a result of the transaction but should de-leverage fairly quickly given the growth profile of the company and staggered nature of the purchase payment."

Telefonica has agreed with PT to acquire its 50% stake in Brasilcel, the vehicle which holds their joint venture interests in Vivo. Telefonica will pay EUR5.5bn in 2010 and the remaining EUR2bn on 31 October 2011. Good cash flow generation and the growth of Latin American businesses should allow the company to return leverage (net debt plus commitments / EBITDA) to the lower end of the company's target range of 2x-2.5x by FYE11. On a funds from operations (FFO) net adjusted basis Fitch would expect leverage to fall to around 2.5x by this date from 2.8x at FYE09.

The announcement brings to a close a protracted period of negotiations between the Iberian incumbents and paves the way for a merger between Vivo and Telesp, Telefonica's fixed line business in Brazil. Fitch notes a period of integration will now follow and management will work on delivering improvements at Telesp, which has seen both revenues and cash flow weaken.

Fitch notes that ratings headroom has reduced with the announcement of this transaction, with Telefonica facing challenges on a number of fronts, including the condition of the Spanish economy, which is having a more pronounced effect on its domestic business than previously expected, along with weakening performance of some of its fixed line businesses in Latin America (such as Peru, Colombia and as mentioned, Brazil).

Pre-distribution free cash flow/revenues, nonetheless, remains strong at around 15%. This, along with FFO net adjusted leverage trending towards 2.5x and below, are important considerations underpinning the current ratings.

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