Nov 19 (Reuters) – (The following statement was released by the rating agency)
Fitch Ratings has assigned Telefonica SA’s (TEF, BBB+/Negative) proposed perpetual subordinated securities an expected rating of ‘BBB-(EXP)’. The securities are being issued by Telefonica Europe B.V. and guaranteed on a subordinated basis by TEF. 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 ordinary share capital, while coupon payments can be deferred at the issuer’s discretion. As a result, the ‘BBB-(EXP)’ rating is two notches below TEF’s Long-term Issuer Default Rating (IDR), which reflects the securities’ increased loss severity and heightened risk of non-performance relative to the senior obligations. This approach is in accordance with Fitch’s criteria, “Treatment and Notching of Hybrid in Nonfinancial Corporate and REIT Credit Analysis” dated 13 December 2012 at www.fitchratings.com.
The proposed securities qualify for 50% equity credit as they meet Fitch’s criteria with regards 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 GBP, have no formal maturity date and will envisage a non-call 7 (NC7; i.e., they cannot be called for seven years) structure. The issuer has a call option to redeem the notes at par on the first call date (in 2020) and at any interest payment date thereafter. Fitch notes there will be a coupon step-up of 25bps from year 12 onwards (2025) and an additional step-up of 75bps 27 years after the issue date (2040). According to Fitch’s criteria, the first call date and the coupon step-up date are not treated as effective maturity dates due to the cumulative amount of the step-ups not exceeding 1% throughout the life of the instruments. However, the issuer will no longer be subject to replacement language disclosing the company’s intent to redeem the instrument from 2040 with the proceeds of a similar instrument or with equity. Hence, 2040 is viewed as the effective maturity date for the proposed NC7 securities. The instrument’s equity credit would switch to zero five years prior to this date (i.e. 2035).
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
Sovereign Pressure Eased
The revision of the Outlook on the Spanish sovereign (BBB/Stable) to Stable on 1 November has eased sovereign-linked pressures on TEF. While Spain exited recession in 2H13, recovery is still expected to be relatively weak. Consumer and telecom spending are likely to exhibit a lagged effect and remain under pressure, although these pressures will ease. The potential for further austerity and the risk of higher funding costs linked to sovereign yields has reduced. With Fitch guiding to a maximum three notches between Spain and TEF and the Outlook on the sovereign now on Stable, sovereign-linked pressure has clearly reduced.
German Deal Constructive
The proposed combination of Telefonica (Berlin: TNE5.BE – news) ‘s German operations with E-Plus will create the country’s largest mobile operator by customers and second largest by revenues. In a market currently dominated by T-Mobile and Vodafone, the consolidation of the market down to three mobile network operators (MNOs), will, in Fitch’s view, create a more balanced playing field, allowing the combined business the opportunity to exploit the economies of scale the existing incumbents have. The transaction’s conservative structure, including an equity stake in the enlarged business, along with the proposed equity being raised (including the upcoming hybrid), minimise any potential leverage impact.
Deleveraging and Liquidity
Despite eurozone conditions, TEF has raised around EUR19bn in debts markets over the past 18 months, as well as effecting cash savings through changes to its distribution policies (most of which will be seen in 2013) and asset sales. Fitch considers that management reacted well to what looked like a challenging year at its start, in terms of financial markets and the company’s ability to deleverage. The 2012 dividend holiday both preserves cash and provided time to achieve disposals on management’s own terms.
Spanish Pressures Remain
While TEF has the best diversification among the western European incumbents, Spain still accounts for close to one-third of EBITDA. While technically out of recession, economic conditions remain a concern with high unemployment, weak consumer confidence and intensifying competition expected to maintain pressure on domestic revenues. The 4Q12 launch of TEF’s quad-play Fusion product has not stabilised mobile subscriber losses, resulting instead in a wholesale re-pricing of the market. However, the company’s focused fibre roll-out (3 million homes passed at 3Q13) is improving its broadband market share and subscriber numbers.
Brazilian Paradox
Accounting for 22% of 2012 EBITDA and one of the group’s key growth drivers, the performance of Brazil in 2012 was mixed. The business is the market number one in a competitive mobile market, consistently generating strong organic growth and good margin expansion. However, its fixed-line business is under significant pressure, as both the company and wider market are losing access lines to mobile substitution. Currency weakness has had a compounding effect with 2012 EBITDA falling by 2.7%, despite 4.8% organic growth. These pressures have continued in 2013.
