Corporates

Telecommunications / EMEA

2012 Outlook: European Telecoms and Cable

Weak Revenue Prospects, Strong Balance Sheets
Outlook Report
Rating Outlook

Rating Outlook
Increasing Technology Disruption: Over the top (OTT) applications and the proliferation of connected smart devices will continue to drive strong growth in fixed and mobile data traffic. This data revenue growth will at best offset declines in traditional voice and SMS services as intense competition and economic austerity ensure deeper discounts on bundled services. New revenue models to capture a share of OTT services will remain experimental and insignificant to ratings movement over the Outlook period. Fibre and Spectrum Phased: While the sector struggles to find revenue growth, capex spend on fibre roll-out and spectrum will continue to be phased. Capital budgets will be reserved for must-have spectrum auctions and on selective network investment to compete effectively for service offerings where strong competition (e.g. Cable TV networks) exists. Cable will Compete Effectively: Cable companies have largely undertaken their DOCSIS 3.0 capex upgrades and will be able to compete aggressively on broadband speeds while retaining some pricing power on TV packages. Cable cash flow growth should continue to outperform the incumbent telco sector and, consequently, credit profiles in the cable sector are expected to continue to improve. EBITDACapex Stable: Technology enables operating efficiencies. There is still significant cost to be taken out of European telcos P&Ls to underpin EBITDA margins. Moreover, only 3040% of a telcos annual capex budget is maintenance capex, providing some headroom in times of macroeconomic stress. Countries more affected by austerity that dont face aggressive cable competition (e.g. Italy and Greece) will cut capex significantly and retain stable EBITDA Capex ratios (see Southern European Telecom Capex Flexibility, 30 September 2011).
15%

STABLE

Rating Outlooks
(%) 100 80 60 40 20 0 Positive Source: Fitch Stable Negative 10% 75%

Populist Regulation: Pockets of exposure to further mobile termination rate cuts still exist although these are more limited now. The EU regulators also remain committed to reducing the cost of roaming. These populist measures will further dent telco revenue prospects but are unlikely of themselves to be ratings significant. Strong Balance Sheets: In marked contrast to 10 years ago (2002 dotcom/3G bubble), the majority of European telcos balance sheets remain healthy, reflecting lower average leverage, stronger cash balances and well-phased debt maturity profiles, underpinning ratings.

Related Research
European Mobile (June 2011) Southern European Telecom Capex Flexibility (September 2011) Global Telecom Portfolio - Sector Credit Factor Compendium Analysis (May 2011)

What Could Change the Outlook

Sovereign Downgrades: There is no direct sovereign linkage imputed into Fitchs European telco ratings. In certain circumstances, country experience can exert pressure on domestic telco ratings (e.g. Greece, Portugal, Italy) caused by austerity measures. Operator service revenues have shown a closer correlation to weakening GDP over the past 18 months. A material weakening of European GDP forecasts beyond that currently forecast by Fitch and included in the agencys ratings model assumptions may affect sector names and the Outlook. Regulation: Unfavourable decisions on material sector issues such as regulating copper, net neutrality or the forced unbundling of cable TV could have an adverse effect on issuers.

Analysts
Michael Dunning +44 20 3530 1178 michael.dunning@fitchratings.com Damien Chew +44 20 3530 1424 damien.chew@fitchratings.com Stuart Reid +44 20 3530 1085 stuart.reid@fitchratings.com Nikolai Lukashevich +7 495 956 9968 nikolai.lukashevich@fitchratings.com

