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March 24 (Reuters) - (The following statement was released by the rating agency)
Fitch Ratings has assigned Telefonica SA’s (TEF, BBB+/Negative) proposed EUR benchmark perpetual subordinated securities an expected rating of ‘BBB-(EXP)'. The securities will be issued by Telefonica Europe B.V. and guaranteed on a subordinated basis by Telefonica SA. The final rating is contingent on the receipt of final documents conforming materially to the preliminary documentation.
The upcoming hybrid securities are proposed to be deeply subordinated and to rank senior only to TEF’s share capital, while coupon payments can be deferred at the discretion of the issuer. As a result of these features, the ‘BBB-(EXP)’ rating is two notches below TEF’s Long-term Issuer Default Rating (IDR), which reflects the securities’ increased loss severity and heightened risk of non-performance relative to senior obligations. This approach is in accordance with Fitch’s criteria, “Treatment and Notching of Hybrid in Non-financial Corporate and REIT Credit Analysis” dated 23 December 2013 at www.fitchratings.com.
The proposed securities qualify for 50% equity credit as they meet Fitch’s criteria with regard to subordination, effective maturity of at least five years, full discretion to defer coupons for at least five years and limited events of default, as well as the absence of material covenants and look-back provisions.
The proposed securities will be issued in EUR and have no formal maturity date. The documentation provides for the potential issuance of two tranches, a non-call 6 (NC6) and non-call 10 (NC10). The issuer has a call option to redeem the notes at par on the first call date (in 2020 for the NC6 and in 2024 for the NC10) and at any interest payment date thereafter.
There will be a coupon step-up of 25bps from year ten onwards (2024) and an additional step-up of 75bps 20 years after the first call date onwards (in 2040 for the NC6 and in 2044 for the NC10). According to Fitch’s criteria, the first call date and the coupon step-up date are not treated as effective maturity dates due to the cumulative amount of the step-ups being lower or equal to 1% throughout the life of the instruments. However, the issuer will no longer be subject to replacement language disclosing the company’s intent to redeem the instrument from 2040 (for the NC6) and 2044 (for the NC10) with the proceeds of a similar instrument or with equity. Hence, 2040 and 2044 are viewed as the respective effective maturity date for the NC6 and NC10 securities. The instrument’s equity credit would switch to zero five years prior to this date (i.e. in 2035 for the NC6 and 2039 for the NC10).
There is no look-back provision in the securities’ documentation, which gives the issuer full discretion to unilaterally defer coupon payments. Deferrals of coupon payments are cumulative and the company will be obliged to make a mandatory settlement of deferred interest payments under certain circumstances, including a declaration or payment of a dividend.
Proactive Portfolio Management & Deleveraging
A spike in leverage, following the 2010 Vivo acquisition and coincident economic slowdown, has been managed well. A combination of material cuts to its distribution policy, the sale of non-core assets and stake sales, along with hybrid issuance has seen the company reduce net debt to EUR46.6bn (EUR43.6bn adjusted for post FY13 disposals) - i.e. adjusted for 50% equity credit assigned to the hybrid instruments. This compares with debt of EUR56.3bn at FYE11. Fitch expects funds from operations (FFO) net adjusted leverage to stabilise around 3.3x in 2014 and beyond, a level that is consistent with the large European incumbent peer group and a ‘BBB+’ rating. FFO net adjusted leverage was 3.2x at FYE13.
Telefonica exhibits stronger portfolio diversification than similarly rated peers, such as Deutsche Telekom and Orange SA. Of this group, Telefonica is least reliant on its domestic market at 45% contribution to operating cash flow (OCF; EBITDA less capex) from Spain in 2013, compared with Deutsche Telekom’s 70% from Germany and Orange’s 65% from France. Fitch estimates that following the E-Plus transaction (which remains subject to regulatory approval), Germany will account for 9% and the UK a 10% contribution - boosting the cash flow from competitive but nonetheless stronger performing northern European economies, while Latin America will contribute 39%. Such broad diversification offers protection against economic cycles as well as structural shifts and maturing regional trends.
Domestic Operating Environment Remains Tough
Spain is still Telefonica’s single largest market, accounting for 43% of forecast 2014 OCF. A domestic economy characterised by high unemployment and weak domestic consumption, along with an increasingly tough competitive environment will continue to weigh on this part of the business. Telefonica’s “Fusion” quad-play product has fundamentally shifted pricing in the market, though without slowing the pace of mobile subscriber losses. The incumbent lost a total of 1.6 million mobile customers in the 12 months to December 2013, while mobile service revenues contracted by 16%. Aggressive MVNO mobile offers have had a significant impact on the established operators, while Vodafone’s acquisition of ONO, the country’s largest cable operator, is likely to increase fixed line and quad-play pressures. Domestic EBITDA fell 7% in 2013. Further contraction is likely in 2014 and may continue beyond, in Fitch’s view.
Currency volatility primarily related to Telefonica’s Latin American businesses had a material impact on 2013 reported results - revenues suffered a negative EUR5bn currency impact; with a EUR1.7bn effect felt at the EBITDA level.
Currency devaluation in Brazil, Argentina and Venezuela has been significant, with the prospect of any near-term easing in these pressures far from certain. While its LatAm operations generally report top-line growth and solid underlying performance, currency volatility removed the underlying growth benefits of the LatAm business in 2013 and in the absence of any material appreciation will continue to impact reported group level results in 2014.
Fitch estimates that LatAm countries in 2014 will account for around 39% of Telefonica’s OCF and their currencies at 8% of group debt, giving rise to a currency mismatch. Euro zone countries are forecast to represent 52% of OCF, compared with an estimated 80% of euro-dominated debt.
Measured M&A Approach
M&A risk at Telefonica is viewed by Fitch as measured and its intentions in this area have been well-articulated by management. Recent activity has focused on the sale of non-core operations with the agreed disposal of businesses in the Czech Republic and Ireland expected to raise around EUR3bn in proceeds in 2014. Disposal proceeds along with approximately EUR900m to be raised from minorities (at the Telefonica Deutschland level) in a rights issue accompanying the E-Plus acquisition will offset the EUR5bn cash component of the German acquisition. The company’s leverage neutral approach to funding this deal underlines caution in financial policies, which Fitch views positively. The possibility of market consolidation in Brazil would be a transaction that makes strategic sense - regulatory barriers to such a development are though considered high.
Negative: Future developments that could lead to negative rating actions include:
-FFO net adjusted leverage approaching 3.5x with little expectation that deleveraging comfortably below this level can be achieved organically.
Mid-single digit or below pre-dividend FCF margin would increase downgrade pressure.
Positive: Future developments that could lead to a revision of the Outlook to Stable, are:
- FFO net adjusted leverage well below 3.5x on a sustained basis. A mid-to-high single digit pre-dividend free cash flow (FCF) margin, which is also deemed an important metric at ‘BBB+', on a consistent basis is likely to help stabilise the Outlook
The following ratings are affirmed:-
Telefonica SA Long term IDR: ‘BBB+'; Negative Outlook
Telefonica SA Short term IDR: ‘F2’
Telefonica Europe BV‘s/Telefonica Emisiones’ bonds: ‘BBB+’
Telefonica Finance USA LLC’s preference shares: ‘BB+’
Telefonica Europe BV subordinated hybrid securities: ‘BBB-'