OREANDA-NEWS. Fitch Ratings has upgraded Netherlands-based Royal KPN N. V.'s (KPN) Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'BBB' from 'BBB-'. The Outlook on the IDR is Stable. A full list of rating actions is at the end of the commentary.

The upgrade reflects Fitch's view that KPN is on a more sustainable competitive track within its domestic consumer market. The position may strengthen over time on the back of bundled product offerings, network investments and a more rational fixed line market environment. This is likely to enable KPN to sustain its recent stabilisation in adjusted group EBITDA, grow free cash flow (FCF) and maintain leverage and an operating profile commensurate with a 'BBB' rating.

We expect weakness in the business segment may continue over the next two to three years. However, the declines are likely to have a diminishing impact after 2016 at the group level, as growth in the consumer division and cost control in network, operations and IT will enable the business division's EBITDA declines to be progressively off-set.

KEY RATING DRIVERS

Sustainable Position in Consumer Emerging

After a period of decline in its domestic market driven by intense competition, regulatory pressures and sectoral shifts, we believe KPN's operational profile and EBITDA trajectory is on a more sustainable footing. The combination of investments in fibre and broadband networks and bundled products offers should enable the company to compete more effectively in the consumer market. Fibre and DSL based technologies are cost effectively diminishing the broadband speed advantage of cable operator Ziggo, while product bundling is providing a point of differentiation from mobile-only operators in certain market segments.

No Immediate Consolidation Threat

We believe the recently announced merger of Vodafone Netherlands and Ziggo stands a good chance of receiving competition and regulatory approval. The merger will be a form of market consolidation, removing competition from one wholesale-based mobile operator and one wholesale-based fixed line operator. The merger will create an effective duopoly in local network infrastructure access, which we consider is likely to create a more rational market environment in the consumer broadband and fixed line segment (29% of KPN's domestic revenues), enabling greater control of prices.

Both KPN and Vodafone/Ziggo are defending subscriber and revenue market shares in the consumer segment that are close to each other. We estimate KPN, Ziggo and Vodafone account for around 80% of total Dutch telecoms market revenue in 2015. Given the maturity of the Dutch broadband and mobile market, we believe that both operators are likely to deploy strategies that optimise market value rather than drive significant increases in market share, which may be costly and unlikely to yield a sustainable increase in incremental FCF.

The competitive dynamics in the Dutch market, in our view, are more likely to be driven by Tele2 Netherlands' pricing strategy and segment positioning following its recently launched own mobile network and how T-Mobile Netherlands chooses to avert the loss in its mobile market share.

Business Drag Likely to Remain

In 2015, KPN derived 40% of its domestic revenues from its business segment. They declined by 9% yoy driven by repricing of single play mobile services, loss of traditional fixed line voice revenues, migration to IP based products and macro-economic pressure on network and IT services. Management's strategy to stabilise the decline is having some positive effects. This has been to reduce costs and grow multi-play products and new services such as cloud, IoT and M2M. However, there is limited visibility around when the division's EBITDA will stabilise.

Fitch's base case assumes that the business division's decline in adjusted EBITDA will reduce to 7%-8% yoy in 2016 from 12% in 2015. Thereafter, we assume the rate of decline will continue to improve but it may take another two to three years before stabilisation is achieved. However, the declines are likely to have a diminishing impact post 2016 at the group level as growth in the consumer division and cost control in network, operations and IT enables the division's EBITDA declines to be progressively off-set.

Improving FCF to Support Leverage

KPN's funds from operations (FFO) adjusted net leverage at the end of 2015 reduced to 3.1x from 4.1x in 2014 primarily driven by debt reduction following asset disposals and improving operating FCF. We believe the company has the capacity to maintain leverage around this level. This assumes dividend growth in line with pre-dividend FCF and that KPN continues to receive dividends from its 15.5% stake in Telefonica Deutschland (TEFD) or that a leverage-neutral stance is taken on the use of any future sales proceeds. Dividends from the stake currently have a 0.15x positive impact on FFO adjusted net leverage.

The ability to maintain a steady leverage profile is supported by a gradual improvement in KPN's pre-dividend FCF margin to 11% over the next three years from a projected 9% in 2016. The growth in FCF will primarily be driven by stabilising EBITDA, reducing capex, minimal cash taxes and a reduction in interest costs as the company reduces debt.

Mobile Market Risks Manageable

We expect the Dutch mobile market will continue to remain competitive following the launch of Tele2's mobile network. We estimate that at the end of 2015 Tele2 had a subscriber market share of 4% to 5%. The low market share remains a risk for KPN's credit profile in the event Tele2 takes a prolonged, aggressive approach to its pricing policy driven by a potential short-term need to fill network capacity. To date, the greatest impact has been in the lower value, price sensitive segments of the market. This may spread to other segments over time.

In the medium to long term, Tele2's suboptimal spectrum holdings may begin to restrain its operational flexibility without further investment. In the meantime, KPN has a number of levers to minimise the impact of increased competition. These include the ability to offer triple and quad play services over its own network, maintain investments in network quality, increase the value of its bundled services, raise prices in the fixed line portfolio and maintain subscriber acquisition and retention costs at elevated levels while reducing other operational costs.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer are:

- Revenue change of -3.5% in 2016 gradually improving to -1% by 2018.

- Broadly stable EBITDA of EUR2.4bn, driven by a 2.5 percentage point improvement in EBITDA margin between 2016 and 2018.

- A stable capex to sales ratio of 17.5% to 18% excluding spectrum.

- A dividend pay-out ratio of 70% of pre-dividend FCF (excluding any dividend proceeds from TEFD)

- All TEFD dividends received are passed through to shareholders.

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

- Revenue and EBITDA growth across all divisions combined with strengthened operating profile and competitive capability.

- Expectations of FFO adjusted net leverage sustainably below 3.0x.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

- A deterioration in KPN's domestic operations that result in declining EBITDA.

- Expectations of FFO adjusted net leverage remaining above 3.5x on a sustained basis.

- Aggressive shareholder remuneration policy that is perceived by Fitch not be in line with company's operating risk profile.

FULL LIST OF RATING ACTIONS

Long-term IDR: upgraded to 'BBB' from 'BBB-', Outlook Stable

Senior unsecured debt: upgraded to 'BBB' from 'BBB-'

Subordinated capital securities: upgraded to 'BB+' from 'BB'