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 view.
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 revised downward.
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 leverage.
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 dividends.
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 instruments.
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 group level.
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