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Fitch Revises Telefonica's Outlook to Negative

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Fitch Ratings has revised the Outlook on Telefonica's Long term Issuer Default Rating (IDR) to Negative from Stable and affirmed the IDR at 'BBB .'

At the same time, the agency has affirmed the senior unsecured rating of the bonds issued by Telefonica Europe to 'BBB+' and Telefonica Finance USA's preference shares to 'BB+'. The agency has affirmed Telefonica's Short-term IDR at 'F2'.

­The Negative Outlook reflects the ongoing weakness in important underlying markets such as Spain, the UK and Eastern Europe. This is partially offset by results from Latin America. In this regard, Fitch's rating case assumptions on growth are more conservative than management forecasts. In addition, Fitch positively notes efforts to reduce leverage through adjustments to the distribution policy and from asset sales. However, a lot of uncertainty remains around the timing of these sales as well as the potential for further and sustained macro weakness across Europe but particularly in Spain. Fitch expects Telefonica to manage these risks within the boundaries of the agency's rating guidelines for a downgrade and any signs that the group is unable to do so will result in further negative rating action.

Fitch note that actions announced by the company last week, including a second scrip dividend and asset disposals, send an important message in terms of the company's willingness and determination to protect credit metrics. However, Fitch considers they also confirm the degree to which management no longer expects the breadth and diversity of the business to generate the organic deleveraging that was previously expected.

In this context, Telefonica's unadjusted net debt to EBITDA target of 2.35x for YE12 may not be met. The ratio stood at 2.55x at Q112. Telefonica's FFO net leverage (which takes into account cash interest and tax payments) stood at 3.4x at YE11 and is high relative to its European peers. A material reduction in this metric, trending towards 3.0x and below, will be important in terms of maintaining ratings at the current level. A metric expected to remain consistently above 3.0x is likely to lead to a downgrade.

Fitch considers the estimated EUR3.2bn of cash savings over 2012/2013 through scrip dividends, and what could amount to multi-billion euro asset sales, to be helpful in terms of the company's desire to reduce its overall net debt position. The exact nature, value and timing of asset sales remains unclear and execution risk will be present until disposals are completed. Potential ownership dilution in core assets to less than 60% may cause Fitch to reassess the basis of consolidation from the current position of full consolidation of this entity to one of proportionate EBITDA consolidation. Under current rating case assumptions, in isolation, this would be relatively neutral to the rating but may pressure the ratings when combined with further weakness in underlying business or delays in asset sales.

Forecast pre-dividend free cash flow margin is expected to be compressed due to operating conditions and spectrum investment, with the latter likely to remain high through 2013. This metric stood at 13.4% in 2011, which is strong for the ratings. Given the pressures discussed, Fitch accepts the metric may fall into high single digit territory over the next two years, although would expect a metric above 9% in order to maintain the current ratings.

The expectation that 2012 and 2013 debt maturities are fully covered from existing cash and unused bank lines is implicit in the current rating and Outlook. However, Fitch notes that a material deterioration in the Spanish sovereign situation may result in unexpected shortfalls in terms of available bank lines or an ability to access short-term CP. This could pressure the current solid liquidity position and would likely result in further negative rating action.

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