SP base-case operating scenario
Our base case factors in approximately flat consolidated revenues in 2012-2014
thanks to the benefits derived from the group's large presence in more dynamic
Latin American markets. Telefonica's public guidance includes flat to positive
revenue growth in 2012. We anticipate high-single-digit drops in domestic
revenue in 2012-2014 and overall low-single-digit declines in the rest of
Europe, dragged down by intense price competition, particularly in the U.K.
This should be offset by more buoyant Latin American markets where we forecast
mid-single-digit growth in revenues. Solid growth in wireless services in the
latter region could potentially be dragged down by more challenging fixed line
services, given the adverse impact of fixed to mobile substitution, and by
adverse regulations and various country risks.
We foresee a mid-single-digit consolidated organic EBITDA decline for
full-year 2012 and a drop of more than 2 percentage points in our fully
adjusted EBITDA margin. Telefonica's public guidance includes a decline of
less than 2.1 percentage points in its "OIBDA margin" (operating income before
depreciation and amortization) for 2012. In 2013-2014, we anticipate a
possible further low-single-digit EBITDA decline. In the second half of 2012,
we think the diffusion of recent repricing measures across Telefonica's
existing customer base will continue to constrain domestic EBITDA and average
revenue per user (ARPUs), after 12% and 15% declines year-on-year posted in
the second quarter of 2012 in fixed broadband and mobile, respectively. That
said, at this stage, we think the group's massive restructuring efforts in
Spain, as well as its revised handset subsidies policy for its domestic
operations, should help mitigate margin erosion and sustain domestic margins
above 40% (about 44% in first-half 2012). At the same time, heavy retention
and acquisition costs in other markets, such as the U.K., and commercial
efforts to sustain growth in Brazil will likely dilute overall margins in our
We believe that challenging macroeconomic and competitive factors, risks of
adverse fiscal measures and inflating interest expenses, as well as execution
risks, will continue to impair our visibility on Telefonica's future
performances. We therefore intend to closely monitor the group's performance
over the coming quarters to assess whether our base case would need to be
S&P base-case cash flow and capital-structure scenario
Overall we think the likely decline in EBITDA and a drop in cash conversion
compared with previous years, brought about by likely higher interests and
taxes, will lead to lower generation of cash flow from 2012 onward. Still, we
anticipate, irrespective of company projections, annual generation of free
cash flow (FCF) of more than EUR6 billion on average over 2012-2014, before
outlays on spectrum acquisitions.
However, we think the group's recent decision to cancel November 2012 and May
2013 cash and scrip payments to shareholders will lead to substantial cash
savings and, together with recent EUR1.3 billion disposal proceeds, help to
reduce debt leverage from a 3.2x fully adjusted debt to EBITDA peak in June
2012 down to about 3x by year-end 2012.
We note that the group's reported leverage ratios exceeded management's public
guidelines at end-March 2012 and even more so at end-June 2012, although we
think the divergence should diminish in the second half as Telefonica reduces
At this stage, we anticipate only slight improvement in credit metrics in
2013, because lower cash dividends could be offset by likely lower overall
EBITDA and a potential temporary spike in capital expenditures, triggered by
spectrum auctions that will likely occur in the U.K.
We also note the positive effects generated by the full consolidation of
Telefonica's 74%-owned Brazilian operations, as these operations are generally
less leveraged than the parent company, and consolidated cash flows likely
overstate the share of cash potentially available to Telefonica through
We are aware of management's intention to execute additional disposals in 2013
but we have not factored them into our forecasts at this stage, given
execution risks and uncertain timing and proceeds.
Telefonica's short-term rating is 'A-2'. We assess Telefonica's liquidity as
"adequate," according to our criteria, based on the following elements:
-- Our estimate of 1.35x coverage of liquidity uses to available sources
for the 12 months to end-June 2013.
-- Our estimate, irrespective of company projections, of consistent and
robust annual FCF generation of more than EUR6 billion on average over
2012-2014, before outlays on spectrum acquisitions.
-- Solid and diversified bank relationships and access to geographically
diversified sources of funding.
-- Existence among 2012 debt maturities of EUR2 billion in perpetual
preferred shares issued by Telefonica Finance USA LLC (not rated) that can be
extended at the option of the group beyond 2012, although at a higher coupon.
