S&P Cuts Telecom Italia (TI) to Junk; Outlook Negative
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Standard & Poor's Ratings Services today said it lowered its long- and short-term corporate credit ratings on Italy's incumbent telecommunications operator Telecom Italia SpA (NYSE: TI) to 'BB+/B' from 'BBB-/A-3'. The outlook is negative.
At the same time, we lowered our issue rating on TI's existing senior unsecured debt to 'BB+' from 'BBB-' and assigned a '3' recovery rating to this debt. We lowered our issue rating on TI's €750 million subordinated hybrid bond to 'B+' from 'BB' and assigned a '6' recovery rating to this bond.
We removed the issuer and issue ratings mentioned above from CreditWatch, where we placed them with negative implications on Oct. 7, 2013.
We have also assigned our 'B+' issue and '6' recovery ratings to TI's proposed combined €1.3 billion, three-year mandatory convertible bonds.
The downgrade reflects our belief that TI's reported EBITDA will continue to decline in the next two years, given the challenging competitive, economic, and regulatory environments in which it operates. We also consider that the group is unlikely to trim adjusted debt enough to more than offset operating pressures while rapidly and materially improving its key credit metrics sufficiently to sustain the previous rating.
Following a recent meeting of its board of directors and the resignation of the previous chairman, TI has announced measures designed to accelerate debt reduction and strengthen domestic performances, including the planned sale of its subsidiary in Argentina and the proposed mandatory convertible. We acknowledge that some of these steps could support TI's credit quality, including its competitive position in the long run. That said, we think it will take time for the group to deliver tangible positive results and we see potential execution risks. In our view TI will likely continue to face persistent headwinds given Italy's weak economy, fierce competition, and possible negative effects from regulation. In addition, a new chairman has yet to be appointed and stability in senior management, which we view as an important credit consideration, remains to be confirmed over time.
The uncertainty about TI's governance continues to weigh negatively in our assessment of the group's management and governance as "fair." In particular, it's difficult to foresee what strategic impact Spain-based Telefonica S.A.'s potentially controlling, indirect stake in TI may have. Telefonica recently upped its stake in TI's largest shareholder, Telco, and we understand it could increase it further in the future.
We forecast sluggish GDP growth of 0.5% and 0.9% in 2014 and 2015 for Italy, with unemployment remaining at a high of about 12%. Households' constrained disposable income, a depressed housing market, and small and midsize corporates seeking to cut costs, will likely translate into a still-weak backdrop for the telecoms sector. We consequently anticipate that highly price-sensitive consumers and businesses and the fragmented wireless market will exacerbate pricing pressures for traditional voice products. In our view, it remains to be seen to what extent the marketing of more value-added data centric, enriched, and converged offers can compensate for the decline in revenue from traditional products.
In fixed-line communications, traditional telephony revenues--still representing more than 40% of the division's revenues--will likely continue to fall and weigh on revenues. In addition, fixed-line broadband growth materially lags behind the levels we see in comparable European markets, despite low penetration in Italy. While we see TI's heightened focus on next generation technology of fiber and fourth-generation (4G) wireless networks as positive in the long run, we believe that this will require large investments, potentially weakening TI's cash generation and its organic ability to reduce
debt.
We think TI's 67% owned Brazilian subsidiary broadens the group's diversity and provides benefits from operating in a very large and growing market. But this subsidiary will only partly offset domestic pressures, and its contribution is also subject to currency swings.
At this stage, we estimate group revenues (excluding Argentinian operations) will drop by about 7% in full-year 2013 and by low single digits in 2014 and 2015. We believe the falls will stem mainly from a midsingle-digit revenue drop in Italy in 2014-2015 and low- to midsingle-digit organic growth in Brazil (excluding handset sales). We foresee group EBITDA (excluding Argentinian operations) falling by about 10% in full-year 2013 and decreasing again in 2014-2015, but to a lesser extent owing to softer revenue decline, a more benign impact from regulated termination and roaming rates, and cost-cutting efforts. Combined, these factors should help to sustain still-high EBITDA margins of about 39%-40% (excluding Argentinian operations) in 2014-2015. We foresee group EBITDA (excluding Argentinian operations) eroding by 4%-5% in 2014 and by 2%-3% in 2015.
We foresee positive but diminishing discretionary cash flows, held back by heavy investment outlays required to roll out 4G mobile network and extend fiber penetration in the fixed network in Italy. We also factor in continuously heavy outlays in Brazil to extend and upgrade the network. We therefore anticipate fixed investments of about 18%-20% of revenues and annual free cash flow in the €1 billion to €1.5 billion range over 2014-2015, leaving about €0.5 billion-€1.0 billion in annual discretionary cash flow after dividends.