www.fitchratings.com

17 November 2011

Corporates
Figure 1

Key Issues
Revenue Growth Challenges Remain
Across Europe, regulatory (MTR/roaming cuts) and competitive actions have continued to take their toll on telco operator service revenues. The cable sector has largely been spared regulatory intervention and has also benefited from an ability to upsell services. The cable sector outperforms telcos on revenue growth (see Fig.3). However, regulatory pressures for telcos, though not exhausted, are slowly waning and are unlikely to be the major driver of topline weakness that they have been in the past. Instead, it is technology advancement and continued high levels of competition in Europe that is challenging the next phase of revenue pressure for incumbent telcos. In the same way that technology-driven Voice-Over-InternetProtocol (VOIP) products forced a rebalancing of traditional fixed-line voice tariffs in favour of bundled broadband data packages, similar services are forcing the rebalancing of mobile tariffs into bundled, tiered-usage packages. To illustrate, Vodafone reported that non-messaging data made up 82% of traffic in H1FY12, but accounted for only 15% of service revenue. To rebalance this mismatch, operators are pushing higher-priced tiered-usage packages for mobile. For fixed-line they are pushing higherpriced faster access or bundling triple-play product offerings to create customer stickiness and increase revenue-generating units (RGUs). In southern Europe however, as the macro picture deteriorates further, traditional revenues have declined quite rapidly as customers are not switching to these more expensive options (see below). Overall, there is evidence to suggest that data revenue growth will at best provide only a limited substitute for waning voice and SMS revenues. Leading operators, which focus investment on building high network quality and migrating customers to integrated data bundles, may be able to offset most declines in traditional voice usage. However even these operators are only able to reflect relatively flat service revenues (excluding MTR cuts). To achieve longer-term real growth, operators will need to find ways to secure new service revenues, which will likely mean partnerships with other sectors. Examples are machine-tomachine (M2M) remote meter reading by utility companies and other location-based services in the mobile sector as well as gaming/entertainment options in the fixed segment. To date these services are nascent but they are likely to offer revenue upside to the gatekeeper incumbent telco industry if ways can be found to share in the opportunity.

Western Europe Mobile Service Revenue Growth

The North/South divide
North Europe South Europe Europe 8 (YoY %) 3 1 -1 -3 -5 -7
Q308 Q408 Q109 Q209 Q309 Q409 Q110 Q210 Q310 Q410 Q111 Q211 Q311F Q411F Q112F Q212F

Source: Fitch

Figure 2

Non-Msg Data Revenue Growth and Employment

North employment (LHS) South employment (LHS) North rev. growth (RHS) South rev. growth (RHS) Employment rate (%) 94 92 90 88 86 84 82
Q107 Q307 Q108 Q308 Q109 Q309

Non-msg. data rev. growth (%) 45 40 35 30 25 20 15 10 5

Q110 Q310 Q111

Source: Fitch; employment figures from Bloomberg

Economic Uncertainty Adds Pressure

Over the past 18-24 months Fitch has witnessed a growing correlation between sharp declines in GDP growth and the behaviour of consumers in relation to telecoms services. This has been reflected most severely in mobile services where consumers opt for cheaper tariff packages, consume less data and renew handset contracts less frequently. Mobile services have also experienced an increase in potential tariff bypass services such as VOIP, particularly as Smartphones Instant Messaging (IM) and VOIP applications have proliferated and economic stress increases. Fitch expects these trends to continue over the Outlook period, adding further pressure to operators revenue generation. In the fixed segment, cable and telco operators that are able to offer market-leading bundled triple-play (telephony, broadband, TV) service offerings will retain some revenue stability on the fixed-line side. This is because home entertainment has proven to be quite resilient as a relatively cheap, feel-good alternative to other forms of entertainment in times of economic stress.

Figure 3

Domestic Fixed Line Revenue Growth (YoY %) incumbents vrs cable

Incumbents 8% 6% 4% 2% 0% -2% -4% -6% -8%
Q308 Q408 Q109 Q209 Q309 Q409 Q110 Q210 Q310 Q410 Q111 Q211

Cable

Source: Fitch

2012 Outlook: European Telecoms and Cable November 2011

Corporates
Sector Summary and Triggers
Figure 4

Sector Summary Strongest to Weakest

Company IDR France Telecom S.A. AOutlooka Stable Revenue Q311 EBITDA margin slightly down at 35.4% and revenue off 2% as group feels competitive pressures building in its domestic markets ahead of Iliads free mobile launch. Competition in domestic fixed not likely to abate but gradual fibre deployment should protect or improve FTs broadband position. 9M11 revenue in local currencies increased by 3% and EBITDA by 5% In 1HFY12, group organic service revenue growth +1.4% with Europe -1.3% and emerging markets +8.4%. Growth should carry on into 2HFY12, especially with the impact of regulatory cuts on voice revenue trailing off. Costs Further operational efficiencies identified (including the creation of a procurement JV with Deutsche Telekom). The frontloaded nature of these savings should limit margin erosion. Possible short-term ratings triggers (including press release and report extracts see full release and/or report for fuller set of possible triggers) Current conservative financial policy is protecting the rating. Increased domestic competition but still a strong market position and some EM growth should see FT remain one of Europes stronger telco groups. Material deterioration in FT's domestic position leading to weakening margins towards 30% and pre-dividend free cash flow (FCF) margin below 10% would exert pressure on the ratings.

