OREANDA-NEWS. Fitch Ratings has affirmed UK telecom operator Vodafone Group Plc's (Vodafone) Long-term Issuer Default Rating (IDR) at 'BBB+' with a Stable Outlook. A full list of rating actions is available at the end of this commentary.

Vodafone is comfortably positioned at the 'BBB+' rating level. The group benefits from global scale, diverse operations and sound liquidity. Free cash flow (FCF) generation and leverage are under pressure from acquisitions, network upgrades and extensions, and exceptional spectrum investments. However, the underlying operating performance of the group is improving, and deleveraging is expected once the current cycle of investment is complete and capital expenditure and spectrum costs normalise.

KEY RATING DRIVERS

Stabilising Trends in Europe
Vodafone's revenues began to show signs of stabilisation in Europe in FYE2015, reflecting subscriber growth, some early indications of price recovery and accelerating demand for data following the rollout of 4G. Competition is, however, likely to remain fierce in several key markets. In particular, Fitch expects the group's strong position in enterprise in the UK to come under threat from BT, if its acquisition of EE is approved.

Nevertheless, Vodafone now has converged offerings in all its major markets and the key will be to translate the group's network capabilities and service differential into a reduction in churn and stable ARPU.

Emerging Market Exposure
Vodafone's emerging market presence presents considerable opportunity given the lack of fixed line infrastructure, fairly strong economic growth, favourable demographics, and growing demand for data in these economies. However, this is accompanied by notable regulatory and political risk, highlighted by the recent tax case in India and the inflated spectrum investments required to remain active in the country. Competition in India is also expected to intensify due to the entrance of a new, well-funded operator that is likely to stimulate a price war to take market share from existing incumbents.

Vodafone's increasing emerging market exposure also increases the group's risk to FX fluctuations, although the presence of local currency debt helps mitigate this risk.

Project Spring on Track
Vodafone is halfway through its two-year, GBP19bn Project Spring investment programme designed to modernise its network and differentiate itself through higher network and service quality so as to capitalise on the global growth in data and increasing trend towards fixed-mobile convergence. Strategically, Fitch views the pursuit of network differentiation as an important target given Vodafone's long-term objective to position itself at the premium end of the market. However, visibility of a return on an investment of this magnitude remains limited.

Leverage Set to Spike
Fitch expects Vodafone to have limited headroom within its current rating over the next two to three years due to exceptional capex relating to the completion of Project Spring and substantial spectrum investments in Germany and India. However, we expect funds from operations (FFO) adjusted net leverage to stay below the 3.5x threshold for a downgrade and deleveraging is likely to occur once the investment cycle has peaked.

Liquidity is comfortable given GBP6.9bn of reported cash and cash equivalents at end-March 2015 as well as GBP2.9bn of liquid short-term investments and access to approximately GBP5.2bn of undrawn committed revolving credit facilities.

Event Risk
Vodafone has announced that it is in 'early stage discussions' with Liberty Global concerning a 'possible exchange' of 'selected assets'. An asset swap could arguably make strategic sense for both parties, although the structure of any transaction is presently unclear. Vodafone is also reportedly assessing the feasibility of an IPO of Vodafone India, but is likely to want to retain a majority stake in the subsidiary given the diversification benefits of the asset and attractive growth opportunities in the country.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Vodafone include:
- Low single-digit group revenue growth over the next three years reflecting a continued stabilisation of service revenues in Europe and mid-to-high single-digit service revenue growth in Africa, Middle East and Asia Pacific
- Broadly stable group EBITDA margin of around 27.5% to 28% over the next three years
- Capex-to-sales ratio (excluding spectrum) of 20% in FYE2016 before declining thereafter
- Significant spectrum payments of GBP3.8bn in FYE2016 (Fitch excludes all deferred spectrum license costs in the calculation of FFO adjusted net leverage).

RATING SENSITIVITIES

Future developments that may, individually or collectively, lead to a negative rating action include:
- FFO adjusted net leverage sustainably above 3.5x (FYE15: 2.9x), which would lead to a downgrade
-Pressure on FCF from EBITDA margin erosion, higher capex and shareholder distributions, or significant underperformance in the main operating subsidiaries

Future developments that may, individually or collectively, lead to a positive rating action include:
-FFO adjusted net leverage falling sustainably below 2.5x
- High single-digit pre-dividend FCF margin on a sustained basis
-Stabilisation of operating performance across Vodafone's main operating subsidiaries

FULL LIST OF RATING ACTIONS

Vodafone Group Plc
Long-term IDR: affirmed at 'BBB+'; Outlook Stable
Senior unsecured rating: affirmed at 'BBB+'
Short-term IDR: affirmed at 'F2'
Commercial paper programme: affirmed at 'F2'.