OREANDA-NEWS. Fitch Ratings has affirmed South Korea-based SK Telecom Co., Ltd.'s (SKT) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) and its senior unsecured rating at 'A-'. The agency has also upgraded wholly owned subsidiary SK Broadband Co., Ltd.'s (SKB) Long-Term Foreign- and Local-Currency IDRs and senior unsecured rating to 'A-' from 'BBB+'. The Outlook on both companies' IDRs is Stable.

We have equalised SKB's ratings with SKT's given evidence of strengthening operational and strategic linkages between two entities, following SKT's acquisition of minorities' 49.4% stake in SKB in April 2015. SKT's rating and Stable Outlook reflects Fitch's view that the company's financial profile will remain commensurate with the current rating level over the next 12 to 18 months as market competition remains stable and capex remains moderate.

KEY RATING DRIVERS
Stable Operating Performance: Fitch expects SKT's profitability to improve in the short term with the benefit of lower marketing costs and rising average revenue per user (ARPU). With the Handset Distribution Act in October 2014, Fitch believes marketing spending will remain low in the near term, which should lead to stable operating performance. For 2015, we expect SKT's marketing cost to be about 25% of total revenue (FY14: 32.5 %). However, one-off costs related to early retirement of staff will limit the upside in EBIT margin in 2015.

Easing Competition: Fitch believes that the regulator's scrutiny of the market will prevent a price war and continue to keep wireless competition in check in the near term. Implementation of the Handset Distribution Act, which seeks to make operators' subsidy practices more transparent, substantially lowered price competition between major telecom operators. We expect mobile number porting to stay at a lower level after it decreased by 40% from July 2014 to July 2015.

Data Usage Increases: We expect wireless data traffic volume to continue to increase, helping ARPU. With premium tariff plans that include more data becoming more popular, we expect ARPU to grow modestly in the near term. However, removal of subscription fees and the rising number of users who take up price-discount plans will constrain the rise in ARPU. SKT has around 17.9 million LTE users (62.6% of total subscribers as at end-1H15) and the monthly data usage per LTE user increased 26% yoy to 3.3GB in 2Q15.

Leverage Increases Marginally: Fitch expects SKT's FFO-adjusted net leverage to remain at around 1.3-1.4x in the short term (2014: 1.35x). The one-off cash outflows for buying out the minorities in SKB and paying the early-retirement benefit are likely to result in slightly higher leverage ratio in 2015 compared with 2014, despite improved operating performance. However, leverage may improve in 2016 with positive FCF as a result of lower marketing costs and moderate capex.

SKB Equalised with SKT: We assess the relationship between SKB and its parent SKT to be close enough to align the ratings, under Fitch's Parent and Subsidiary Linkage criteria. SKB's fixed-line operation is of great importance to SKT's market position, particularly with respect to its ability to compete with other integrated operators, such as KT Corporation (A-/Stable) and LG Uplus Corporation. In addition, SKT would face reputational risk should SKB fail. Therefore, Fitch believes that SKT is highly likely to provide financial assistance to SKB if required.

SKB's Profitability under Pressure: SKB's margin is unlikely to improve in the short term due to continued decrease in fixed-line ARPU and increase in marketing costs for the internet protocol television (IPTV) and media businesses. Revenue should continue to rise as growth in the B2B and IPTV businesses offset the decline in the fixed-line business. Fitch expects marketing expenses for the IPTV and B2B segments to increase as competition intensifies. We expect the company to focus on volume expansion via sales of bundle packages at the expense of margin improvement.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for the companies include the following:

SKT (Based on consolidated financials)
- Revenue in 2015 to remain broadly the same as that in 2014
- EBIT margin to improve slightly due to lower marketing costs
- Capex to remain at around KRW3.1trn (cash basis) in 2015 (2014: KRW3.14trn)
- Free cash flow to be negative in 2015 and then turn positive in 2016.

SKB
- Revenue to increase in the low single digits in 2015
- EBIT margin to decline due to increase in marketing and content costs
- Capex to remain at around KRW600bn in 2015 (2014: KRW600bn)
- Negative free cash flow to continue in the near term

RATING SENSITIVITIES
SKT
Negative: Future developments that may, individually or collectively, lead to negative rating action include
- Deterioration in the operating environment resulting in operating EBITDAR margin sustained below 25% (2014: 27.7%)
- FFO-adjusted net leverage of over 1.75x on a sustained basis (2014: 1.35x)
- Negative pre-dividend free cash flow on a sustained basis

Positive: Future developments that may, individually or collectively, lead to positive rating action include
- Improvement in the operating environment resulting in operating EBITDAR margins above 35%
- FFO-adjusted net leverage of below 1.25x on a sustained basis
- Positive pre-dividend free cash flow on a sustained basis

SKB
Negative: Future developments that may, individually or collectively, lead to negative rating action include
- An indication of weaker ties or a negative rating action on SKT

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

LIQUIDITY
Weakening Liquidity: Fitch expects SKT's liquidity to remain adequate, supported by its ready access to capital markets when it needs external financing and credit lines of around KRW500bn. SKT's liquidity has deteriorated since 2014 due to increased working capital needs. The company's total cash and cash equivalents was KRW1.1trn as at end-June 2015 (end-1H14: KRW1.7trn), which fell short of short-term obligations of KRW1.5trn.