S&P base-case operating scenario
The resilience of VMI’s subscription-based business model to prolonged difficult economic conditions in the U.K., and our expectations of steady take-up of bundled (“triple-” or “quadruple-play”) products and premium services, should translate in our opinion into sustained solid operating performance in the fourth quarter of 2012 and throughout 2013.
Competition in the broadband Internet, telephony, and TV markets should remain fierce, with constant evolution in product bundles and ongoing promotions launched by all U.K. network players. Nevertheless, we positively observed some price increases for voice line rental, voice tariffs, and broadband service in 2011 and 2012 for all market players. We believe further modest price increases are conceivable over the next two years.
Revenues in the first nine months of 2012 grew by 3.1%, as a result of average revenue per user (ARPU) increases in the group’s core residential cable division and accelerating growth in the business division.
For 2012 and 2013, we project in our base-case scenario that increased take-up of bundled products and premium services, supported by growing customer demand for VMI’s very-high-speed broadband service and new generation TV platform, TiVo, should translate into about 3% to 4% growth in revenues. This should support an EBITDA margin of about 40%.
However, VMI’s EBITDA margin is likely to remain lower than the margins of some of its cable peers such as Liberty Global Inc. (B+/Positive/--), Kabel Deutschland Holding AG (BB-/Stable/--), and Ziggo Bond Co. B.V. (BB/Stable/--). We consider that this is on account of VMI’s structurally high marketing spend in the U.K. and margin dilution from VMI’s sizable mobile business.
S&P base-case cash flow and capital-structure scenario
The one-off step-up in network investments this year to support the doubling of broadband speeds offered to subscribers should lead in our opinion to a slight decline in VMI’s full-year 2012 free operating cash flow (FOCF) generation, which we consider as still solid, compared with the GBP492 million generated in 2011. Nevertheless, we think that moderate revenues and EBITDA growth in 2013, combined with a likely return of network investments to 2010-2011 levels of 16%-17% of total sales, should translate into a marked increase in FOCF in 2013, in excess of GBP600 million in our base-case scenario, which would be a record for the company. Adjusted free operating cash flow to debt stood at about 7% at the end of September 2012, roughly stable year on year.
This, combined with sound visibility on the direction and thresholds of management’s financial policy in the near term, could result in an adjusted gross debt-to-EBITDA ratio at, or slightly below, 3.5x by mid-to-late 2013, compared with 3.6x at end-September 2012, gradually down from 3.8x at end-December 2011. This is a level we would view as adequate to consider a one-notch rating upgrade.
VMI refinanced a large portion of its senior unsecured notes in October 2012, through several tender offers on existing notes funded by issuing new notes at much lower rates. However, despite the resulting reduction in future interest expense, this refinancing will have a slight negative impact on VMI’s leverage ratio in the short term, as the group added approximately GBP120 million of debt to its balance sheet in order to fund premium cost and fees associated with the tender offers.
VMI’s liquidity is “adequate” under our criteria. On Sept. 30, 2012, the group had unrestricted cash and cash equivalents of GBP113.4 million and an undrawn GBP450 million revolving credit facility (RCF) due 2015. The $500 million senior unsecured bond issued in first-quarter 2012 and the $900 million and GBP400 million issued together in October 2012 further improved VMI’s financial flexibility, leading to a predominantly long-term debt maturity profile. On Sept. 30, 2012, and pro forma for the recent refinancing, the group had no large debt maturity until 2018. We expect VMI’s sources of liquidity, including cash and credit line availability, to exceed its uses, including projected shareholder returns, by about 1.5x in the next 12 months.
Despite ongoing substantial shareholder returns in the form of share repurchases, we anticipate that VMI’s discretionary cash flow generation after share repurchases will be close to zero or slightly negative in 2012 and 2013, thus not materially affecting net liquidity sources.
In addition to certain debt incurrence covenants in its bond documentation, VMI is subject to certain financial maintenance covenants in its senior bank facilities. These include thresholds for the leverage ratio (consolidated net debt to consolidated operating cash flow) and interest coverage ratio (consolidated operating cash flow to consolidated total net cash interest payable). According to our projections, the headroom under these covenants should remain adequate in the coming year, at or above 20% under our base-case scenario.
