S&P Lifts Outlook on BT Group plc (BT) to Positive; 2015 Metrics Stronger than Anticipated

Standard & Poor's Ratings Services revised its outlook on BT Group plc (NYSE: BT) (BT) to positive from stable. At the same time, we affirmed our 'BBB' long-term and 'A-2' short-term corporate credit ratings on BT as well as our issue ratings on the group's debt.

The outlook revision follows BT's stronger metrics for fiscal year 2015 than we previously anticipated, and its consistently strong operating performances, which led it to affirm its guidance for modest EBITDA growth this year despite higher content costs. This prompted us to revise our base case to reflect our anticipation of further EBITDA margin upside potential, in spite of increasing content costs. Under our current base case, pro forma for the acquisition of U.K.-based mobile operator EE, we expect debt to EBITDA of less than 2.5x, funds from operations (FFO) to debt trending toward 35%, and free operating cash flow (FOCF) to debt after pension contributions above 15% by the end of fiscal year 2017 (ending March 31, 2017), which is sooner than in our previous forecast. Furthermore, we continue to assume that the group's pending acquisition of EE--if completed as planned and that any changes imposed by the competition authority would preserve the transaction's key aspects--will meaningfully strengthen its business risk profile. The group has indicated that the review process could end by the first quarter of 2016.

Our revised forecasts, including the acquisition of EE and a stronger business risk profile, are, in our view, commensurate with our 'BBB+' rating--one notch higher than the current rating on BT.

In our assessment of BT's business risk profile, the combination of BT's fixed business with EE's mobile business would further enhance BT's competitive position and scale in the U.K. This will reduce BT's exposure to fixed telecommunications and related fixed-mobile substitution risk. Furthermore, it should provide BT with cross-selling opportunities, an advantage in convergent fixed-mobile services, and cost synergies opportunities.

In addition, and critical to our assessment, the combination of the high-quality fixed and mobile networks, leveraging BT's increasingly fiber-based infrastructure with EE's wide 4G coverage and solid spectrum position, should provide long-term differentiating advantages versus lower quality networks. Also, as the industry increasingly moves toward data traffic services provided across a variety of equipment--including smartphones, tablets, and PCs--we believe that integrated operators with higher-than-average network quality, such as the combined entity, should be able to better monetize the traffic growth, attract higher average revenues per user (ARPU), and better retain customers.

In our revised base case, before the transaction, we foresee a slight 1%-2% annual decline in revenues at BT level for the next two years. This would be propelled by pressure on revenues from the wholesale segment, and to a lesser extent at BT Global Services and Business, driven by a mix of regulatory effects, shrinking large contracts, declining legacy technologies, and fierce price competition. However, continuous growth in BT consumer revenues, albeit softening somewhat to about 5% in 2015 and about 4% in 2016, would cushion some of that pressure, thanks to consistent growth in the fixed broadband subscriber base, as well as related ARPU, which should increasingly benefit from higher IP-TV penetration and BT's sports content offering.

At the same time, we think that BT will continue its strong cost savings track record, an area where the group positively differentiates itself from peers. Despite the extra costs incurred on sports events rights acquisition, we still foresee improving EBITDA margin overall at BT's current scope of consolidation, translating into slightly progressing absolute EBITDA. Pro forma for the announced acquisition, we see the adjusted EBITDA margin dropping to 34%-35%, compared with our assumption of about 38% for fiscal 2016, diluted by EE's weaker EBITDA margin, and rebounding thereafter thanks to ongoing underlying cost improvements and cost synergies from the integration of EE.

In our view, BT will continue to generate solid free cash flow and positive discretionary cash flows after dividends, share buybacks, and pension contributions.

At the BT level, we currently anticipate a fully adjusted debt-to-EBITDA ratio of about 2.4x for the fiscal year ending March 31, 2016, dropping to 2.3x in fiscal 2017, and a ratio of FFO to debt at about 30%. Pro forma for the announced acquisition, we anticipate a ratio of fully adjusted debt to EBITDA of 2.4x in fiscal 2017, FFO to debt progressing toward 35%, and FOCF to debt above 15%.

The positive outlook reflects our view that, should BT complete the pending acquisition on EE as planned, the group's business risk profile would significantly benefit from EE's solid mobile position and opportunities to offer fixed and mobile converged services, and from the high quality of respective networks.

In addition, we anticipate that in such a scenario, key credit metrics in fiscal 2017 (ending March 31, 2017) would likely be commensurate with a 'BBB+' rating, one notch higher than our current rating on BT.

We would likely raise the ratings on BT by one notch if the EE acquisition closes as expected, assuming the group's credit metrics and operating performance stay in line with our current forecasts for fiscal 2017, and any changes imposed by the competition authority preserve the transaction's key aspects.

Ratio guidelines for our 'BBB+' rating--such as Standard & Poor's adjusted ratios of debt to EBITDA of less than 2.5x, FFO to debt trending toward 35%, and FOCF to debt after pension contributions above 15%--are somewhat more demanding compared with those of some of BT's European peers. This partly reflects the potential for material swings in leverage metrics on the back of volatility in pension assets and liabilities. We acknowledge that the pension deficit may fluctuate over time and potentially cause swings in BT's adjusted credit metrics.

Weaker operating performances than we currently foresee, or any material changes to the planned acquisition's key parameters, or failure to complete the transaction, could remove the potential of rating upside.

At the current rating level and current scope, rating pressures could arise if its adjusted debt to EBITDA exceeds 3x or FFO to debt drops below 25%.

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