November 29, 2017 / 2:04 PM / a year ago

Fitch Rates Telefonica's Hybrid Securities 'BB+(EXP)'

(The following statement was released by the rating agency) LONDON, November 29 (Fitch) Fitch Ratings has assigned Telefonica SA's (BBB/Stable) proposed euro benchmark perpetual subordinated securities an expected rating of 'BB+(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. The 'BB+(EXP)' rating is therefore two notches below Telefonica'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, "Non-Financial Corporates Hybrids Treatment and Notching Criteria" dated 27 April 2017 at 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 euros and have no formal maturity date. The issuer has a call option to redeem the notes at par within the three months ending on the first reset date (which will be over five years after the issue date) and at any interest payment date thereafter. There will be a coupon step-up of 25bp after the first call date and an additional step-up of 75bp thereafter. The first call date and the coupon step-up date are not treated as effective maturity dates under Fitch's criteria due to the cumulative amount of the step-ups being lower or equal to 1% throughout the life of the instruments. The documentation includes non-binding, intention-based replacement language that supports our permanence assessment of the hybrid instruments. 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. KEY RATING DRIVERS Well-Positioned Operating Subsidiaries: Telefonica's ratings are supported by a portfolio of assets competitively well positioned and geographically well diversified across Europe and Latin America. The operator has a leading Spanish domestic market position, which drove about 42% of group EBITDA less capex in 9M17. The Spanish operations underpin Telefonica's ratings and consolidation has improved market structure, while the company's investments in network, content and bundled products sustain its competitive capability. FCF Generation Constrained: We expect Telefonica's EBITDA to grow by 1%-2% over the next two to three years, driven by revenue growth in Latin America and Spain, cost savings across its business portfolio and margin expansion in Germany resulting from the extraction of ongoing merger synergies. However, capital expenditure levels are likely to remain high over the next two to three years as Telefonica continues to invest in fibre and mobile broadband networks to support its commercial strategy across its footprint. However, the higher capex will restrain the company's free cash flow (FCF) generation, with a likely 3%-4% post-dividend FCF margin. Gradual Organic Deleveraging: Telefonica's fund from operations (FFO)-adjusted net leverage at the end of 2016 was 3.9x. We expect this to decline to around 3.4x by 2018. The decline is driven by a combination of organic FCF, the sale of a stake in the group's tower company, Telxius, and the conversion of EUR1.5 billion of mandatory convertible notes in 2017. Emerging Market Exposure: Telefonica derived around 48% of its EBITDA (end-2016) from its Latin American operations and from countries with a non-investment-grade rating. The exposure increases Telefonica's cash flow risks, which as a proportion are higher than in its immediate peer group of diversified western European operators such as Orange SA (13%) and Vodafone Group (27%). The exposure also has an impact on Telefonica's leverage, with most of Telefonica's debt euro and UK pound denominated. DERIVATION SUMMARY Telefonica is rated broadly in line with other geographically diversified European telecoms operators such as Orange (BBB+/Stable), Deutsche Telekom AG (BBB+/Stable) and Vodafone (BBB+/Stable). A relatively higher exposure to emerging markets with sub-investment-grade ratings results in slightly lower leverage per rating band compared to peers. Telefonica and the peer group combine strong operational positions in fixed and/or mobile with large and diverse cash flow generation. Operators with a single market focus such as Royal KPN N.V. (BBB/Stable) and BT Group Plc (BBB+/Stable) have tighter leverage thresholds for their ratings. KEY ASSUMPTIONS Fitch's key assumptions within the rating case for Telefonica include: - revenue growth of around 0.5% to 1% over the next two to three years; - EBITDA margins expanding to around 32% by 2020; - capex to sales ratio of 15% to 16% over the next two to three years; - reported operating income before depreciation and amortisation has been considered as EBITDA. RATING SENSITIVITIES Developments that may, individually or collectively, lead to positive rating action include: - FFO adjusted net leverage falling sustainably below 3.3x - Improved competitive position in Telefonica's domestic and other key international markets combined with strong growth in pre-dividend FCF Developments that may, individually or collectively, lead to negative rating action include: - FFO-adjusted net leverage trending above 3.8x on a sustained basis - Pressure on FCF driven by EBITDA erosion, FX and capital repatriation constraints, higher capex and shareholder distribution, or significant underperformance in the core domestic and international markets LIQUIDITY Telefonica continues to have strong liquidity, with positive Fitch-defined pre-dividend FCF generation of around EUR3 billion; at end-3Q17 the cash balance was EUR3.7 billion and EUR12.5 billion undrawn committed credit lines, which are adequate to cover upcoming debt maturities. Contact: Principal Analyst Rachel Chin Associate Director +44 20 3530 1629 Supervisory Analyst Tajesh Tailor Senior Director +44 20 3530 1726 Fitch Ratings Limited 30 North Colonnade London E14 5GN Committee Chairperson Damien Chew, CFA Senior Director +44 20 3530 1424 Media Relations: Pilar Perez, Barcelona, Tel: +34 93 323 8414, Email:; Adrian Simpson, London, Tel: +44 203 530 1010, Email: Additional information is available on 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 Non-Financial Corporates Hybrids Treatment and Notching Criteria (pub. 27 Apr 2017) here Additional Disclosures Dodd-Frank Rating Information Disclosure Form here Solicitation Status here Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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