October 6, 2017 / 4:07 PM / 10 months ago

Fitch Maintains Sky at 'BBB-', Rating Watch Positive

(The following statement was released by the rating agency) LONDON, October 06 (Fitch) Fitch Ratings has maintained Sky plc's Long-Term Issuer Default Rating (IDR) and senior unsecured ratings at 'BBB-'. Both ratings remain on Rating Watch Positive (RWP), where they were placed on 16 December 2016 after Twenty-First Century Fox, Inc. (FOX) announced its intention to acquire full control of the UK-based direct-to-home broadcaster. The RWP reflects Fitch's expectation of strong strategic and operational links with Sky's higher-rated parent as per Fitch's parent-subsidiary (PSL) methodology assuming the FOX transaction proceeds. See our previous commentary <a href="https://www.fitchratings.com/site/pr/1016739"> Here. The transaction has been referred to the UK's Competition and Markets Authority, whose conclusions are expected by March 2018. If the transaction were not to proceed, Fitch expects Sky's ratings to remain at 'BBB-' given the company's underlying business and financial risk profile. Fitch considers Sky to be uniquely positioned as the UK's leading pay-TV platform, having established the UK as the most developed pay-TV market in Europe. Sky enjoys a strong business risk profile complemented by its wider telecoms capabilities including a strong broadband position and nascent mobile business. Constraining factors are high leverage, a competitive UK communications market, near-term cash flow pressures and exposure to content rights inflation. KEY RATING DRIVERS Rating Watch Positive, PSL: If the FOX transaction goes ahead, Fitch will rate Sky using its PSL methodology. With FOX the stronger-rated entity, the criteria allow rating uplift closer to the parent based on legal, strategic and operational ties. Fitch believes strategic links will be strong given the importance placed by FOX on owning the pan-European pay-TV operator and the perceived benefits in scale and diversification in content ownership, business platform and geography. Fitch would expect Sky to continue to be managed largely independently and to remain focused on its existing strategy. The potential for direct operational or cost synergies is limited. Legal ties in terms of direct support for subsidiary debt are uncertain as it is not clear how FOX intends to fund Sky over the medium term. We do not assume a parent guarantee or cross-default into the parent debt. On this basis, we could rate Sky one notch lower than FOX once the transaction completes. Given FOX's current rating of 'BBB+', this would lead to an upgrade of Sky's rating to 'BBB'. Sustained Operating Performance: Sky's businesses continue to perform well. Despite the maturity and competitiveness of its core TV/communications markets, the UK and Ireland delivered 4% constant-currency growth in the year to June 2017 (FY17), levels that comfortably outpace incumbent telecom revenues. Growth in these markets is slowing although Sky reports continued success in adding subscribers and sustaining other operating metrics. The pace of additions is nonetheless slowing and churn rates have ticked up, albeit remaining at best-in-class levels. The less-developed continental European businesses are growing well. Leverage Stabilising, but High: Sky's leverage is high for its standalone ratings level, the company closing FY17 with FFO lease-adjusted net leverage of 3.1x compared with a downgrade threshold of 3.2x. Our rating case envisages a metric of 3.3x in FY18, breaching the downgrade guideline. The metric will continue to be affected by near-term cash flow and margin pressures resulting from content rights inflation compounded historically by the non-cash movements in debt driven by sterling's depreciation following the EU referendum. Fitch estimates a cumulative non-cash movement of GBP1.3 billion has added about 0.5x of leverage over the past two years. Deleveraging beyond 2018 is expected given an anticipated recovery in operational cash flows although foreign-exchange risk remains. Content Rights Inflation and Competition: The UK and Ireland businesses experienced 2.6 percentage points of margin compression in FY17, which was mainly a result of content rights inflation and in particular inflation in the new English Premier League (EPL) contract starting the 2016/17 season, in Fitch's view. In nominal terms, the contract is worth GBP1,392 million a season, an 83% increase over the previous agreement. The premium-led nature and sports bias of the group's TV offer are likely to sustain these pressures. Competition for sports rights in the UK, notably