OREANDA-NEWS. Fitch Ratings says Telecom Italia SpA's (TI, BBB-/Stable) ability to convert improving operating trends and underlying EBITDA into stronger cash flow is key to the stability of its rating.

The company's leverage at end-2015 was high: net debt/EBITDA was 3.6x and FFO adjusted net leverage was 4.3x. Cash flow improvements, driven mainly by domestic performance, should result in modest deleveraging in 2016 and 2017. Headroom remains limited, as we expect TI's FFO adjusted net leverage to remain at around our downgrade threshold of 4.2x in 2016, improving to an estimated 4.0x by end-2018. TI's cash flow visibility is lower than most of its peers; stability and improvements in operating cash flow and deleveraging over the coming quarters will be important to the rating.

TI's revised efficiency targets announced at its 1Q16 results underline management's commitment to improving domestic financial performance, especially in 2016. Fitch believes a number of one-off items affected 2015 results and cash flow should gradually improve through 2016. On a trailing 12-month basis, FFO adjusted for non-recurring items (as defined by Fitch, mainly the costs related to a high level of bond buybacks) at 1Q16 improved to EUR5.9bn, from EUR5.7bn at FYE15. Gradual but sustainable improvements are important, as transformational events such as further asset sales are unlikely.

Unlike some of its peers, TI has few of the levers available to larger, more diversified group's to reduce leverage. The ordinary dividend has been cut completely and the savings share payout has been reduced to a minimum. Opportunities for non-core disposals are limited. However, TI's sale of its Argentina stake and the conversion of the mandatory convertible are positive, which together should provide around EUR2.0bn in debt relief in 2016. A further sell-down of TI's Inwit stake appears to have been put on hold; although any resulting benefits from this would in part be offset by an increase in lease adjusted debt.

TI's efforts to reduce leverage have been challenged by the conflicting ambitions of network investment and a need to improve cash flow and credit metrics. We believe that network investment in Italy, a country where fibre deployment has lagged that of other markets, is supportive of long-term operational trends. The competitive threat from Enel's Open Fiber project underlines the importance of TI's investments, which should improve TI's convergent and triple-play service offering.

Enel's fibre plans could provide a significant alternative wholesale infrastructure. TI aims to rollout superfast broadband to 84% of Italian households by 2018, while Enel's Open Fiber project is targeting to reach 7.5m fibre homes over the next few years. With Enel yet to begin its fibre deployment, delivery of the project will be important, as will TI's ability to remain ahead of Open Fiber roll-out. We believe an effective alternative network could strengthen retail convergent competition from Vodafone and others, as well as the more obvious threat to TI's existing wholesale revenues.

Potential changes to the shape of the Italian mobile market, in particular the proposal of an Iliad-backed new entrant should the WIND/H3G merger go ahead, do not pose a significant threat to the current market structure, in our view. Market conditions have proven intensely competitive in recent years. However, market leaders, TIM and Vodafone, have been successful in imposing a more disciplined and rational approach to market pricing.

Formerly a growth driver, TI's Brazilian operations (TIM Brasil) are suffering mainly from macro effects. We do not view TIM Brasil as a key cash flow contributor to the group or as a significant credit driver, although it could be a drag on the group's revenue and EBITDA over the next one to two years given the macro environment. Fitch would not expect to react to this alone, provided that TIM Brasil is not significantly underperforming the wider market and that margin and cash flows are being defended. Fitch does not expect major changes to the shape of the market while Oi is being restructured. Nevertheless, consolidation remains likely over the medium term, with TIM Brasil's involvement in such an event continuing to be viewed by Fitch as event risk.