TeliaSonera

A-

Stable Stable

Vodafone Group Plc A-

Telefonica SA

BBB+

Stable

Deutsche Telekom, AG

BBB+

Positive

Royal KPN N.V.

BBB+

Stable

Significant cost restructuring efforts have supported margins. Vodafone is coming to the end of the two-year 1bn cost-cutting exercise announced in Nov 2009. Management continues to look for efficiency gains. The rate of EBITDA margin decline slowed in 1HFY12, and the company expects 2HFY12 to show a similar trend. Telefonica is one of the few incumbents to Telefonica enjoys strong (mid-40s) report top-line growth although its domestic EBITDA margins domestically helped by business has come under significant pressure, continued emphasis on costs. European with Spanish sales expected to be down by margins in the 20s are driven by the mid-high single digits in 2011. While Latin competitive conditions of the UK and America and the European operations continue O2s fourth operator position in Germany. to offset Spain, growth is undershooting Capex remains high driven by spectrum previous expectations. acquisition and heavy LatAm investment. Domestic mobile revenue has shown signs of Cost-cutting remains a top priority, both stabilisation in Q2-Q311, with domestic fixeddomestically and internationally, which line revenue pressures somewhat abating. OTE will help preserve margins. DT is well on results will likely continue to weigh on the top track with its Save For Service line although downward pressure decelerated programme, which achieved EUR476m in Q311. Revenue will likely continue modestly of savings in 9M11. shrinking across Europe. Revenue fell 2.3% year on year in 9M11 as Considered an efficient operator. cable competition continues to penetrate the Continued focus on costs (including the triple-play segment and as the group feels the ongoing restructuring at Getronics) continued effect of rebalancing domestic tariffs should limit the deterioration in to cope with widespread IP bypass profitability. applications.

Conservative metrics drive the rating. Aggressive shareholder distributions or M&A activity, leading to substantial growth of leverage, might put pressure on the rating. With the increasing relevance of dividends from Verizon Wireless, Fitch believes using funds from operations (FFO) adjusted net leverage is a more appropriate measure to judge leverage. Vodafones ratings could come under pressure if FFO/adjusted net leverage rises above 3.0x, without evidence that the company could reduce debt to meet Fitchs expectations of the metric decreasing to 2.5x by March 2013. With Telefonica downgraded to BBB+ in September 2011, the company sits relatively comfortably within this rating level. Any positive action would require unadjusted leverage (net debt/EBITDA) to recover to a level approaching 2x. Currently at around 2.5x, negative pressure might be felt were the metric to push closer to 2.7x-2.8x and look like it would remain there. Cash conversion (predividend FCF to sales) is good in the low-mid teens although near-term pressures will remain given ongoing spectrum costs. A sale of US business is likely to improve operating profile and lead to a material deleveraging which, if coupled with a commitment to a conservative financial policy, may lead to an upgrade. An offsetting factor could be building macro economic concerns for DTs remaining European portfolio.

Conservative and visible financial policy of maintaining net debt/EBITDA in a 2.0x2.5x range and KPN's decision to revise down its historically generous shareholder distribution policy a sign that management is taking a more pragmatic view on the operational challenges should ensure stability in the rating.

2012 Outlook: European Telecoms and Cable November 2011

Corporates
Sector Summary Strongest to Weakest (Cont.)
Company Telekomunikacja Polska S.A. (TPSA) IDR BBB+ Outlooka Stable Revenues Continued weak 9M11 revenue performance in the fixed segment driven by fixed-to-mobile substitution and migration to cable TV offerings. Visible improvement in mobile underpinned by the pricing strategy initiated in early 2010 (net subscriber adds and stable ARPU). Mild revenue erosion in domestic fixed (copper network) and mobile offset by solid growth in the Nordic segment and cable business (YouSee). The group continues to benefit from strong domestic market position and triple-play business mix. 1HFY12 revenue before specific items fell 3% while underlying revenue excluding low-margin transit revenue fell 1%. BT reiterated its guidance for underlying revenue ex transit growth of -2% to 0% in FY12, with an improvement to 0% to +2% in FY2012/13. 9M11 domestic revenue down 7.7% with mobile most affected. Despite these pressures PTs fixed-line business has performed well in terms of defending market share and developing a successful iPTV service, which is particularly important given an effective cable competitor. Continued competitive pressure has seen TI's domestic revenue fall 5.6% in 9M11, but the quarterly underlying revenue trend continues to improve. TIM Brasils underlying service revenue grew 11.5%. Costs Continued focus on costs led to gradual improvements in EBITDA margin (before exceptional items) in each of the quarters of 2011, especially in mobile. Network sharing agreement with PTC (PLN1bn in opex and capex savings) expected to provide some medium-term margin relief. Solid track record in streamlining the business. Ongoing initiatives expected to protect profitability levels. Possible short-term ratings triggers (including press release and report extracts see full release and/or report for fuller set of possible triggers) Rating is underpinned by strong market position, France Telecom ownership and a track record of good financial discipline.

