December 18, 2017 / 1:03 PM / a year ago

Fitch Maintains Sky on Rating Watch Positive

(The following statement was released by the rating agency) MOSCOW/LONDON, December 18 (Fitch) Fitch Ratings is maintaining Sky plc's Long-Term Issuer Default Rating (IDR) and senior unsecured ratings of 'BBB-' remain on Rating Watch Positive (RWP) following the announcement that The Walt Disney Company (Disney; A/Stable) will acquire 21st Century Fox, Inc. (FOX; BBB+/RWN). Fitch placed Sky's ratings on RWP on 16 December 2016 following the announcement of FOX's intention to acquire full control of the UK-based direct-to-home broadcaster. Both transactions are subject to regulatory approval. Assuming either both or only FOX/Sky transactions go ahead Fitch will view Sky's ratings in the context of the broadcaster's ownership by a stronger ultimate parent whether it is Disney or FOX. We expect strong strategic and operational links with Sky's higher-rated parent as per Fitch parent-subsidiary (PSL) methodology. However, legal ties in terms of direct support for subsidiary debt are less certain as it is not yet clear how FOX or Disney intend to manage the capital structure of the group. Subject to successful transactions and more clarity on how a parent plans to fund its subsidiary in the medium term, the ratings of Sky might be notched higher from its standalone profile for parental support. Fitch expects to resolve the RWP once the two transactions are finalised. If the transactions do not proceed, Fitch presently expects to affirm Sky's ratings at 'BBB-' given the company's underlying business and financial risk profile. Fitch views Sky as 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 that is 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 Disney to Acquire FOX. Fitch has placed the 'BBB+' IDR of FOX on Rating Watch Negative following the announcement that Disney will acquire certain of FOX's assets in an all-stock transaction valued at approximately USD69 billion. Fitch's actions are driven by the lack of clarity regarding how FOX's existing debt will be treated and where it will ultimately reside in Disney's capital structure. While Fitch would assume FOX would benefit from strong strategic and operational ties it acknowledges the weak legal ties between FOX and Disney. As such, Fitch's Parent Subsidiary Linkage criteria allows for a subsidiary's IDR to be notched below the parent, typically within a range of three notches. FOX expects to continue efforts to close its previously announced USD15 billion, all-cash transaction for the remaining 61% equity stake of Sky it does not own. A positive rating action for Sky is possible if either both or only FOX/Sky transaction succeed, reflecting potentially positive implications of ownership by a stronger ultimate parent. If the FOX/Sky deal are cancelled Sky's ratings should be affirmed at 'BBB-' providing the company's standalone operating and financial profile do not change materially. 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 5% constant-currency growth in 1Q FY18 (financial year end June), levels that comfortably outpace incumbent telecom revenue. Growth in these markets is slowing although Sky reports continued success in adding subscribers and maintaining 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 at a healthy pace. Leverage Stabilising but High: Sky's leverage is high for the company's standalone rating. Sky ended FY17 with funds from operations (FFO) lease-adjusted net leverage of 3.1x compared with our 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 that is compounded historically by the non-cash movements in debt driven by sterling's depreciation following the EU referendum. Deleveraging beyond 2018 is forecasted given an expected recovery in operational cash flows although foreign-exchange risk remains. Competitive UK Communications Market: Fitch views 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 intense 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 broader peer group includes telcos such as BT Group plc, Royal KPN N.V. (BBB/Stable) and TDC A/S (BBB-/Stable), sub-investment grade cable operators such as Virgin Media Inc. and Telenet Group Holding N.V (BB-/Stable), and media conglomerate Vivendi SA (BBB/Stable). Sky's business model is nonetheless quite idiosyncratic given the company's position as the founder of pay-TV in the UK, a premium content-led business model and attendant exposure to content rights inflation. We regard Sky as strongly 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 content rights inflation and its business model and cash flow potentially face greater challenges than the telcos and cable operators. This drives a standalone rating 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% in 2018-2021, with sports content rights suppressing margins in FY18 (Bundesliga costs) and FY20 (English Premier League 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; and - Approximate GBP400 million dividend payment in FY18 (including a special dividend of GBP171 million), increasing to in excess of GBP600 million beyond. RATING SENSITIVITIES The rating sensitivities for Sky's ratings on a standalone basis are as follows: Developments That May, Individually or Collectively, Lead to Positive Rating Action -Expectations of FFO net leverage remaining consistently below 2.7x (including transponder costs). -Free cash flow (FCF) margin consistently in high single digits (FY17: 2.7%). -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 - Expectations of FFO net leverage remaining consistently above 3.2x (including transponder costs). -Expectations of FCF margin remaining 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 over-the-top TV 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 billion revolving credit facility due 2021. Sky has sufficient cash to cover the next three years' worth of debt maturities with their revolving credit facility extending this period further. Contact: Principal Analyst Joe Howes Analyst +44 20 3530 1382 Supervisory Analyst Slava Bunkov Director +7 495 956 9931 Fitch Ratings CIS Ltd 26 Valovaya Street Moscow 115054 Committee Chairperson Damien Chew, CFA Senior Director +44 20 3530 1424 Media Relations: Adrian Simpson, London, Tel: +44 203 530 1010, Email: adrian.simpson@fitchratings.com. Additional information is available on www.fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary. Applicable Criteria Corporate Rating Criteria (pub. 07 Aug 2017) here Parent and Subsidiary Rating Linkage (pub. 31 Aug 2016) here Additional Disclosures Solicitation Status here Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. 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