Fitch Affirms TalkTalk Telecom at 'BB-'; Outlook Stable
(The following statement was released by the rating agency) LONDON, December 11 (Fitch) Fitch Ratings has affirmed TalkTalk Telecom Group Plc's (TalkTalk) Long-Term Issuer Default Rating (IDR) at 'BB-'. The Outlook is Stable. A full list of rating actions is detailed below. The rating reflects TalkTalk's sizeable position in the UK broadband market, focus on a niche value-for money segment and a business model that currently generates below-sector average free cashflow (FCF) margins. The company's funds from operations (FFO)-adjusted net leverage for FY18 (financial year ending March) is expected to be 3.8x, higher than our original forecast. This removes any headroom the company had within its rating at 'BB-'. TalkTalk's strategy to drive subscriber growth at a time of ongoing network upgrades and slowing market growth is likely to weigh on EBITDA over the next two to three years. The Stable Outlook reflects that underlying key performance indicators (KPIs) are trending in a positive direction and that potential improvements in regulated wholesale prices may be supportive. However, a lack of improvement in organic deleveraging capacity could become a risk if operational performance weakens or flexibility for investments is reduced. KEY RATING DRIVERS Sizeable Position, Low Margins: TalkTalk focuses on the value-for-money segment of the UK telecoms market and operates a national telecoms infrastructure with local access achieved through the purchase of regulated wholesale products from incumbent BT Group Plc. TalkTalk has around 4 million broadband subscribers with a market share of about 16%. The company's current scale drives a business model with fairly low operating and pre-dividend FCF margins (8% and 2.5% respectively in FY17). This leaves little room for manoeuvre and makes continued strong operational delivery essential. Slowing Growth, Increasing Competition: Growth in total UK broadband market lines has slowed to 2% in 2016 from an average of 4% over the preceding three years. We expect growth in 2017 to be 1.5% as household penetration reaches around 92% (Fitch estimates). The slowdown makes growing TalkTalk's subscriber base harder as it increasingly depends on the churn of other operators many of whom operate sizeable convergent telecoms platforms with stronger operating margins. Within this context, Vodafone UK has rapidly grown its broadband subscriber base to 278,000 with highly price-competitive offerings. New Strategy, Cost to Grow: TalkTalk's new management team has, in our opinion, rightly refocussed the company's strategy to grow the core fixed broadband subscriber base, improve the company's network and take a lighter approach to investments in mobile. The growth, however, is likely to weigh on EBITDA due to higher subscriber acquisition costs and potentially lower average revenue per user (ARPU). The company in parallel will manage an ongoing upgrade to its core network, the full benefits of which may take around two to three years to feed into cost savings. Positive KPIs, Sustainability Key: TalkTalk's 1H FY18 results indicate that a variety of the company's key performance indicators (KPI) are showing signs of operational improvement. During the period, the company's on-net subscriber base grew 46,000, churn was reduced to 1.3% 1H FY18 from 1.5% in FY17 and subscriber acquisition cost per gross addition also improved. These improvements are supportive of the company's operating position; however, sustaining them at an affordable cost level will be vital for the economics of the company's medium- to longer-term business model. No Headroom in Rating: Reduced EBITDA expectations have removed any leverage headroom TalkTalk had in its rating. TalkTalk's EBITDA guidance at the lower end of GBP270 million-GBP300 million for FY18 implies a FFO adjusted net leverage of 3.8x. Fitch's base case now forecasts that leverage at this level will remain broadly stable over the next two to three years, holding just within the downgrade sensitivities for a 'BB-' rating. This reflects a FCF margin of 0%-1%, which incorporates a dividend of GBP75 million a year and does not include any retained benefits from regulatory price decreases that may occur in 2018. Long-Term Business Model Unknowns: The continued growth of fibre-based broadband lines creates some uncertainties on TalkTalk's future product mix and cost structure. Fibre-based local access lines while benefiting from higher ARPU also have higher regulated wholesale costs. The growth of fibre could imply TalkTalk's business model may change to incorporate a greater mix of variable costs with lower operating margins. The company should be able to offset lower margins through reduced network capex at the FCF level. Visibility of the eventual outcome for TalkTalk is currently low and dependent on regulated prices and commercial trade-offs between wholesale-based products and own local access network build. DERIVATION SUMMARY TalkTalk's rating reflects a sizeable broadband customer base and the company's positioning in a large but niche, value-for-money segment. The company's operating margins are below the average of the telecoms sector. This largely reflects an unbundled local exchange network architecture and dependence on regulated wholesale products for 'last-mile' connectivity. The company is less exposed to trends in cord 'cutting' or 'shaving' but has some uncertainties in its long-term cost structure as a result of increasing fibre-based products and evolving regulation. Higher-rated peers such as BT Group Plc (BBB+/Stable), Sky Plc (BBB-/RWP) and Virgin Media Inc. (BB/Stable) benefit from varying combinations of full local loop network access ownership, and greater revenue diversification as a result of scaled positions in multiple products segments such as mobile and Pay-TV and higher operating margins. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer - Revenue to decline 2% in FY18 before gradually increasing to around 1% per year by FY20. - EBITDA margin of 15.4% in FY18 and gradually increasing to 16.4% by FY20. - Capex-to-sales ratio of 7% to 8%. - Dividends of GBP75 million per year. - A blended operating lease multiple of 5.3x. RATING SENSITIVITIES Developments that May, Individually or Collectively, Lead to Positive Rating Action - Strong operational performance, accompanied by a financial policy track record in managing Fibre to the Premise (FTTP) investments and dividend distributions, leading to high-single digit pre-dividend FCF margin. - Comfortable liquidity headroom and FFO fixed charge cover above 3.0x; - FFO adjusted net leverage sustainably below 3.3x. Developments that May, Individually or Collectively, Lead to Negative Rating Action - A material deterioration in KPIs or an increase in competitive intensity in the UK broadband market; - A contraction in pre-dividend FCF margin to low single digits; - Shrinking liquidity headroom or FFO fixed charge cover sustained below 2.5x; - FFO adjusted net leverage sustained above 3.8x. LIQUIDITY Improved liquidity: TalkTalk issued GBP400 million of bonds in 2017 and refinanced its bank debt in May 2017. Following the refinancing , TalkTalk has access to total committed revolving credit facilities of GBP640 million (undrawn GBP220 million) and debtor securitisation of GBP75 million (undrawn GBP2 million). Despite our forecast of minimal FCF over the next two to three years, we view TalkTalk's liquidity as satisfactory. FULL LIST OF RATING ACTIONS TalkTalk Telecom Group Plc - Long-Term IDR affirmed at 'BB-'; Outlook Stable - Senior unsecured notes due 2022 affirmed at 'BB-' / Recovery Rating 'RR4'. Contact: Principal Analyst Peter Wormald Analyst +44 20 3530 1357 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: Adrian Simpson, London, Tel: +44 203 530 1010, Email: adrian.simpson@fitchratings.com. Additional information is available on www.fitchratings.com. 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