OREANDA-NEWS. June 30, 2015. Fitch Ratings has revised Telefonica SA's Outlook to Stable from Negative, while affirming its Long-term Issuer Default Rating (IDR) at 'BBB+'. A full list of rating actions is available below.

The revision of the Outlook to Stable is driven by expectations of stabilising operational trends within Telefonica's domestic market in Spain and improving group EBITDA over the next 12 to 18 months. Higher capital expenditure and spectrum costs, combined with the resumption of full cash dividends, are however likely to restrain free cashflow (FCF) generation and the pace of organic deleveraging in the next two years.

Depending on the pace of underlying EBITDA growth in 2015, Telefonica's funds from operations (FFO) net adjusted leverage is likely to remain broadly stable at 2014 levels of 3.6x (adjusted for full-year consolidation of E-Plus and GVT and assuming that Telefonica O2 UK remains a continuing operation). This leaves little headroom within Telefonica's current rating until the sale of Telefonica O2 UK is completed in 1H16 or until the company deleverages organically, which could start from 2016.

KEY RATING DRIVERS

Improved Spanish Market Backdrop
Market consolidation has structurally changed the Spanish telecoms market. The acquisition of 'challenger' telecoms operators ONO and Jazztel by Vodafone and Orange respectively leaves three operators controlling over 85% of sector revenue, all with similar economic motives and return characteristics. With an improving macro-economic backdrop in the country, it is likely that all three operators will rebalance their strategies more towards profitability rather than market share, potentially allowing the market to normalise.

Stabilising Operational Trends in Spain
In 2014, Telefonica Spain accounted for over 36% of total group pro-forma EBITDA and a greater proportion of operating FCF. The Spanish operations have been experiencing revenue declines of approximately 10% per annum on average between 2012 and 2014 as a result of competition, tariff rebalancing and regulation.

We expect the rate of decline to slow significantly during 2015 with revenues stabilising thereafter. The improvement is likely to be driven by a combination of tariff increases, improving competitiveness from high-speed broadband and Fusion products, and lower incremental impact from regulated price decreases.

Improving Group EBITDA
Fitch expects that Telefonica's declining group EBITDA trend (2012-2014: CAGR -14.5%) are likely to reverse during 2015 and grow over the next two to three years. EBITDA growth will be driven by a combination of factors: the acquisition of GVT in Brazil, the extraction of consolidation synergies in Germany, organic growth and positive FX drivers from Latin American operations in 2015, cost control and stabilisation of revenues in Spain.

Despite some visibility on the impact of FX on EBITDA for 2015 the impact thereafter is uncertain and poses a risk to the growth profile of the group. Latin America, including Brazil, accounts for approximately 48% of total 2014 pro-forma group EBITDA making some of Telefonica's credit metrics highly sensitive to FX swings and capital controls. Historically, organic revenue growth over the past five years has been consistently strong, while reported growth due to FX volatility has been mixed and negative on some occasions.

At the debt level, Telefonica uses derivatives and the issuance of multi-currency gross debt to reduce the currency mismatch where possible. Still, approximately 60% of Telefonica's debt is EUR-denominated compared with approximately 43% of EBITDA.

Restrained FCF Generation
Fitch expects capital expenditure levels to remain high over the next two to three years as Telefonica continues to invest in fibre and mobile broadband networks to support its commercial strategy across its footprint. The company will also need to absorb the cost of new spectrum in Germany and Brazil in 2015 (Fitch assumes around EUR1.9bn). Combined with the resumption of full cash dividend payments, higher investment costs may temper FCF growth in the short- to medium-term.

Financial Flexibility Likely to Improve
Fitch expects Telefonica's financial flexibility to be constrained in the short-term, with FFO adjusted net leverage likely to remain stable at 3.6x by end-2015 on a pro-forma basis. Fitch's base case view of Telefonica does not include the sale of Telefonica O2 UK. Under the base case scenario, we believe that Telefonica can deleverage organically from 2016 with FFO adjusted net leverage likely to fall below 3.3x by 2018. This reflects growth in group EBITDA, gradual reduction in investment costs from 2017 and assumes a lower-than-average historical organic growth rate for Latin America.

The sale of Telefonica O2 UK, which is likely to complete in 1H16, will generate approximately EUR12.6bn initially. This has the capacity to reduce FFO adjusted net leverage by up to 0.5x, depending on shareholder remuneration and the ability to improve Telefonica's financial flexibility swiftly.

KEY ASSUMPTIONS

- Pro-forma calculations assume a full year of consolidation of E-Plus in 2014 and GVT in 2015. Telefonica O2 UK is treated as a continuing operation and sale proceeds are not included.
- Further 1.5.pp loss of subscriber mobile market share in Spain by 2017.
- Spanish mobile average revenue per user (ARPU) to continue declining in 2015 before stabilising.
- Pro-forma group YoY revenue growth (assuming full consolidation of GVT and E-Plus) of around 8% in 2015 and 1%-1.5% thereafter.
- Broadly stable group EBITDA margin at around 30% to 30.5% (including restructuring costs) over the next three years.
- Capex-to-sales ratio (including spectrum) to increase to over 20% in 2015, from 19% in 2014, before declining to below 17% by 2018.
- Reported operating income before depreciation and amortisation has been considered as EBITDA.

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, result in negative rating action include:
- FFO adjusted net leverage sustainably above 3.5x, which would lead to a downgrade
- Pressure on FCF driven by EBITDA erosion, FX and capital repatriation constraints, higher capex and shareholder distribution, or significant underperformance in the core domestic and international markets.

Positive: Future developments that may, individually or collectively, result in positive rating action include:
- FFO adjusted net leverage falling sustainably below 2.5x.
- Improved competitive position in Telefonica's domestic and other key international markets combined with growth in pre-dividend FCF.

FULL LIST OF RATING ACTIONS

Telefonica SA
- Long-term IDR: affirmed at 'BBB+', Outlook revised to Stable from Negative
- Senior unsecured: affirmed at 'BBB+'/'F2'
- Short-term IDR: affirmed at 'F2'

Telefonica Europe B.V. / Telefonica Emisiones S.A.U
- Senior unsecured bonds: affirmed at 'BBB+'
- Subordinated hybrid securities: affirmed 'BBB-'

Telefonica Finance USA LLC
- Preference shares: affirmed 'BB+'