Fitch Downgrades Tele2 Russia Due to Uncertainty Over Rostelecom Merger
Published on: 24th Mar 2014
By: Ian Mansfield
Fitch Ratings has downgraded Tele2 Russia's ratings to 'B ' from 'BB ' and put them on Rating Watch Negative (RWN) on uncertainty over the final terms of its proposed joint venture agreement with Rostelecom.
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. An expected merger with Rostelecom's mobile assets would significantly expand its territory of operations, subscriber base and network/spectrum capacity, but also expose the company to notable integration risks, and lead to a significant increase in capex and leverage.
New Shareholding Structure
Although the terms of the deal are not yet final, Fitch believes that Rostelecom has not made a commitment to become a majority shareholder in the merged entity. As a result, Fitch's downgrade of Tele2 Russia's rating to 'B+' reflects, among others, a 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.
Fitch believes Tele2 Russia and Rostelecom are close to signing a joint venture agreement. The rating watch will likely be resolved once a legally binding joint venture agreement between Tele2 Russia and Rostelecom is concluded and once the new legal entity undertakes that Tele2 Russia's current bonds are recourse to the new entity. A failure to do so would be viewed as a rating risk, which is reflected in the RWN.
Government-controlled VTB - a majority shareholder of Tele2 Russia - earlier announced that it was a financial investor in the potential JV and already divested of a 50% stake to a consortium of private investors. Fitch believes that it is likely to divest significantly further to 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 prospective enlarged company would face significant integration challenges, given distinctly different business cultures at Tele2 Russia and Rostelecom. The operator will have to rapidly beef up 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 our view. The company's plans to aggressively enter the so far untested 4G and 3G data market also entail a fair amount of execution risks.
We expect leverage will likely rise significantly on the back of substantial debt that is likely to be 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 we estimate that it is unlikely that leverage would be lower than 3x net debt /EBITDA and 4x on funds from operations (FFO) adjusted net basis.
Larger Scale Positive
Following the merger, Tele2 Russia would emerge as a significantly larger player with a 16% subscriber market share servicing over 38 million customers. The company would have 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.
Tele2R's business model has been efficient with a tight control over operating costs and capex leading to strong free cash flow generation. Fitch believes it would be a challenge to preserve the company's lean business model after the company has been severed from 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.