S&P Raises Outlook on Chunghwa Telecom Co., Ltd (CHT) to Stable

Standard & Poor's Ratings Services said today that it had revised its outlook on Chunghwa Telecom Co. Ltd. (CHT)(NYSE: CHT) to stable from negative. At the same time, we affirmed our 'AA' long-term corporate credit rating and 'cnAAA' long-term Greater China regional scale rating on the telecom operator.

"We revised the outlook because we believe that proposed deregulation that could weaken CHT's dominant market position in fixed-line business is unlikelyto materialize in the next one to two years," said Standard & Poor's credit analyst Anne Kuo. "In addition, we believe that the growing penetration of mobile fourth generation (4G) and cable TV services in the market will serve as partial substitutions for CHT's fixed line business, thus lowering the need for regulatory intervention."

Standard & Poor's believes that margin pressures from previous regulatory action have reduced and will continue to moderate due to the regulator's strategic change to indirect from direct pricing intervention. This change has been achieved by lowering the fees mobile phone companies charge other carriers to terminate calls on their networks instead of mandatorily cutting retail pricing.

"We have affirmed the ratings because we expect CHT to maintain its dominant market position in fixed-line business and leading market share (about 37% for 2G plus 3G mobile users as of October 2014) over the next one to two years," said Ms. Kuo. "We also affirmed the ratings because we believe that CHT will sustain strong profitability supported by integrated business lines, and maintain a very robust financial risk profile with very low leverage and strong cash flow generation."

We expect CHT's strong branding, high-quality networks, and well-established customer base to help the company maintain its market positions in fixed-line and wireless businesses, despite growing competition. We also believe that CHT's scale economies continue to underpin the company's good cost competitiveness. These factors support our assessment of CHT's business risk profile as "strong." The potential for adverse regulatory intervention such as local loop unbundling remains the key risk for CHT to sustain its competitive position and business risk profile; however, we believe such intervention is unlikely to materialize at least in the next 12 months. Local loop unbundling refers to the regulatory process of allowing multiple telecommunications operators to use connections from the telephone exchange to a customer's premises.

We expect the impact of regulatory pricing intervention on CHT's profitability to lessen over the next one to two years, as intervention is likely to decline. CHT's EBITDA margin improved to 38.1% for the first three quarters of 2014, up from 36.6% in 2013, following consecutive years of declining margins under repeated regulatory intervention. Nonetheless, we expect the company to continue to face margin pressure over the next one to two years due to rising 4G-related costs including handset subsidies and marketing expenses. However, the impact is likely to be tempered by CHT's strong customer base, integrated business lines, efforts to enhance its value-added services, bundled product offerings, and leverage of its extensive network coverage.

CHT's acquisition of favorable bandwidths for 4G mobile services has helped the company to gain market share at a quicker pace than its main competitors, and we expect CHT to largely maintain this advantage over the next one to two years. However, the benefit of 4G market growth on CHT's average revenue per user (ARPU) uplift has been limited, despite the rapid growth of the company's 4G subscriber numbers particularly driven by the launch of a new iPhone model and unlimited tariff plan. We do not expect a significant increase in data usage from the roll-out of 4G services to monetize over the next several months. This is because CHT's aggressive pricing strategy and generous data allowance to boost its subscriber base are likely to weaken the company's margin in the next several quarters. However, we expect ARPU to rise moderately after the promotional period terminates and CHT implements tiered-pricing.

In our opinion, CHT has minimal leverage and a very conservative financial policy with very low risk tolerance. We expect the company to keep its ratio of debt to EBITDA well below 0.5x for the next one to two years while maintaining very strong cash flow generating ability. This is despite the high acquisition costs of 4G mobile service licenses, the resultant rollout costs, CHT's slightly declining profitability, and the company's high cash dividend payout. We expect CHT to maintain its high dividend payout ratio. However, we believe that the company will maintain its solid balance sheet over the next few years, supported by strong cash flow generation and the company's flexibility to adjust its cash dividends when needed to support additional capital spending. These factors support our view of CHT's financial risk profile as "minimal."

"The stable outlook reflects our view that CHT will maintain its strong competitive position as the dominant player in Taiwan's fixed and mobile telecom sector, while maintaining a minimal financial risk profile," added Ms. Kuo. "The outlook also reflects our view that the impact and timing of potential regulatory interventions, including local loop unbundling, remains highly uncertain and is unlikely to materialize over the next one to two years."

We may lower the rating if the Taiwan regulator instigates further material negative actions (including local loop unbundling) that materially erode CHT's competitive position, or if there is a significant increase in mobile competition that materially changes the existing market structure and erodes CHT's profitability. We may also lower the rating if CHT's adjusted ratio of debt to EBITDA rises above 1.5x, although we view the likelihood as very low over the next one to two years. In addition, any lowering of our rating on the Taiwan sovereign or Transfer & Convertibility assessment on Taiwan (AA+) below 'AA' would likely reflect a worsening of CHT's operating environment and financial flexibility, which in turn could lead us to downgrade CHT.

Upside rating potential is highly unlikely in the next few years, but would be reliant on a significant improvement in CHT's competitive position and operating diversity, while maintaining a minimal financial risk profile and strong profitability.

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