from BT, has added significant inflationary pressure while the potential for over-the-top (OTT) providers, such as Netflix or Amazon, to enter auctions adds further risk. Competitive UK Communications Market: Fitch considers the UK, by far Sky's largest individual market, a particularly competitive market. In fixed line and TV both the incumbent BT Group plc (BBB+/Stable) and cable operator Virgin Media Inc. (BB-/Stable) have developed strong product offerings and market positions. BT's entrance to pay-TV in 2012, with an emphasis on exclusive sports content, has changed the nature of the sector, while a four-player network-based mobile market makes competition high and convergence potentially more important to the UK consumer. Against this backdrop, Sky has established a strong commercial proposition with strengths across all main service platforms. DERIVATION SUMMARY Sky's peer group includes smaller or less geographically diverse telcos, including BT, Royal KPN N.V. (BBB/Stable) and TDC A/S (BBB-/Stable), higher rated sub-investment-grade cable operators like Virgin Media and Telenet Group Holding N.V (BB-/Stable), and media conglomerate Vivendi SA (BBB/Stable). Sky's business model is nonetheless quite idiosyncratic given its position as the founder of pay-TV in the UK, its premium content led business model and attendant exposure to content rights inflation. We regard Sky as very well positioned in the UK pay-TV market and that management understands the need to provide a complete communications offering in this market given its expansion into telecoms services. Its revenue growth remains stronger than most of the telcos, but margins face pressure from rights inflation and its business model and cash flow potentially face greater challenges than the telcos and cable operators. This drives a standalone ratings profile at the lower end of the investment-grade range. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - Low- to mid-single-digit revenue growth; about 4.5% in 2018, falling to about 3.5% through 2021 - Adjusted EBITDA margin of 16%-17% across the rating horizon, with sports content rights suppressing margins in FY18 (Bundesliga costs) and FY20 (EPL costs). - Margins strengthening above 17% in FY21 given cost savings and scale economies in Germany and Italy. - Group capex to remain at about 7% of sales. - Approximate GBP400 million dividend payment FY18 (including a special dividend of GBP171 million), increasing to in excess of GBP600 million beyond that date. RATING SENSITIVITIES Developments That May, Individually or Collectively, Lead to Positive Rating Action -FFO net leverage that was expected to remain consistently below 2.7x (including transponder costs). -Free cash flow margin consistently in high single digits. -Evidence of the resilience of the company's operating environment and core pay-TV business. Developments That May, Individually or Collectively, Lead to Negative Rating Action -FFO net leverage that was expected to remain consistently above 3.2x (including transponder costs). -Expectations that free cash flow margin were likely to be consistently below 4%. -Material deterioration in Sky's operating environment and key performance indicators; including the impact of content rights inflation, material weakening in reported churn, average revenue per user or evidence that OTT is becoming a more significant threat to its traditional pay-TV business. LIQUIDITY Strong Liquidity: At end-June 2017, Sky reported cash and cash equivalent of GBP2.5 billion and access to an undrawn GBP1.0 billion revolving credit facility due 2021. Sky has sufficient cash to cover the next three years' worth of debt maturities with their RCF extending this period further. FULL LIST OF RATING ACTIONS Sky plc Long-Term IDR: maintained at 'BBB-'; Rating Watch Positive Senior unsecured rating: maintained at 'BBB-'; Rating Watch Positive Contact: Principal Analyst Joe Howes Analyst +44 20 3530 1382 Supervisory Analyst Stuart Reid Senior Director +44 20 3530 1085 Fitch Ratings Limited 30 North Colonnade London E14 5GN Committee Chairperson Tajesh Tailor Senior Director +44 20 3530 1726 Summary of Financial Statement Adjustments for the Period Ended June 2017: Leases: Fitch has adjusted debt by adding 8x yearly operating lease expense related to long-term assets; 5x estimated transponder lease expenses: in aggregate about GBP1.9 billion of lease adjusted debt was added to FY17 reported debt. Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@fitchratings.com. Additional information is available on www.fitchratings.com. 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