Fitch affirms Sri Lanka Telecom at ‘B+’/‘AAA’

Fitch Ratings has affirmed Sri Lanka Telecom PLC’s (SLT) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at ‘B+’ and its National Long-Term Rating at ‘AAA(lka)’. 

The Outlook is Stable. They have also affirmed the ‘AAA(lka)’ national rating on the company’s Rs. 7 billion debt program. SLT’s senior unsecured debt of up to Rs. 7 billion is rated at the same level as its National Long-Term Rating as the debentures rank equally with other senior unsecured obligations.

SLT’s IDRs are constrained by Sri Lanka’s IDRs (B+/Stable), per Fitch’s Government-Related Entities Rating Criteria, as the state holds a majority stake in SLT directly and indirectly, and exercises significant influence on its operating and financial profile. 

SLT’s second-biggest shareholder, Malaysia’s Usaha Tegas Sdn. Bhd. with 44.9%, has no special provisions in its shareholder agreement that would dilute the Government’s significant influence over SLT.

SLT’s standalone credit profile, assessed by Fitch at ‘BB’, is stronger than that of its owner, reflecting the company’s market-leading position in fixed-line services and second-largest position in mobile, along with its ownership of an extensive optical-fibre network. 

The standalone profile is also underpinned by its mid-single-digit percentage growth prospects, moderate estimated 2018 FFO adjusted net leverage of 1.7x and stable operating EBITDAR margin.

Key rating drivers are as follows: 

Strong State linkages: Fitch sees SLT’s status, ownership and control by the Sri Lankan sovereign as ‘Strong’. The State’s ownership of SLT gives it significant influence over the company’s operating and financial policies. Fitch views the support track record and expectations for the likelihood of state support for SLT as ‘Strong’, given its strategic importance in expanding the country’s fibre infrastructure. Historically, SLT has not required tangible financial support due to its strong financial profile.

State’s incentive to support: Fitch sees the socio-political implications of a default by SLT as ‘Moderate’ due to the presence of three other privately owned telcos. However, it could affect the fixed-line market because SLT acts as a policy company to invest in fibre networks across the island to support the government’s vision of fibre-based internet for all households. Fitch also sees the financial implications of a default as ‘Strong’ as a financial default by SLT may have a strong impact on the availability and cost of financing options for other government-related entities.

High Capex, Negative FCF: Fitch expects SLT to have negative free cash flow (FCF) during 2019-2020 (estimated 2018 negative FCF of Rs. billion-Rs. 3 billion) as cash flow from operations may be insufficient to fund large capex plans to expand the fibre infrastructure and 4G mobile networks. SLT’s 2019 capex will likely remain high, around 28%-30% of revenue, as it aims to complete its 4G population coverage to around 95% by end-2019.

Fitch expects SLT to continue to invest in expanding fibre coverage as it targets to connect about one million homes by 2020-2021 from an existing 70,000 homes currently. Typically, SLT would need to lay fibre for at least two million homes to get half of the households connected. 

Fitch expect SLT’s fibre investments to have low returns due to the country’s low broadband tariffs. Dividends are likely to remain around Rs. 1.6 billion-Rs. 1.8 billion in the next two to three years.

Data drives growth: Barring any tax shocks, Fitch expects revenue to grow by a mid-single-digit percentage during 2019-2020, driven by data and fixed-broadband growth. Fitch expects 4G smartphone penetration to improve from the current 25% with the proliferation of cheaper Chinese phones. Revenue rose strongly by 6.5% in the first nine months of 2018, driven by fixed-broadband and mobile usage after a temporary usage slump in 2017 due to higher taxes on voice and data. Fitch expects the Government’s recent announcement on the removal of floor rates for voice call charges to have a limited impact on growth.

Industry consolidation, M&A risk: Fitch believes the recently announced merger between Hutchison Telecommunications Lanka Ltd. and Etisalat Lanka Ltd. is likely to relieve some competitive pressures that have undermined telecom companies’ revenue and EBITDA growth in recent years. The merger is pending regulatory approval. Industry consolidation is likely to provide some relief from pricing pressure, especially in the data segment where telcos have not been able to fully capture the strong growth in data traffic.

SLT’s National Long-Term Rating could come under pressure if it were to carry out a debt-funded acquisition of the smallest telco – Bharti Airtel Ltd.’s (BBB-/Stable) Sri Lankan subsidiary, Airtel Lanka. However, any rating action will be based on the acquisition price, funding structure, and the financial and operating profile of the combined entity.

Stable sector outlook: Fitch’s outlook for the Sri Lankan telco sector is stable as Fitch expects the mean net leverage for SLT and mobile market leader, Dialog Axiata PLC (AAA(lka)/Stable), to remain stable at around 1.4x in 2019. Fitch expects the sector’s cash generation to improve, driven by higher mobile and broadband data usage, which however, will be insufficient to fund the large capex requirement, leading to negative FCF. Fitch also expects average operating EBITDAR margins to remain stable at around 34% (2018 estimate: 34%), driven by improving economies of scale in the data and home broadband segment, offsetting the negative impact of the changing revenue mix.

Derivation summary is as follows:

SLT’s standalone rating reflects its moderate financial profile and strong market position in the fixed-line industry segment and second-largest position in the mobile market. SLT has lower exposure to the crowded mobile market and more diverse service platforms than Dialog. However, Dialog has a larger revenue base and better operating EBITDAR margin than SLT while SLT’s forecast FFO adjusted net leverage and FCF profile are worse than that of Dialog.

SLT has a larger operating scale and a wider EBITDAR margin than Hemas Holdings PLC (AA-(lka)/Stable), which is a diversified conglomerate with exposure to pharmaceuticals, fast-moving consumer goods, leisure and transport. Hemas is the largest private retail pharmaceutical distributor in the country and the second-largest home care and personal care manufacturer. Hemas’s FFO adjusted net leverage is likely to be better than SLT’s over the medium term.

Fitch’s key assumptions within its rating case for the issuer 

• Revenue to grow by mid-single-digit percentage, driven by fixed-broadband and mobile data services in 2018-2019.
• Capex/revenue to remain high at around 28%-30% as SLT expands it fibre and 3G/4G networks.
• Operating EBITDAR margin to remain stable at around 29%-30%.
• Effective tax rate of 28%.
• Dividend payout of Rs. 1.6 billion-Rs. 1.8 billion.

Developments that may, individually or collectively, lead to Positive rating action: 

• An upgrade in Sri Lanka’s IDRs would result in corresponding action on SLT’s IDRs;
• A weakening of links between SLT and the sovereign could result in SLT’s Local-Currency IDR being upgraded above Sri Lanka’s Local-Currency IDR. However, SLT’s Foreign-Currency IDR will remain constrained by Sri Lanka’s Country Ceiling of ‘B+’
• There is no scope for a national rating upgrade as SLT is at the highest rating on the Sri Lankan scale.

Developments that may, individually or collectively, lead to Negative rating action:

• A downgrade of Sri Lanka’s IDRs would result in corresponding action on SLT’s IDRs;
• A debt-funded acquisition of a smaller operator could threaten SLT’s National Long-Term Rating, depending on the acquisition price and the financial profile of the combined entity.