-- Some additional flexibility from a number of disposable assets,
including equity accounted stakes.
These strengths are mitigated, however, by the following elements:
-- Sovereign and bank-related negative market sentiment that could boost
financing costs when the company's large annual maturities of both outstanding
debt and undrawn bank facilities are due.
-- Heavy annual long-term debt maturities of EUR7 billion to EUR8 billion
annually in the next few years, as well as the need to renew a large part of
undrawn facilities in the next two years. Given the sheer size of the required
refinancing, capital availability could be affected, at least temporarily, by
a shaky financial environment, which could require extraordinary measures.
-- Our expectations of modest, though positive, generation of
discretionary cash flows (DCF) in the next two years, after shareholder
remuneration, and possible substantial cash outlays for spectrum acquisitions
in 2012 or 2013. This is likely to result in only limited absolute debt
reduction capacity from organic cash flows.
We expect Telefonica to actively refinance in the next few quarters to
maintain an adequate liquidity profile. We note that the group has refinanced
or extended material amounts of bank facilities since year-end 2011. However,
we cannot exclude the possibility that refinancing could fall short, at least
temporarily, of what is necessary for its liquidity to remain adequate,
according to our criteria.
We think that any persistent capital market turmoil, particularly affecting
the funding of southern European companies, could seriously impede the
issuance of new bonds on a large scale. We also believe that Telefonica,
although not entirely exposed to Spain, has to compete for its large
refinancing needs with an increasing number of 'BBB' category borrowers,
including the Spanish government and banks. Therefore, we consider the
development of our liquidity coverage ratios in the next quarters to be an
important factor to the ratings.
Our expectation that liquidity uses will cover available sources by 1.35x for
the next 12 months to end-June 2013 is based on:
-- About EUR7.5 billion of undrawn and committed facilities available at
end-June-2012 and maturing beyond the next 12 months.
-- EUR5 billion of cash and cash equivalents, excluding cash held in
Venezuela, at end-June 2012.
-- Our own forecast of positive DCF, after the recently revised dividend
policy, but before some likely cash out on spectrum acquisitions.
-- Gross long- and short-term debt maturities of about EUR11.1 billion in
the next 12 months as at end-June 2012 (including about EUR2 billion in
commercial paper; excluding the EUR2 billion of preferred shares).
We are not aware of any covenants or ratings triggers in Telefonica's debt
To our knowledge, there are no cross-default clauses between Telefonica S.A.
and both its wholly owned issuing entities and its subsidiaries. Therefore, a
default by any of the group's subsidiaries would not trigger a default at the
While we still view Telefonica's liquidity as adequate after recent
refinancing activity, we think its heavy 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
additional disposals) are a threat to its credit quality in the current
capital and banking environment.
The negative outlook reflects the possibility of a downgrade in 2012-2013 if
liquidity were to worsen to "less than adequate" under our criteria, which
would result in the long-term rating being capped at 'BB+'. We could also
lower the ratings if Telefonica significantly underperforms our base-case
expectations, leading for instance to a high-single-digit consolidated decline
in EBITDA in 2012 or a mid-to-high single digit drop in 2013 compared with our
current forecasts of mid-single and low-single digit declines, respectively.
If Telefonica's adjusted ratio of debt to EBITDA were to soar to above 3.3x,
we would also consider a downgrade.
In addition, a downgrade of Spain to 'BB' or below would lead us to cap
Telefonica's rating at 'BBB-' or below, in application of our criteria.
Conversely, a downgrade of Spain by up to two notches to 'BB+' would not
necessarily lead us to lower our ratings on Telefonica. In such a case,
however, we would not exclude taking a negative rating action, as potentially
rising economic or financing constraints could lead us to eventually revise
our business risk profile assessment or our base case downward.
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
-- Credit FAQ: How Sovereign Credit Quality Affects The Ratings On
Southern European Telecoms Incumbent Operators, May 17, 2012
-- Nonsovereign Ratings That Exceed EMU Sovereign Ratings: Methodology
And Assumptions, June 14, 2011
-- Methodology And Assumptions: Liquidity Descriptors For Global
Corporate Issuers, Sept. 28, 2011
-- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded,
May 27, 2009
-- 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