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Fitch to Keep Tele2 Russia on Rating Watch Negative

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Fitch Ratings says that it is maintaining Tele2 Russia on review for a possible debt ratings downgrade following continued uncertainty over the development strategy and funding options of its joint venture with Rostelecom.

Although the first stage of setting up a joint venture between Tele2R and Rostelecom has been concluded, the new entity has delayed making a legal undertaking that would make Tele2R's current bonds recourse to the new entity. Fitch says that the failure to do so would be viewed as a ratings risk.

The review will likely be resolved once the new entity narrows its funding and strategic development options and undertakes that Tele2 Russia's current bonds are recourse to the new entity.

Tele2 Russia is a successful regional mobile-only operator in Russia with a lean and efficient business model. It is uniquely positioned as a mild price discounter. A merger with Rostelecom's mobile assets significantly expanded its territory of operations, subscriber base and network/spectrum capacity, but also exposed the company to notable integration risks, and will likely lead to a significant increase in capex and leverage.

New Shareholding Structure

Tele2R's ratings are notched two notches down for corporate governance under the approach Fitch takes with most Russian companies. The corporate governance discount reflects, among others, the risk that private investors with a fairly weak credit profile and non-transparent strategy may end up as effective controlling shareholders of the new entity.

Owing only 45% of voting shares, Rostelecom is not committed to become a majority shareholder in the merged entity, which rules out any support under Fitch's parent-subsidiary methodology. The remaining 55% voting stake belongs to a consortium of private investors led by VTB, a government-controlled bank. VTB has previously announced that it was a financial investor in the JV and already divested of 50% of its investment in Tele2R. Fitch believes that it is likely to further reduce its exposure to this asset as it would be unusual for a bank to hold on to an equity investment in a non-financial corporate.

Organic Development; Integration Challenges

The enlarged company faces significant integration challenges, given the different business cultures at Tele2 Russia and Rostelecom. The operator will have to rapidly strengthen its 3G and 4G network coverage if it is to take advantage of its wide spectrum portfolio. Tele2 Russia has so far been quite successful in launching greenfield mobile operations in new Russian territories. However, the large scale of new geographic expansion presents significant operating challenges, in Fitch's view.

The company's plans to aggressively enter the so far untested 4G and 3G data market also entail execution risks.

High Leverage

Fitch expects leverage will likely rise significantly on the back of RUB37bn of debt that was transferred to the new company along with Rostelecom's assets and aggressive greenfield capex. The enlarged operator is planning to swiftly roll-out 4G and 3G networks, which would require substantial investments. We believe Tele2 Russia is exploring a number of options regarding its development strategy, but Fitch estimates that it is unlikely that leverage would be lower than 3x net debt /EBITDA and 4x on a funds from operations (FFO) adjusted net basis.

Temporary spikes above the downgrade trigger levels caused by rapid development may be accommodated within the current rating level provided that these would be accompanied by positive operating trends and substantial network coverage improvements.

Larger Scale Positive

Following the merger, Tele2 Russia emerged as a significantly larger player with a 16% subscriber market share servicing over 38 million customers. The company has a sufficiently large spectrum portfolio on a par with its larger domestic peers. It is likely to remain uniquely positioned as a mild-discounter and a value-for-money operator with a stronger growth profile versus the industry. However, the Russian market is already highly penetrated so that any expansion is likely to be accompanied by increased competition.

Lean Operations

Tele2R's business model has been efficient with tight control of operating costs and capex leading to strong free cash flow generation. Fitch believes it will be challenging to preserve the company's lean business model after the company has been severed from the business processes of its former shareholder, Tele2 AB.

New Regulation Positive

The introduction of mobile number portability in December 2013 should benefit the company and help it to gain market share at the expense of its larger peers. This new regulation allows Tele2 Russia to more fully exploit the benefits of its market positioning as a mild price discounter.

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Tags: tele2  rostelecom  fitch ratings  Russia