TEXT-S&P affirms Telefonica at 'BBB/A-2'; outlook negative

Thu Dec 20, 2012 9:51am EST

Rationale

The rating affirmation reflects our view that Telefonica's recently accelerated refinancing and asset disposal activity demonstrate the company's willingness and ability to bolster liquidity and keep leverage in check.

As a result, we see Telefonica maintaining for the foreseeable future an adequate liquidity position, as defined under our criteria. Adequate liquidity is a criteria requirement for an investment-grade rating. This view includes our assumption that the group will be willing and able to complete at least EUR7 billion-EUR8 billion in annual medium-term refinancing or new financing and will generate about EUR1.9 billion in discretionary cash flows after dividends in our forecasts, potentially complemented by other measures such as asset disposals.

In our revised forecasts, irrespective of group projections, we project overall low-single-digit annual revenue decline and low- to mid-single-digit EBITDA decline in 2013-2014. We see domestic EBITDA dropping by around 10% annually in 2013-2014, but we think this would be to a large extent offset by low to mid-single-digit EBITDA growth in Latin America. In the rest of Europe, we foresee an overall decline, but to a much smaller extent than in 2012, which was hit by a sharp margin fall in the U.K. in particular. U.K. margins have somewhat recovered since the second quarter of 2012.

Our anticipation for the domestic market factors in a protracted depressed economic environment, with high unemployment and dropping household incomes that should continue to foster price sensitive consumer behavior and weigh on average revenue per user. At the same time, though, we think the group's tight focus on acquisition and retention costs, aggressive moves toward fixed and mobile bundles, fixed cost measures, and the already high penetration in the subscriber base of the lower tariffs launched a year ago, should help to at least prevent an accelerated deterioration of domestic performances and maintain domestic EBITDA margin above 40%. Assuming continuously positive growth achieved in more favorably oriented Latin American markets, consistent performances in Germany, and a sustained margin recovery in the U.K., we think the group's broad asset portfolio should overall help to generate about EUR6 billion in annual free cash flows before spectrum acquisition.

We therefore continue to assess the group's business risk profile as strong at this stage, reflecting the benefits of its extensive geographic and asset diversity across non correlated markets, including a collection of well-established regional positions across Latin and Central American markets, and our anticipation that the group will effectively defend its solid positions and sustain its high margin in Spain thanks to various cost and commercial initiatives. This should help to significantly cushion the impact of a depressed domestic economy on the group's consolidated figures, and warrants in our view a rating one notch higher than the sovereign rating. We assess Telefonica's management and governance as satisfactory, as we think that management has been tackling more pro-actively operational challenges and the risks generated by a shaky sovereign environment and uncertain capital markets in recent months, through acceleration of asset disposals and sharp dividend cuts in particular, and will continue to prioritize debt reduction and strengthening of the group's liquidity in 2013.

We think that our fully adjusted ratio of debt to EBITDA for Telefonica will improve to about 3.0x-3.1x at end-December 2012 from 3.2x at end-September 2012 and 3.3x at end-June 2012, thanks to the debt reduction capacity provided by recent asset disposals and fourth-quarter free cash flow. We view this ratio as slightly improving in 2013-2014, thanks to some likely further absolute debt reduction that should over-compensate for our forecast EBITDA decline; this would provide some more comfort within the maximum 3.3x level that we consider adequate for the rating. (Given less than full ownership in key contributing divisions of Brazil and Germany, we estimate that pro rata for effective ownership, the ratio would be about 0.2x higher, but still commensurate with the rating.) We also foresee the adjusted ratio of FFO to debt to remain higher than the mid-20s, a level we consider is a minimum for the rating.

We understand that management is looking at various options to accelerate debt reduction and support liquidity, including further asset monetization. We have not included further asset disposals at this stage in our base case, but we think any such additional measures could help to strengthen liquidity and, to an extent, key credit metrics (after factoring in any impact on dividend leakage and considering effective ownership).

Liquidity

The short-term rating on Telefonica is 'A-2'. We assess Telefonica's liquidity as "adequate," according to our criteria, based on the following elements:

-- Our estimate of more than 1.7x coverage of liquidity uses by available sources for the 12 months to end-September 2013.

-- Our estimate, irrespective of group projections, of robust annual free cash flow generation of around EUR6 billion over 2013-2014, before outlays for spectrum acquisitions.

-- Solid and diversified bank relationships and access to geographically diversified sources of funding.

-- Some additional flexibility from a number of disposable assets, including equity accounted stakes, and the possibility to further trim dividends or delay dividend resumption if needed.

-- A solid refinancing track record in 2012, with about EUR15 billion in total refinancing or new financing measures achieved to date.

These strengths are mitigated, however, by the following elements:

-- Massive annual long-term debt maturities increasing from EUR6 billion in 2013 toward a EUR11 billion peak in 2015.

-- Our view of the relatively short tenor of the group's undrawn facilities, which mainly mature in 2013-2015, therefore requiring ongoing extension or refinancing to maintain a sufficient undrawn long-term cushion.

-- Sovereign and bank-related negative market sentiment that could heighten financing costs when the company's large annual maturities of both outstanding debt and undrawn bank facilities are due.

-- Given the sheer size of the required refinancing, capital availability could be affected, at least temporarily, by the shaky sovereign context and uncertain capital and banking environments.

