Fitch Revises Telecom Italia's Outlook to Stable; Affirms at 'BBB-'
The revision of TI's Outlook to Stable primarily reflects the performance of the company's domestic operations, along with the emphasis management is placing on customer experience and network investment, which in Fitch's view are likely to continue to support these trends. Important steps towards repairing the balance sheet are also key considerations.
The company will report a number of one-offs in 2015 including litigation and labour restructuring provisions and significantly increased finance leases due to the real estate project which are expected to deliver future cash flow savings. The combined effect is forecast to result in the company's funds from operations (FFO) adjusted net leverage spiking to around 4.5x by YE15; above Fitch's downgrade guideline of 4.25x. Corporate transactions, including the effective equity proceeds of the mandatory convertible (due November 2016) are expected to bring this metric back below the guideline in 2016. Fitch's scenario analysis including the impact on leverage of the proposed savings share exchange and possible disposal proceeds, suggest the potential for further improvement and underline our view that management is committed to deleveraging.
KEY RATING DRIVERS
Domestic Trends Improving
Fitch considers the trends in TI's domestic operations are improving, within both the fixed and mobile operations. Mobile had been subject to a period of intense competitive pressures, which combined with pressures in the economy was a key factor in reported EBITDA declines consistently in the high single digit range. A more rational pricing environment and the prospect of mobile market consolidation, along with a delayed (relative to other markets) but accelerating fibre build in the fixed line business have resulted in much improved revenue trends. Domestic revenue declines have reduced to low single digits, reflecting improvement in fixed line declines and mobile trends which turned positive in 3Q15, leading Fitch to believe the company will be able to stabilise underlying domestic EBITDA, which management is targeting for 2016. Fitch previously guided a material improvement in domestic trends was necessary if the Outlook was to be revised to Stable, which we believe is being delivered.
Italian Mobile Market Recovering
The Italian mobile market remains competitive while overall revenue trends have been affected materially by the economy. This effect has been more pronounced in southern Europe. However, there are signs of market repair. Fitch estimates 2Q15 total Italian market revenues were flat year on year; a significant improvement from the high single digit declines being recorded as recently as mid-2014. TI reported mobile growth in 3Q15. Market competition remains high and somewhat split, with TI and Vodafone pursuing a higher value data focussed strategy with an emphasis on customer experience and network quality. WIND and 3 Italia remain challengers, focussed on gaining subscriber market share and more aggressive pricing strategies. Nonetheless, ARPU and revenue trends appear to suggest a more rational pricing environment, which the proposed WIND/3 Italia merger should help support. EU competition/regulatory clearance of the merger remains outstanding. Fitch would view clearance of the deal as supportive of a stabilising price environment and network investment but we have not factored it into the ratings.
Evolving Ownership
Following the break-up of the Telco Partnership (in which Telefonica was the main shareholder) and sale by Vivendi of its Brazilian fixed broadband business, GVT, to Telefonica, Vivendi is TI's single largest shareholder with a stake of approximately 20%. Xavier Niel, owner of France's Illiad, is also reported to have acquired derivative positions which according to market disclosures currently represent an interest of around 15%.
Fitch has not factored these developments into the ratings although the motivations or intentions of material shareholders are important to monitor. The strategic logic of Vivendi's interest in TI has merit, with the owner of France's leading pay-TV platform, Canal Plus, thought to be interested in the potential of TV distribution opportunities by partnering with TI in Italy and potentially Brazil.
Fibre Catch-Up; Right Strategy
Fibre investment in Italy has been slow relative to other European markets. In a recent report (European Broadband Networks dated 26 October 2015 at www.fitchratings.com), we found Italy's next generation access (NGA) coverage to be the lowest among Europe's five largest economies. Management at TI seem focussed on improving this position, expecting to have reached 40% NGA coverage by YE15 and having set a target of 75% coverage by 2017. Pragmatically, investment is mainly focussed on less expensive fibre to the cabinet but with 100 cities being targeted for some fibre to the home rollout. Fitch considers fibre investment an important strategic investment. Although it has implications for capex, it is important for the wider economy, political relations and ultimately TI's business.
Customer penetration of fibre is growing from a low base, as is a small but fast growing IPTV customer base, the fixed broadband base gradually improving and broadband ARPU increasing quite strongly. Despite TI's leveraged balance sheet (relative to investment grade peers) Fitch regards the medium-term operational strength of any incumbent requires an emphasis on network quality. In this regard TI's fibre investments are important and we view them positively.
Brazil Remains Event Risk
The prospect of market consolidation in Brazil remains the subject of much speculation, with questions focussed on whether TI would either sell its mobile operations in the country or potentially undertake some kind of merger or partnership with mobile market number four and fixed line incumbent, Oi (BB/Negative). The economic and competitive environment in the market has seen growth in this business slow considerably, while the depreciation of the Brazilian real has had a significant impact on reported results from this business. However, we believe the medium-term fundamentals of the business remain intact.
Fitch views any transaction in Brazil as event risk, although believing that management continue to view Brazil as an important market. We consider the regulatory perspective around market consolidation may be shifting, given the view that some form of market consolidation or a transaction that improves the market and financial position of Oi could potentially support infrastructure investment.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for TI include:
- Flat domestic revenues and mid-single digit declines in Brazil in 2016-2017.
- Stable EBITDA margin above 40% in 2015, improving slightly 2016-2018.
- Total capex of EUR14bn in 2015-2017 decreasing to around 18% of revenues thereafter.
- One-off provisions of around EUR850m in 2015-2016 due to regulatory litigation and workforce restructuring.
- Financial discipline including a cautious approach to dividends will be maintained
- EUR1.3bn mandatory convertible treated as equity proceeds upon conversion in 2016.
RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to positive rating action include:
- FFO net adjusted leverage below 3.75x on a sustained basis.
- Sustained improvement and domestic and fixed and mobile operations as well as stabilisation of operations in Brazil.
Future developments that may, individually or collectively, lead to negative rating action include:
- FFO net adjusted leverage sustainably above 4.25x.
- Tangible worsening of operating conditions or regulatory environment - leading to materially weakened free cash flow performance (relative to our current base case).
LIQUIDITY
TI has a strong liquidity profile with EUR6.7bn of cash and equivalents at end-3Q15 and EUR7bn of available undrawn revolving credit facilities. The company's debt maturity is well spread out with existing liquidity cover refinancing needs through 2019. Projected generation of positive free cash flow from 2016 should provide additional liquidity support.
FULL LIST OF RATING ACTIONS
Telecom Italia S.p.A.
--Long-term IDR: affirmed at 'BBB-', Outlook revised to Stable from Negative
--Senior unsecured rating: affirmed at 'BBB-'
Telecom Italia Capital
--Senior unsecured: affirmed at 'BBB-'
Telecom Italia Finance SA
--Senior unsecured: affirmed at 'BBB-'
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