We think that the Standard & Poor's-adjusted debt-to-EBITDA ratio of the group in 2014-2015 could exceed 3.3x but remain below 3.7x (which would likely translate into 4.0x maximum including Brazilian operations on a pro rata basis), which is the maximum we would consider commensurate with the current rating. We believe the group's cash flow metrics will remain very weak, and that the adjusted ratio of FFO to debt will hover at about 20% in 2014-2015. We base our estimates on our expectation of further declines in EBITDA and FFO, balanced by some positive discretionary cash flows and the proceeds from the announced sale of TI's Argentinian subsidiary.
We will assess the proposed mandatory convertible bonds as having "minimal" equity content at issuance under our criteria, based on the bonds' maturity to conversion of more than two years and given that the required shareholders' authorization might not be obtained. The presence of a make-whole cash payment in case of early conversion is also a negative. Apart from these factors, we think other features of the proposed bonds are in line with "high" equity content. Specifically, the proposed bonds are deeply subordinated, can be converted into shares only if the conversion date falls after the shareholders' agreement, include a conversion price floor equal to the share reference price, and are deferrable at the issuer's discretion. We could raise the proposed bonds' equity content to "high" when their remaining maturity becomes less than two years, assuming that shareholders' approval for their conversion has been obtained, and depending on our perception of TI's financial policy at the time.
The ratings reflect our assessment of the group's business risk profile as "satisfactory" and financial risk profile as "significant." Our view of TI's business risk balances its solid fixed and mobile positions, high EBITDA margins in Italy, and the benefits of geographic diversity in the attractive Brazilian market, against deep-seated mobile price competition, lack of material growth traction in fixed broadband, the challenging economic and regulatory environments in Italy, and our score of "fair" of TI's management and governance. The group's financial risk profile is constrained by its high indebtedness and our perception of TI's lack of flexibility given its shareholder structure. This is tempered, however, by our expectation that TI will generate positive discretionary cash flows.
The negative outlook reflects the possibility of further rating downside in 2014-2015 if TI fails to improve domestic operating performances and EBITDA continues falling by midsingle digits or more through 2014-2015. This could occur if there's a renewed price war in Italy's wireless market, absent a softening in the decline of fixed-line revenues, or the group makes higher investment outlays than we currently expect.
We could lower the ratings on TI if our fully adjusted ratios of debt to EBITDA increase toward 3.7x and FFO to debt drops toward 15%, or if we consider that the group's liquidity is weakening.
We could revise the outlook to stable if the group structurally strengthens its domestic operating performances. Such strengthening would include gradually stabilizing EBITDA, preventing debt to EBITDA and FFO to debt from deteriorating materially, maintaining adequate liquidity, and stabilizing management and governance.
At the same time, we lowered our issue rating on TI's existing senior unsecured debt to 'BB+' from 'BBB-' and assigned a '3' recovery rating to this debt. We lowered our issue rating on TI's €750 million subordinated hybrid bond to 'B+' from 'BB' and assigned a '6' recovery rating to this bond.
We removed the issuer and issue ratings mentioned above from CreditWatch, where we placed them with negative implications on Oct. 7, 2013.
We have also assigned our 'B+' issue and '6' recovery ratings to TI's proposed combined €1.3 billion, three-year mandatory convertible bonds.
The downgrade reflects our belief that TI's reported EBITDA will continue to decline in the next two years, given the challenging competitive, economic, and regulatory environments in which it operates. We also consider that the group is unlikely to trim adjusted debt enough to more than offset operating pressures while rapidly and materially improving its key credit metrics sufficiently to sustain the previous rating.
Following a recent meeting of its board of directors and the resignation of the previous chairman, TI has announced measures designed to accelerate debt reduction and strengthen domestic performances, including the planned sale of its subsidiary in Argentina and the proposed mandatory convertible. We acknowledge that some of these steps could support TI's credit quality, including its competitive position in the long run. That said, we think it will take time for the group to deliver tangible positive results and we see potential execution risks. In our view TI will likely continue to face persistent headwinds given Italy's weak economy, fierce competition, and possible negative effects from regulation. In addition, a new chairman has yet to be appointed and stability in senior management, which we view as an important credit consideration, remains to be confirmed over time.
The uncertainty about TI's governance continues to weigh negatively in our assessment of the group's management and governance as "fair." In particular, it's difficult to foresee what strategic impact Spain-based Telefonica S.A.'s potentially controlling, indirect stake in TI may have. Telefonica recently upped its stake in TI's largest shareholder, Telco, and we understand it could increase it further in the future.
We forecast sluggish GDP growth of 0.5% and 0.9% in 2014 and 2015 for Italy, with unemployment remaining at a high of about 12%. Households' constrained disposable income, a depressed housing market, and small and midsize corporates seeking to cut costs, will likely translate into a still-weak backdrop for the telecoms sector. We consequently anticipate that highly price-sensitive consumers and businesses and the fragmented wireless market will exacerbate pricing pressures for traditional voice products. In our view, it remains to be seen to what extent the marketing of more value-added data centric, enriched, and converged offers can compensate for the decline in revenue from traditional products.
