Fitch Affirms Telefonica's Debt Ratings with a Negative Outlook
Published on: 21st Mar 2014
By: Ian Mansfield
Fitch Ratings has affirmed Telefonica's Long term debt rating at 'BBB ' with Negative Outlook and Short term rating at 'F2'.
Fitch said that the affirmation reflects Fitch's view that Telefonica continues to represent one of the most diverse operating and cash flow profiles among the large incumbent peer group in EMEA. Compared with Deutsche Telekom and Orange, Telefonica exhibits stronger geographic diversification, a lower, albeit significant, reliance on its domestic market, along with significant scale and leading market positions in its international portfolio.
Management has shown both a resolve and ability to reduce debt through disposals and cuts to shareholder distributions. A number of headwinds exist including an intensifying competitive environment in Spain, along with significant currency volatility, mainly due to operations in Latin America.
These downside risks are reflected in the Negative Outlook, although this will likely be revised to Stable if Fitch's current forecasts are met in 2014.
Proactive Portfolio Management & Deleveraging
A spike in leverage, following the 2010 Vivo acquisition and coincident economic slowdown, has been managed well. A combination of material cuts to its distribution policy, the sale of non-core assets and stake sales, along with hybrid issuance has seen the company reduce net debt to EUR46.6bn (EUR43.6bn adjusted for post FY13 disposals) - i.e. adjusted for 50% equity credit assigned to the hybrid instruments. This compares with debt of EUR56.3bn at FYE11. Fitch expects funds from operations (FFO) net adjusted leverage to stabilise around 3.3x in 2014 and beyond, a level that is consistent with the large European incumbent peer group and a 'BBB+' rating. FFO net adjusted leverage was 3.2x at FYE13.
Telefonica exhibits stronger portfolio diversification than similarly rated peers, such as Deutsche Telekom and Orange. Of this group, Telefonica is least reliant on its domestic market at 45% contribution to operating cash flow (OCF; EBITDA less capex) from Spain in 2013, compared with Deutsche Telekom's 70% from Germany and Orange's 65% from France.
Fitch estimates that following the E-Plus transaction (which remains subject to regulatory approval), Germany will account for 9% and the UK a 10% contribution - boosting the cash flow from competitive but nonetheless stronger performing northern European economies, while Latin America will contribute 39%. Such broad diversification offers protection against economic cycles as well as structural shifts and maturing regional trends.
Domestic Operating Environment Remains Tough
Spain is still Telefonica's single largest market, accounting for 43% of forecast 2014 OCF. A domestic economy characterised by high unemployment and weak domestic consumption, along with an increasingly tough competitive environment will continue to weigh on this part of the business.
Telefonica's "Fusion" quad-play product has fundamentally shifted pricing in the market, though without slowing the pace of mobile subscriber losses. The incumbent lost a total of 1.6 million mobile customers in the 12 months to December 2013, while mobile service revenues contracted by 16%.
Aggressive MVNO mobile offers have had a significant impact on the established operators, while Vodafone's acquisition of ONO, the country's largest cable operator, is likely to increase fixed line and quad-play pressures. Domestic EBITDA fell 7% in 2013. Further contraction is likely in 2014 and may continue beyond, in Fitch's view.
Currency volatility primarily related to Telefonica's Latin American businesses had a material impact on 2013 reported results - revenues suffered a negative EUR5bn currency impact; with a EUR1.7bn effect felt at the EBITDA level.
Currency devaluation in Brazil, Argentina and Venezuela has been significant, with the prospect of any near-term easing in these pressures far from certain. While its LatAm operations generally report top-line growth and solid underlying performance, currency volatility removed the underlying growth benefits of the LatAm business in 2013 and in the absence of any material appreciation will continue to impact reported group level results in 2014.
Fitch estimates that LatAm countries in 2014 will account for around 39% of Telefonica's OCF and their currencies at 8% of group debt, giving rise to a currency mismatch. Euro zone countries are forecast to represent 52% of OCF, compared with an estimated 80% of euro-dominated debt.
Measured M&A Approach
M&A risk at Telefonica is viewed by Fitch as measured and its intentions in this area have been well-articulated by management. Recent activity has focused on the sale of non-core operations with the agreed disposal of businesses in the Czech Republic and Ireland expected to raise around EUR3bn in proceeds in 2014. Disposal proceeds along with approximately EUR900m to be raised from minorities (at the Telefonica Deutschland level) in a rights issue accompanying the E-Plus acquisition will offset the EUR5bn cash component of the German acquisition. The company's leverage neutral approach to funding this deal underlines caution in financial policies, which Fitch views positively.
The possibility of market consolidation in Brazil would be a transaction that makes strategic sense - regulatory barriers to such a development are though considered high.