TDC A/S

BBB

Stable

Ratings constrained by TDCs generous distribution policy and limited footprint compared to peers. Worsening trading performance owing to more aggressive competition in fixed (from other cable or utilities players), leading to FCF deterioration and net leverage outside the stated 2.1x on a sustainable basis, might put pressure on the ratings.

BT Group Plc

BBB

Stable

Portugal Telecom SGPS SA

BBB

Negative

Telecom Italia SpA

BBB

Negative

Virgin Media Inc

BB+

Stable

Sustained underlying revenue growth, with stable EBITDA margin and FCF generation leading to further deleveraging, together with evidence of an improving competitive position could result in an upgrade. The turnaround of Global Services and the performance of BT Retail in a highly competitive market are critical to maintaining BT's credit profile. Deterioration in the key operating and financial metrics in these divisions could lead to a downgrade. PT continues to focus on costs given Outlook reflects the risk that domestic austerity measurers may bite harder than underlying top-line pressure. Portuguese expected. Leverage remains acceptable at 2.1x, but is expected to trend higher EBITDA margin of 45.7% wages and over the next two years, as the impact of cash payments relating to the transfer of salaries down 8.4% in 9M11. With most of pension obligations to the state push net borrowings higher. The absence of a its fibre roll-out complete, capex, which dividend receipt from Brazilian asset, Oi, in 2011 is likely to depress near-term has been relatively high compared to the cash flow, although headroom exists at present relative to a 3.0x leverage metric, peer group, has peaked. seen as the pressure point for a downgrade. Cutting efforts have meant that underlying Any expectation that TI could not keep leverage as measured by unadjusted net domestic EBITDA fell 5.1%. Capex and debt to EBITDA (excluding Telecom Argentina) sustainable below 3.0x could result working-capital controls meant operating in TIs IDR being downgraded to BBB-. Another key consideration for further FCF grew by EUR516m in 9M11 vs 9M10. negative rating action would be a worsening of the companys domestic business's In Brazil, underlying EBITDA less capex operating and financial profile. increased by 16% in 9M11 9M11 revenue up 3.3 % (down compared to 9M11 EBITDA grew 5.4%, faster than Negative rating action could result if operating trends deteriorated over a period of FY2010 revenue growth of 5.8%), with the revenue. Considered reasonably efficient two to three quarters, leading to a significant deterioration in revenue and profits. A company benefitting from the up-selling of operator. Operating costs are under lack of progress in deleveraging, with Fitch's expectation of funds from operations triple-play services and faster broadband control and margins continue to improve. (FFO) adjusted net leverage remaining at around 3.5x over the medium term, would speeds. However, year-on-year revenue growth Network related costs have been reduced also put pressure on Virgin Media's ratings. for the core consumer business slowed down following a review of the companys Fitch does not anticipate further positive rating action unless the company shows through the first three quarters of 2011. property portfolio. greater financial discipline, such as significantly lowering its current net leverage target of 3x. There would also need to be evidence of a strong and sustainable improvement in Virgin Media's competitive position.

Opex fell 4% in 1HFY12, driving 1HFY12 EBITDA growth of 3%. BT expects EBITDA to grow in FY12 despite expected declines in revenue.

