OREANDA-NEWS. Fitch Ratings, Moscow, 04 March 2016: Fitch Ratings has affirmed JSC Transtelecom Company's (TTK) Foreign- and Local-Currency Long-Term Issuer Default Ratings (IDR) at 'B+' and National Long-Term rating at 'A-(rus)' and changed the Outlook to Stable from Negative. TTK's senior unsecured debt has been affirmed at 'B+'/'RR4' and domestic senior unsecured debt at 'A-(rus)'. The Short-Term IDR is affirmed at 'B'.

The change in the Outlook reflects our expectation that the company will focus on improving its free cash flow (FCG) generation and deleveraging. We expect its leverage to fall to sustainably below the downgrade threshold of 3x ND/EBITDA and 4x FFO adjusted net leverage by the end of 2016. Improvements in FCF generation will be supported by discipline on capital spending, efficiency improvement initiatives, rising customer take-up in territories already covered by TTK's fibre network, and only a modest increase in competition.

TTK runs a large-capacity fibre backbone network laid along the Russian railways. It operates under an asset-light business model and leases its core fibre network from its 100% shareholder Russian Railways (BBB-/Negative). TTK holds established positions in the inter-operator segment, and has developed a sufficiently large end-user broadband franchise, with a total subscriber base in excess of 1.9 million customers.

KEY RATING DRIVERS
Focus on Deleveraging.
TTK pursues a strategy of increasing revenue and profitability from its existing broadband network while maintaining strict capital expenditure discipline. We expect that the company should turn FCF positive in 2016 which, coupled with improving EBITDA generation, will result in lower debt and leverage. The company is planning to apply a significant share of its FCF to absolute debt reduction of over RUB1bn a year.

Significant Absolute Scale
With 1.9 million total subscribers in January 2016, TTK has sufficiently large absolute scale with a profitable retail business. Operating outside large cities, TTK is facing moderate competition in its targeted areas, with Rostelecom being the key rival. We believe tariffs will remain rational as the main players are unlikely to unleash an aggressive price war. It remains to be seen if operators can succeed in their efforts to increase average revenue per user (ARPU), but the market has stabilised, with the broadband ARPU estimated flat qoq in 3Q15.

However, TTK is unlikely to significantly grow its retail broadband market share, which it estimated at 5.6% in regional Russia (i.e. excluding the capital cities of Moscow and St.Petersburg) in January 2016. In our view, further market share growth will be stalled by modest investment in network expansion and a market slow-down - the Russian retail broadband subscriber base only grew by 3% in 2015.

Economic Downturn Supports Wholesale Segment
TTK will benefit from slower backbone capacity expansion by other operators. With the economic downturn in Russia, telecom operators have significantly cut their investment in new backbone networks. They will continue leasing capacity from independent network operators including TTK, which is one of the largest players in the inter-operator segment. We believe that an acceleration of network investment is unlikely in the current weak economy in Russia, which would shield TTK's revenue in the wholesale segment for at least the next two to three years.

Expansion in International Transit Traffic Segment Likely
TTK also has growth opportunities from international transit routes connecting Asia and Europe through Russia. By-pass routes around Russia typically require interconnection between several international operators, which may complicate logistics, reduce service quality and increase time delays on the route. Therefore Russian operators, including TTK, which can provide homogenous coverage of large distance spans, have a competitive advantage in this market.

Rising Penetration, Cost Efficiency Will Help Margins
We estimate that TTK's profitability should keep rising, benefiting from cost efficiencies and better use of its existing network. TTK's EBITDA margin is likely to rise to above 20% in 2015 and gradually grow to the mid-twenties by 2017 and 2018 (compared to 20% in 2014). TTK's margin is likely to remain lower than peers, reflecting lower scale and higher payments for infrastructure owned by RZD.

The company simplified its organisational structure in 2015, which has provided opportunities for substantial cost-cutting including on headcount. TTK can reasonably expect to grow customer penetration of its fibre network. The company is a relatively new in the retail broadband market, and its customer take-up on covered territories should grow closer to that of established peers with rates in the mid-thirties percentage range. This is mainly due to the good quality of TTK's fibre network and high broadband speeds.