In fixed-line communications, traditional telephony revenues--still representing more than 40% of the division's revenues--will likely continue to fall and weigh on revenues. In addition, fixed-line broadband growth materially lags behind the levels we see in comparable European markets, despite low penetration in Italy. While we see TI's heightened focus on next generation technology of fiber and fourth-generation (4G) wireless networks as positive in the long run, we believe that this will require large investments, potentially weakening TI's cash generation and its organic ability to reduce
debt.
We think TI's 67% owned Brazilian subsidiary broadens the group's diversity and provides benefits from operating in a very large and growing market. But this subsidiary will only partly offset domestic pressures, and its contribution is also subject to currency swings.
At this stage, we estimate group revenues (excluding Argentinian operations) will drop by about 7% in full-year 2013 and by low single digits in 2014 and 2015. We believe the falls will stem mainly from a midsingle-digit revenue drop in Italy in 2014-2015 and low- to midsingle-digit organic growth in Brazil (excluding handset sales). We foresee group EBITDA (excluding Argentinian operations) falling by about 10% in full-year 2013 and decreasing again in 2014-2015, but to a lesser extent owing to softer revenue decline, a more benign impact from regulated termination and roaming rates, and cost-cutting efforts. Combined, these factors should help to sustain still-high EBITDA margins of about 39%-40% (excluding Argentinian operations) in 2014-2015. We foresee group EBITDA (excluding Argentinian operations) eroding by 4%-5% in 2014 and by 2%-3% in 2015.
We foresee positive but diminishing discretionary cash flows, held back by heavy investment outlays required to roll out 4G mobile network and extend fiber penetration in the fixed network in Italy. We also factor in continuously heavy outlays in Brazil to extend and upgrade the network. We therefore anticipate fixed investments of about 18%-20% of revenues and annual free cash flow in the €1 billion to €1.5 billion range over 2014-2015, leaving about €0.5 billion-€1.0 billion in annual discretionary cash flow after dividends.
We think that the Standard & Poor's-adjusted debt-to-EBITDA ratio of the group in 2014-2015 could exceed 3.3x but remain below 3.7x (which would likely translate into 4.0x maximum including Brazilian operations on a pro rata basis), which is the maximum we would consider commensurate with the current rating. We believe the group's cash flow metrics will remain very weak, and that the adjusted ratio of FFO to debt will hover at about 20% in 2014-2015. We base our estimates on our expectation of further declines in EBITDA and FFO, balanced by some positive discretionary cash flows and the proceeds from the announced sale of TI's Argentinian subsidiary.
We will assess the proposed mandatory convertible bonds as having "minimal" equity content at issuance under our criteria, based on the bonds' maturity to conversion of more than two years and given that the required shareholders' authorization might not be obtained. The presence of a make-whole cash payment in case of early conversion is also a negative. Apart from these factors, we think other features of the proposed bonds are in line with "high" equity content. Specifically, the proposed bonds are deeply subordinated, can be converted into shares only if the conversion date falls after the shareholders' agreement, include a conversion price floor equal to the share reference price, and are deferrable at the issuer's discretion. We could raise the proposed bonds' equity content to "high" when their remaining maturity becomes less than two years, assuming that shareholders' approval for their conversion has been obtained, and depending on our perception of TI's financial policy at the time.
The ratings reflect our assessment of the group's business risk profile as "satisfactory" and financial risk profile as "significant." Our view of TI's business risk balances its solid fixed and mobile positions, high EBITDA margins in Italy, and the benefits of geographic diversity in the attractive Brazilian market, against deep-seated mobile price competition, lack of material growth traction in fixed broadband, the challenging economic and regulatory environments in Italy, and our score of "fair" of TI's management and governance. The group's financial risk profile is constrained by its high indebtedness and our perception of TI's lack of flexibility given its shareholder structure. This is tempered, however, by our expectation that TI will generate positive discretionary cash flows.
The negative outlook reflects the possibility of further rating downside in 2014-2015 if TI fails to improve domestic operating performances and EBITDA continues falling by midsingle digits or more through 2014-2015. This could occur if there's a renewed price war in Italy's wireless market, absent a softening in the decline of fixed-line revenues, or the group makes higher investment outlays than we currently expect.
We could lower the ratings on TI if our fully adjusted ratios of debt to EBITDA increase toward 3.7x and FFO to debt drops toward 15%, or if we consider that the group's liquidity is weakening.
We could revise the outlook to stable if the group structurally strengthens its domestic operating performances. Such strengthening would include gradually stabilizing EBITDA, preventing debt to EBITDA and FFO to debt from deteriorating materially, maintaining adequate liquidity, and stabilizing management and governance.
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