The issue rating on VMI’s subsidiary Virgin Media Investment Holdings Ltd.’s senior secured bank facilities and notes is ‘BBB-’ (two notches higher than the ‘BB’ corporate credit rating on VMI). The recovery rating on this debt remains at ‘1’, indicating our expectation of very high (90% to 100%) recovery for lenders in the event of a payment default. Our recovery rating on the senior secured notes and loans is underpinned by our view of a relatively comprehensive security package provided to secured lenders. However, in the event of an upward revision of the corporate credit rating, upside to the ‘BBB-’ issue rating on this debt is constrained by Standard & Poor’s criteria for notching investment-grade companies’ debt issues.
The issue rating on subsidiary Virgin Media Finance PLC’s senior unsecured notes maturing in 2016 and 2019 is ‘BB-', one notch below the corporate credit rating on VMI. The recovery rating on this debt is ‘5’, indicating our expectation of modest (10%-30%) recovery in the event of a payment default (low end of range).
The issue rating on VMI’s unsecured convertible bond is ‘B+', two notches below the corporate credit rating. The recovery rating on this debt is ‘6’, indicating our expectation of negligible (0%-10%) recovery for creditors in the event of a payment default.
We believe that a default would most likely occur following deterioration in operating performance due to declining revenues and lower margins, in turn the result of stiffer competition and increased marketing costs. At our simulated point of default in 2018, we project that total EBITDA will have fallen to about GBP830 million and that the group will have refinanced $1 billion of convertible notes maturing in 2016 with a similar subordinated instrument.
Our going-concern valuation envisages a stressed enterprise value of about GBP4.8 billion, using a 5.75x stressed EBITDA multiple. After deducting enforcement costs and prior-ranking claims of about GBP660 million, we calculate that there will be about GBP4.1 billion available for lenders. We assume about GBP3.8 billion outstanding under the senior secured bank loans and notes (including six months of prepetition interest and a fully drawn revolving credit facility), which leaves about GBP350 million for senior unsecured noteholders. Assuming about GBP1.9 billion of outstanding senior notes (including six months prepetition interest) at default, we estimate recovery prospects of 10%-30% for these instruments, with coverage at the low end of this range. Small changes in our valuation assumptions, such as EBITDA at default and valuation multiples, or potential changes in the capital structure that could affect either the mix or overall amount of debt, could create volatility in recovery prospects for unsecured lenders.
Thereafter, there is negligible value left for the convertible bond, hence the recovery rating of ‘6’ (0% to 10% recovery expectation) on this instrument.
The positive outlook signals that we could raise the rating by one notch in 2013 if VMI can deliver sustained revenues and EBITDA growth from its cable residential and business divisions, resulting in marked FOCF growth and a concomitant improvement in credit metrics. A reduction of Standard & Poor’s adjusted leverage ratio for VMI to 3.5x or below and the improvement and maintenance of adjusted FOCF to debt at about 10% could lead to an upgrade.
In the context of a bleak macroeconomic environment and high broadband and pay-TV competition in the U.K., VMI’s ability to steadily increase penetration of bundled products and advanced services and attract and retain subscribers generating the highest ARPU in the market are likely to be key considerations for the rating over the coming year, along with management’s update on its shareholder return policy beyond 2013. We anticipate at this stage that management will adjust shareholder returns to reflect business prospects and cash generation.
We could revise the outlook to stable if VMI adopts a more aggressive financial policy than we currently expect--which could arise from increasing returns to shareholders before credit metrics improve--or if any deterioration in operating performance or FOCF generation leads to adjusted leverage consistently in the 3.5x to 4.0x range.
Related Criteria And Research
-- Principles Of Credit Ratings, Feb. 16, 2011
-- Use Of CreditWatch And Outlooks, Sept. 14, 2009
-- The Largest Operators Have The Most To Lose In Europe’s Telecom Market, Nov. 7, 2012