The first quarter of 2006 for the EMEA (Europe, the Middle East, and Africa) region's largest telecoms operators saw a continuation of the 2005 trends, says Standard & Poor's Ratings Services. The report card provides an overview of the performance of the 21 largest telcos in the region, and offers Standard & Poor's insight into the three main challenges they face in 2006: M&A, possible marked changes to financial policies, and operating pressures.
In an environment of sluggish organic revenue growth, pressurized operating margins, high cash flows, and generally downbeat prospects for 2006 and 2007, credit markets in the first quarter of 2006 were primarily fuelled by acquisition rumors and fears of changes to financial policies. At the same time, in the wake of the January 2006 LBO of Danish telecoms incumbent TDC by a consortium of private equity houses, continuing reports of private equity firms targeting virtually all midsize European telecoms incumbents--and even some much larger players--have kept the markets on their toes.
"We see this climate continuing throughout 2006," said Mr. Deslondes. "Although margins and cash flow generation will obviously remain critical long-term rating differentiators, we expect near-term rating developments to be driven primarily by M&A activity and changes in financial policies."
S&P says that at the end of the first quarter, nine of 21 ratings in the group under review (excluding ownership-linked ratings) had a negative outlook or were on CreditWatch with negative implications, suggesting that 2006 could be another year of predominantly negative rating actions. In line with our earlier indications, the 'BBB+' rating level now clearly prevails among the largest EMEA telecoms operators, accounting for about 50% of the total, and this situation is set to continue.
In an environment characterized by modest organic growth and mounting shareholder activism, S&P says that it believes that M&A should remain a dominant theme and an important rating factor in 2006, although to a slightly lesser extent than in 2005. Since many operators have now exhausted most of their financial flexibility to carry out debt-financed acquisitions without rating implications, additional transactions could be detrimental in this respect.
Western Europe's largest telecoms operators are often caught between, on the one hand, the mounting pressure generated by their own subdued equity valuation and the need to improve shareholder sentiment, and, on the other, the high equity valuations of the few attractive targets offering meaningful growth potential, thereby significantly diminishing prospects for returns. Consequently, equity-financed transactions still appear unlikely on the whole, and the risks of overpaying and overpromising on acquisitions are real. To avoid these risks, certain European telecoms operators are likely to opt for returning nearly all excess cash flow to shareholders.
Nevertheless, Europe's largest telecoms operators are still benefiting from significant credit quality hedges, with free cash flow generation remaining fundamentally strong. Consequently, S&P would not necessarily react negatively in response to acquisitions that would penalize credit ratios, provided the impact were only temporary and the business profile remained fundamentally strong. Overall, management teams should be in full control of the midterm evolution of capitalization measures, and therefore, any marked deterioration in credit quality should be, to a large extent, a deliberate managerial decision. Also, most of Europe's telecoms operators should be able to rapidly adjust to a significant deterioration in credit markets--a key difference compared with the situation during the prior M&A frenzy.
Together with M&A, radical and long-term adjustments to financial policies may currently represent the most prominent threat to average credit quality in the European investment-grade telecoms sector. Such risks have increased substantially over the past year on the back of lackluster equity performance for most telecoms companies, and generally pose a fairly high threat for credit protection in 2006.
Midsize telecoms operators are generally most exposed to shareholder activism and event risks, and are most likely to implement defensive strategies, resulting in materially more leveraged capital structures. In contrast, Europe's largest telecoms operators are unlikely to seek a deliberate, dramatic deterioration in their credit quality during 2006. Their flexibility to fund substantial capital and technology expenditures, capacity to pursue acquisitions, and maintenance of a solid credit profile to refinance high debt levels through the credit market cycles should prevail.
Nonetheless, S&P acknowledges that the largest operators may be tempted to implement a somewhat more leveraged capital structure, as reflected in financial policies that have gradually shifted away from the leverage ratio targets of about 2x prevailing until 2005, to embrace targets of up to 3x these days. For some time now, S&P says that it has expected the saturated European mobile markets to suffer from intensifying competition and regulatory tariff cuts. In fixed line, downbeat revenue prospects have become almost the norm, and recent guidance given for 2006 has not bucked the trend.
S&P continues to believe, however, that, thanks to their significant scale and high operating cash flow, Europe's former telecoms monopolies are best positioned to reap, over the long term, the operating benefits of technology developments. In 2006 and 2007, free cash flows and operating margins should weaken somewhat, as most operators invest more proactively in network technologies and customer retention, but should remain at acceptable levels. In the context of rapid technology developments and gradual changes in business models, the ability to implement the new broadband and all-IP network and IT frameworks in the most cost-efficient and simple way and to rapidly facilitate the convergence of fixed-line and mobile technologies, while further streamlining operating costs, will be critical success factors."
Posted to the site on 10th April 2006
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