Cash Flows Supported by IRU Proceeds in the Short-Term
Delayed revenue recognition of indefensible right of use (IRU) contracts under international financial reporting standards (IFRS) would result in stronger cash flow than suggested by reported revenue and EBITDA. Advances received under IRU contracts rose by RUB1.0bn in 2014, with a corresponding benefit for cash flows. With international transit capacity typically provided on IRU terms, we estimate that IRU proceeds should be substantial over the next three years. However, there is low visibility over IRU revenues in the longer term.

IRU contracts are concluded on a long-term committed basis, typically 10 years but no less than seven years. Contract costs primarily arise from putting in place necessary network capacity, and buyers make the bulk of their payments at the start of the service as a one-off connection fee, with typically notional monthly maintenance fees thereafter. IRU connection fees are treated as pre-payments recognised through the profit and loss statement over the contract life under IFRS rules. This treatment means that reported revenue at the start of the contract is much less than the cash payment received.

Positive Impact of Capital Expenditure Cuts on Cash Flow Delayed
TTK made a decision to curtail its broadband expansion plans and capital spending in mid-2014, but the full gain from this pivotal decision on cash flow was delayed till 2H15, with only 2016 likely to demonstrate an FCF margin in the low-to-mid single digits.

The company significantly reduced the physical amount of new construction but had to settle accounts payable for capital goods and services supplied in prior periods. A disparity between additions to plant, property and equipment on the balance sheet and cash capital outlays in the cash flow statement was in excess of RUB1.4bn in 1H15, equal to a quarter of its EBITDA for the last twelve months (LTM)-to-June 2015. We expect this disparity to iron out from 2H15.

Relationship With Shareholder
Fitch rates TTK on a standalone basis. Legal ties are weak between TTK and its parent JSC Russian Railways (RZD) (BBB/Negative) as the latter does not guarantee TTK's debt. Owning a telecoms company is not strategic for a railway operator. However, operating ties are strong and RZD is likely to retain control over TTK in the medium term.

TTK provides critical telecom and maintenance services to RZD. Replacing it as a core telecoms operator is not a feasible option for the railway monopoly in the short term, and will require significant advance planning.

RZD's leverage policy is to maintain net debt/EBITDA at below 2.5x. The railway monopoly tends to set guidelines for its subsidiaries in line with internal targets, which suggests parental backing for TTK's deleveraging.

Liquidity
TTK's 2016 debt maturities of approximately RUB5.8bn will be covered by positive free cash flow that we expect at close to RUB1bn and RUB3bn of new bank debt that the company plans to raise in 1Q16. The company's debt maturities are evenly spread over 2016, so TTK may need additional refinancing closer to 2H16 to plug the remaining gap. Some flexibility may be provided by an option to reduce capital expenditure, which may release RUB0.9bn. Refinancing efforts will be helped by TTK's switch to positive FCF generation in 2016.

The management believes that TTK may benefit from stronger EBITDA generation and some one-offs, which would reduce refinancing requirements, but liquidity may be stretched in 2H16 without additional cash inflows. A failure to address refinancing requirements in a timely fashion may put pressure on the ratings.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Continuing moderate revenue pressures in the wholesale segment mitigated by modestly improving broadband revenues, driven by subscriber base increases
- Gradually improving EBITDA margin, supported by maturing broadband operations and lower promotion activities
- Delayed revenue recognition of IRU contracts
- No significant expansion in capital expenditure
- Low dividends before the company achieves further significant deleveraging

RATING SENSITIVITIES
Positive: Stable broadband performance and less volatility in the inter-operator segment coupled with sustainably positive FCF generation and leverage at below 3x FFO adjusted net leverage (broadly corresponding to 2x Net Debt/EBITDA) may lead to an upgrade. A pre-requisite for a positive rating action is a comfortable liquidity position with a short-term liquidity score of at least above 1x.

Negative: Pressures in the inter-operator segment, but also high broadband churn and ARPU declines, leading to a sustained rise in leverage to above 4.0x FFO adjusted net leverage (broadly corresponding to above 3x net debt/EBITDA) without a clear path for deleveraging will likely lead to a downgrade. Liquidity and refinancing pressures may also be negative.