2012 Outlook: European Telecoms and Cable November 2011

Corporates
Sector Summary Strongest to Weakest (Cont.)
Company IDR Hellenic BB Telecommunications Organization S.A. (OTE) Outlooka Evolving Revenues 9M11 revenue continues to suffer form weak macro economic conditions. In fixed, marginally improving trend but net disconnections accounting for 50% of lost lines, show that austerity is materially affecting consumers telecom spend. However visible improvements in mobile suggest that irrational pricing behaviour is abating. 9M11 revenues ahead by 5%, reflecting continued emphasis on upselling multiple services per customer. Some softness in revenue trends causing minor downgrade in FY revenue guidance, to around 5.5%. Consistency with which targets are met, provides comfort over top-line. Costs EBITDA margin will decline but will likely remain within confines of the rating. Inability for significant headcount reductions due to civil servant status of OTEs workforce. Possible short-term ratings triggers (including press release and report extracts - see full release and/or report for fuller set of possible triggers) The rating is affected by sovereign downgrade but is supported by OTEs strong market position in Greece. Severe austerity effects are taken into account in the current rating level which is seen as a base level unless there is further disruption caused by disorderly Sovereign related actions.

Telenet N.V.

BB

Stable

Wind Telecomunicazioni SpA

BB

Neg

Efficient operator, with EBITDA margins for 2011 guided at 52.5%. One of the highest margin operators in the sector, some pressure maybe felt as its MVNO mobile business develops. Capex will remain high, 2011 guidance of 22% of revenues, much of which is success based customer equipment. H111 revenues up 1.6% and EBITDA down Group EBITDA margins weakened at the 1.6%. A good performance in the context of the half year to 37.2% (38.4%) caused by economic climate and the peer group. contraction in both fixed and mobile Spectrum acquisition costs have increased segments. leverage however. Revenue growth in the six months to September 2010 was 6.8%, driven by the uptake of premium TV and broadband. Management expects revenue for FY10/11 to be towards the upper end of the 6.5% to 7% range. Despite a weak economy and a tough competitor in Spanish incumbent, Telefonica, 9M11 performance has been surprisingly resilient revenues ahead by 0.1% and up 2.5% in Q311. This contrasts with mid-high single digit declines from the incumbent. Costs remain well under control. H1FY11 revenue growth of 6.8% translated into EBITDA growth of 10.4%.

The consistency with which management meet public targets, leads to a good level of comfort over expected financial performance. Ratings are constrained by a financial policy that emphasizes shareholder returns and allows for unadjusted leverage (net debt/EBITDA) to trend as high as 4.5x. Leverage that were to remain above this threshold for an extended period would put negative pressure on ratings.

Kabel Deutschland BB Vertrieb und Service GmbH (KDG)

Stable

Rating reflects acquisition by Russia's Vimpelcom which implies a notch uplift for the support that Vimpelcom bring. WIND's leverage is high for its rating category and is estimated by Fitch to reach 4.8x of Net Debt (including PIK debt)/EBITDA at end-2011 as a result of the spectrum investment and economic headwinds. A further rise in leverage (as measured by the above metric) exceeding 5x on a sustainable basis would likely trigger a downgrade Further upward rating movements are expected to be limited by the companys stated leverage target of between 3.0x and 3.5x.

Cableuropa S.A.

Stable

UAB Bite Lietuva

B-

Stable

A major cost cutting exercise in 2009 has been followed by a continued emphasis on efficiency. EBITDA up 3.5% in 9M11 reflects a margin of 50.4%. Cessation of network build and a much reduced and stable capex level is driving materially improved FCF. 9M11 revenues down 2%, driven largely by Marketshare continues to grow rapidly in MTR cuts. EBITDA up 8%, driven by continued Latvia, allowing the company to benefit improvement in the Latvian operations. from economies of scale.

Ratings stabilised at B in June 2010 following successful bank refinancing. Ongoing refinancing activity includes successful 1.0bn senior secured issuance and refinancing of the companys HY notes. Improving cash flow should help address 2013 maturity wall, and has resulted in leverage (net debt/EBITDA) reduce to 4.6x at 3Q11. Revenues are holding up well despite macro climate. If deleveraging can continue in current climate this would arguably support positive rating action. Further positive rating action will only be considered if both the Latvian and Lithuanian operations are generating strong, stable FCF. Negative rating momentum could return if operating results deteriorate to the levels seen in 2009 and negative FCF reduces liquidity.

Rating Watch denoted by RWN/RWP/RWE otherwise text refers to Outlook Source: Fitch, companies

2012 Outlook: European Telecoms and Cable November 2011

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2012 Outlook: European Telecoms and Cable November 2011