-- Our expectations of modest, though positive, generation of annual discretionary cash flow in the next two years, of less than EUR3 billion on average before spectrum, factoring in a resumption of cash dividend distribution from November 2013 onwards and possible substantial cash outlays for spectrum acquisitions in 2013. This is likely to result in only limited absolute debt reduction capacity through organic cash flow generation.

Our expectation that liquidity uses will cover available sources by more than 1.7x (before spectrum in the U.K.) for the next 12 months to end-September 2013 is based on:

-- About EUR8.75 billion of undrawn and committed facilities available at end-September 2012 and maturing beyond the next 12 months.

-- Around EUR7.8 billion of cash and cash equivalents and current financial assets, excluding cash held in Venezuela, at end-September 2012.

-- Disposal proceeds of more than EUR2 billion, after the sale of Atento and the IPO in Germany in fourth-quarter 2012 in particular;

-- Our own forecast, irrespective of group projections, of positive discretionary cash flow in a EUR3 billion-EUR4 billion range after spectrum and dividends in the next 12 months as of end-September 2012.

-- Gross long-term and short-term debt maturities of about EUR9.6 billion in the next 12 months as of end-September 2012.

At this stage, we think that the group would likely need to complete EUR7 billion-EUR8 billion in annual refinancing of drawn and undrawn debt to sustain a next-12-months liquidity ratio of more than 1.2x at all times in the coming years, taking into consideration annual maturities of drawn debt of about EUR8.5 billion on average over 2014-2017, including a peak of EUR10.8 billion in 2015, and the need to renew undrawn facilities. This requirement could be lower if the group were to complete further asset disposals or successfully lengthen its debt maturity structure.

We continue to think that massive annual maturities of both drawn and undrawn debt instruments, combined with our expectation of modest net cash flows after dividends and potential spectrum outlays (but before any further additional disposals) remain a threat to Telefonica's credit quality in the current environment. We think that any persistent capital market turmoil, particularly affecting the funding of southern European companies, could obstruct these companies' large scale bond issuance. We also believe that Telefonica must compete for its large refinancing needs with an increasing number of large domestic borrowers rated in 'BBB' category, including the Spanish government and banks, although it also has access to a diversified pool of capital markets.

We are not aware of any covenants or ratings triggers in Telefonica's debt instruments.

To our knowledge, there are no cross-default clauses between Telefonica S.A. and its wholly owned issuing entities or its subsidiaries. Therefore, a default by any of the group's subsidiaries would not trigger a default at the group level.

Outlook

The outlook is negative, chiefly reflecting the risk of a one-notch downgrade in 2013 or 2014 if the current liquidity cushion were to weaken materially, with an increasing risk that we would revise our liquidity qualifier to "less than adequate" in the following years. This could occur if the group failed to complete sufficient volumes of refinancing on an ongoing basis and to lengthen its debt maturity structure. Additional potential triggers for a downgrade include an even worse than expected domestic market and insufficient cushion derived from international markets, which could weaken credit measures, compromise debt reduction, or make us revise our business risk assessment downward. Any evidence that the group's overall EBITDA would fall by high-single digits in 2013-2014 could precipitate such a revision for example.

Lastly, if credit markets were to dry up or the rating on Spain (BBB-/Negative/A-3) were to drop below investment grade, the rating on Telefonica could be adversely affected, because this might constrain refinancing opportunities; in the latter case, while our criteria would allow a rating of up to two notches above the sovereign, it is likely that Telefonica's rating would stand below this maximum allowed level, because of liquidity concerns in such a scenario (see "Nonsovereign Ratings That Exceed EMU Sovereign Ratings: Methodology And Assumptions," June 14, 2011).

We could revise the outlook to stable if we anticipated that group EBITDA decline would soften materially in 2013 and stabilize thereafter, if leverage stabilized at about 3x or below, and if the group considerably strengthened its liquidity position.

Related Criteria And Research

-- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012

-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011

-- Key Credit Factors: Business And Financial Risks In The Global Telecommunication, Cable, And Satellite Broadcast Industry, Jan. 27, 2009

-- Corporate Criteria--Parent/Subsidiary Links; General Principles; Subsidiaries/Joint Ventures/Nonrecourse Projects; Finance Subsidiaries; Rating Link To Parent, Oct. 28, 2004

Ratings List

Ratings Affirmed; CreditWatch/Outlook Action

To From

Telefonica S.A.

Corporate Credit Rating BBB/Negative/A-2 BBB/Watch Neg/A-2

Senior Unsecured BBB BBB/Watch Neg

Commercial Paper A-2 A-2/Watch Neg

Telefonica Chile S.A.

Telefonica Moviles Chile S.A.

Telefonica Czech Republic AS

Corporate Credit Rating BBB/Negative/-- BBB/Watch Neg/--

Telefonica Chile S.A.

Telefonica Moviles Chile S.A.

Senior Unsecured BBB BBB/Watch Neg

Telefonica Emisiones S.A.U.

Senior Unsecured* BBB BBB/Watch Neg

Telefonica Europe B.V.

Senior Secured* BBB BBB/Watch Neg

Senior Unsecured* BBB BBB/Watch Neg

Commercial Paper* A-2 A-2/Watch Neg

Telefonica Finance USA LLC

Preferred Stock* BB+ BB+/Watch Neg

Telefonica Finanzas Mexico S.A. de C.V.

Senior Unsecured mxAA+ mxAA+/Watch Neg

Telefonica N.A. Inc.

Commercial Paper* A-2 A-2/Watch Neg

*Guaranteed by Telefonica S.A.

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