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Fitch Affirms Portugal Telecom at 'BBB'; Outlook Negative

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Fitch Ratings has affirmed Portugal Telecom's Long term debt ratings at 'BBB' with a Negative Outlook.

­The ratings reflect Fitch's view that at some stage the Portuguese economy will recover - albeit not soon - at which point Portugal Telecom's domestic business may be expected to return to growth. For now, this business is performing reasonably well in the face of harsh consumer conditions. Liquidity is sound - management have halved the dividend for three years (through 2014) saving EUR1.0bn cash relative to its prior commitment. Debt maturities are estimated to be cash covered through 2016.

However leverage is high and fluctuates due to the significance of associate dividends in the metric - a less predictable or visible form of cash flow. Fitch's assessment of Portugal Telecom's 2012 leverage was 2.9x and close to the 3.0x downgrade sensitivity. However, approximately 0.2x of leverage was attributable to 2012's shortfall in associate dividend receipts.

Dividends from Unitel in Angola of EUR50m compared with EUR126m in 2011. Our current rating case envisages leverage falling to 2.8x in 2013 and remaining at this level through 2014, which although high, is still within the guidelines for a 'BBB' rating. Portugal Telecom's domestic operations are considered well managed, with fibre investment high by incumbent standards and the company's TV product is well developed. Portugal Telecom is the leading provider of triple-play in Portugal despite the presence of strong cable competition.

Sovereign Pressure

With the Portuguese sovereign rated 'BB+'/Negative, Portugal Telecom's high domestic concentration leads to a 'BBB' rating that is constrained by the sovereign and is likely to come under material pressure in the event of further downgrades of the state. In the case of Portugal Telecom, any sovereign downgrade from the current level will prompt a corporate downgrade and the gap between the sovereign and corporate expected to remain no greater than two notches.

Importance of Associate Dividends

Associate dividend receipts are important in the context of Fitch's leverage calculation - in Portugal Telecom's case a function of unadjusted net debt to EBITDA (excluding Brazil) plus associate dividends. Associate dividends amounted to 17% of the denominator in 2012 and we forecast it to remain at similar levels. However, timing of receipts is unpredictable, as was seen with Angolan receipts in 2012, while the sustainability of dividends from its Brazilian operations, Oi, remains dependent on the turnaround of that business. Fitch will factor in sustainable dividends in assessing the company's expected credit profile.

Limited Headroom

A shortfall in expected Unitel receipts meant Portugal Telecom's 2012 leverage widened to 2.9x versus a downgrade sensitivity of 3.0x. Unitel is Angola's leading mobile operator and is performing well. However, the timing and size of dividend repatriation are subject to approval by Angola's central bank, with 2012 receipts of EUR50m compared with EUR126m in 2011, while Portugal Telecom reported a short-term financial receivable of EUR216m at YE12, relating to Unitel.

Oi has committed to a BRL2.0bn dividend through 2014, 15.5% of which represents Portugal Telecom's direct economic interest. These receipts are important given that domestic EBITDA is expected to remain under pressure. With some recovery in cash receipts from Angola (our model assumes just over EUR100m), combined with underlying domestic EBITDA pressure, Fitch currently envisages leverage of around 2.8x for 2013. However, the timing and size of cash repatriation from Angola is somewhat unpredictable. This in turn is likely to lead to some volatility in the leverage metric and an important area to monitor.

Efficient Incumbent, Weak Economy

Portugal remains in the grip of sustained recession. Fitch estimates negative growth of 3.2% in 2012 and further contraction of 2.6% in 2013. Telecoms spend, particularly mobile, has proven less defensive than previously thought across all of southern Europe. Nonetheless, Portugal Telecom has developed a strong position in triple-play, helped by a fibre build passing 1.6 million homes. Its Meo TV base is over 1.1 million, growing 17% in 2012, helping it stabilise fixed accesses and grow its residential top line. A sizeable enterprise segment has also proven economically sensitive.

Good Liquidity

Despite its peripheral country domicile Portugal Telecom was nonetheless successful in diversifying funding sources in 2012, raising four-year retail debt, extending the maturity of its core bank facility, accessing EIB and vendor finance, before returning to the Eurobond market in Q412. Retained Vivo proceeds and the decision to half the dividend for 2012-14, boosted domestic cash to EUR3.0bn at YE12 pro-forma for the sale of Macau associate, CTM. The May 2013 EUR1.0bn 7 year benchmark deal confirms current market access is good.

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