Fitch revises Outlook on Sri Lanka Telecom to Negative; affirms at AA+

Dec 23, 2019 (LBO) – Fitch Ratings has revised the Outlook on Sri Lanka Telecom PLC's (SLT) National Long-Term Rating to Negative from Stable and affirmed the rating at 'AA+(lka)'.

They have also affirmed the National Ratings on SLT's outstanding senior unsecured debentures at 'AA+(lka)'.

The rating action follows Fitch's revision of the Outlook on Sri Lanka's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to Negative from Stable.

KEY RATING DRIVERS

Strong State Linkages: SLT's ratings are constrained by the sovereign as per Fitch's Parent and Subsidiary Rating Linkage criteria. We assess the relationship between the sovereign and SLT as one of a weaker parent and stronger subsidiary with strong operational and strategic linkages. The state holds a majority stake in SLT directly and indirectly, and can exercise significant influence on its operating and financial profile. SLT's second-biggest shareholder, Malaysia's Usaha Tegas Sdn Bhd at 44.9%, has no special provisions in its shareholder agreement to dilute the government's significant influence over SLT.

High Capex, Negative FCF: We expect SLT to have negative free cash flow (FCF) during 2019-2020 (2018 negative FCF of LKR3.4 billion), as cash flow from operations could be insufficient to fund capex requirements to expand the fibre infrastructure and 4G mobile networks. We expect SLT's 2019 capex to remain high, at around 28%-30% of group revenue (2018: 26%), as it aims to complete its 4G population coverage to around 95% by end-2019. However, management expects its capex/revenue to drop to around 18%-20% in 2019.

We expect SLT to continue to invest in expanding fibre coverage as it aims to connect about one million homes by 2020-2021, from the 70,000 homes currently enabled. SLT would typically need to lay fibre for at least two million homes for half of the households to be connected. We expect SLT's fibre investments to have low returns due to the country's low broadband tariffs. Dividends are likely to remain around LKR1.6 billion-1.8 billion in the next two to three years.

Data-Driven Growth: We expect revenue to grow by a mid-single-digit percentage during 2019-2020 (barring any tax shocks), driven by data and fixed-broadband growth. We expect 4G smartphone penetration to improve from the current 25% with the proliferation of cheaper Chinese phones. Revenue rose strongly by 7.5% in 2018, driven by fixed-broadband and mobile usage after a temporary usage slump in 2017 due to higher taxes on voice and data. We expect the government's recent announcement to reduce tax on telecommunication tariffs by 25% to support top-line growth.

Further Consolidation Probable: We expect further consolidation, and believe that Airtel Lanka, a subsidiary of Bharti Airtel Limited (BBB-/Negative), may seek M&A due to mobile competition, higher taxes and high capex requirements. The recently concluded merger between Hutch and Etisalat may relieve some competitive pressures that have undermined telecom companies' revenue and EBITDA growth in recent years.

Stable Sector Outlook: Fitch's outlook for the Sri Lankan telco sector is stable as we expect 2020 mean funds from operations (FFO) adjusted net leverage for SLT and mobile leader Dialog Axiata PLC (AAA(lka)/Stable), to remain stable at around 1.7x (2019F: 1.7x). We forecast average cash flow from operations for SLT and Dialog to improve to around LKR32 billion in 2020 (2019F: LKR28 billion), and for revenue and EBIDTA to rise by 5%-6% and 8%-10%, respectively (2019F: 5% and 10%). The average operating EBITDAR margin should stay stable at around 34% (2019F: 34%), driven by improving economies of scale in the data and home-broadband segments - offsetting the negative effect of a changing revenue mix.

DERIVATION SUMMARY

SLT's unconstrained standalone credit profile is stronger than that of the government of Sri Lanka, reflecting the company's market leadership 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 2019 FFO adjusted net leverage of 2.1x, and stable operating EBITDAR margin.

SLT has lower exposure to the crowded mobile market and more diverse service platforms than mobile-market leader Dialog. However, Dialog has a larger revenue base, significantly better operating EBITDAR margin, lower forecast FFO adjusted net leverage and a better FCF profile than SLT.

KEY ASSUMPTIONS

Fitch's Key Assumptions Within Our Rating Case for the Issuer

Revenue to increase by the mid-single-digit percentage, driven by fixed-broadband and mobile-data services in 2019-2020
Capex/revenue to remain high at around 28%-30% as SLT expands its fibre and 3G/4G networks.
Operating EBITDAR margin to remain stable at around 29%-30%.
Effective tax rate of 28%.
Dividend payout of LKR1.6 billion-1.8 billion

RATING SENSITIVITIES

Developments That May, Individually or Collectively, Lead to Stabilisation of the Outlook

A revision of the Sri Lankan sovereign's Long-Term IDR Outlook to Stable from Negative would result in SLT's National Long-Term Rating Outlook revised to Stable.

Developments That May, Individually or Collectively, Lead to Negative Rating Action

A downgrade in the Sri Lankan sovereign's Long-Term IDR would result in a downgrade on SLT's National Long-Term Rating.

For the sovereign rating of Sri Lanka, the following sensitivities were outlined by Fitch in the agency's Ratings Action Commentary of 18 December 2019:

The main factors that individually, or collectively, could trigger a downgrade are:

Failure to place the gross general government debt/GDP ratio on a downward path due to wider budget deficits or the crystallisation on the sovereign balance sheet of contingent liabilities that are linked to state-owned entities or government-guaranteed debt.
Increase in external sovereign funding stresses that threaten the government's ability to meet upcoming debt maturities, particularly in the event of a loss of confidence by international investors.
A further deterioration in policy coherence and credibility, leading to lower GDP growth and/or macroeconomic instability.

The main factors that, individually or collectively, could lead to a revision of the Outlook to Stable:

Stronger public finances, underpinned by a credible medium-term fiscal strategy that places gross general government debt/GDP on a downward path, accompanied by higher government revenue.
Improvement in external finances, supported by lower net external debt or a reduction in refinancing risk; for example, from a lengthening of debt maturities or increased foreign-exchange reserves.
Improved macroeconomic policy coherence and credibility, evidenced by more predictable policy-making and a track record of meeting previously announced economic and financial targets.

LIQUIDITY AND DEBT STRUCTURE

Strong Access to Local Banks: SLT's liquidity - cash of LKR11 billion and committed undrawn bank lines of LKR13.5 billion - at end-December 2018 was sufficient to fund its LKR17 billion of debt maturing in the next 12 months. We expect SLT to refinance its short-term debt in light of its access to local banks. It has a solid record of accessing capital from local banks and capital markets.