Fitch affirms Sri Lanka’s Dialog Axiata at AAA(lka); outlook stable

Fitch Ratings-Singapore/Colombo- 4 April 2018: Fitch Ratings has affirmed Sri Lanka-based telecom company Dialog Axiata PLC's National Long-Term Rating at 'AAA(lka)'. The Outlook is Stable. KEY RATING DRIVERS Market-Leading Position: Dialog's standalone credit profile of 'AAA(lka)' is underpinned by its market leadership in the growing mobile and pay-TV industry segments. We believe the company is in a position to gain revenue market share from smaller telcos, with its superior 3G/4G networks capability. It has a solid financial profile with a revenue growth of 8%-9%, stable operating EBITDAR margin of around 35%-37%, and low Fitch-forecast 2018 FFO adjusted net leverage of 1.2x. High Ratings Headroom: We believe Dialog would receive support from its 83%-parent, Axiata Group Berhad (Axiata) of Malaysia, if its standalone credit profile were to weaken. Dialog and its parent continue to have moderate linkages, which include sharing key management personnel, a common name and common creditors, which could result in reputational risk to Axiata should Dialog fail. Unaffected by CTF Acquisition: Dialog's rating is unaffected by the acquisition of Colombo Trust Finance PLC (CTF), a small non-bank financial institution, for LKR1.3 billion completed in November 2017. Dialog is likely to use it to expand its digital financial services strategy and supplement its payment settlement platform. Dialog is likely to infuse equity of LKR2.05 billion in CTF during 2018-2020 in order to meet an enhanced minimum regulatory capital requirement of LKR2.5 billion by 1 January 2021. CTF's capital structure should then be strong enough to prevent becoming a cash drain on Dialog over the rating horizon. We have fully deconsolidated CTF's debt (which is mainly in the form of deposits) and EBITDA from Dialog in our analysis. Proposed Taxes Credit Negative: Fitch believes that Dialog's 2018 operating EBITDAR margin could narrow to 31%-33% (2017: 38%) and its FFO adjusted net leverage could deteriorate to 1.4x-1.6x (2017: 1.1x) if it were to pay an additional LKR4 billion-6 billion taxes for its mobile towers as proposed by the government. However, we believe there is a high level of uncertainty about the implementation of the taxes and we have not therefore factored these into our base case. Nevertheless, we would expect Dialog's ratings to remain unaffected, even if the taxes were implemented, given the high ratings headroom. The Sri Lankan government's 2018 budget, announced on 9 November 2017, proposes to tax mobile operators LKR200,000 per tower each month. High-Single-Digit Revenue Growth: We expect Dialog's revenue to grow by 8%-9% (2017: 8.5%) during 2018-2019, driven by data services revenue growth of 30%-35% (2017: 39%) and supported by the removal of the 25% telco levy on data services in September 2017. We believe that data services' revenue contribution (2017: 21%) to consolidated revenue will rise to over 25% in 2018. Stable Profitability: Barring proposed tower taxes, we forecast Dialog's operating EBITDAR margin to remain stable around 35%-37% as larger economies of scale in the data segment will support falling profitability on the voice and text segments. Strong data growth is supported by the proliferation of smartphones, with over half of new smartphones activated on Dialog's network being 4G-enabled. Negative FCF on Large Capex: We forecast a small free cash flow (FCF) deficit during 2018-2019 as cash flow from operations will fall short of Dialog's large, ongoing capex plan and dividend commitments. The company will continue to invest about 28%-30% of its revenue in capex each year to expand its 4G networks and its optical fibre infrastructure. We expect dividends to increase to around LKR3.7 billion-LKR4.3 billion (2017: LKR3.2 billion) during 2018-2019. Debt-Funded M&A: Some industry consolidation is likely, with ongoing intense competition in the mobile segment where smaller telcos are unprofitable and face high investment requirements. We believe Dialog and Sri Lanka Telecom PLC (SLT, B+/AAA(lka)/Stable) could acquire smaller telcos to strengthen their market position and consolidate spectrum assets. Dialog's ratings have sufficient headroom for a debt-funded acquisition of a smaller telco for around LKR10 billion-12 billion. DERIVATION SUMMARY Dialog's business risk profile is stronger than that of similarly rated national peers, given its market-leading position in Sri Lanka's mobile industry, stable cash generation, and integrated service offerings. Dialog has a larger revenue base and better operating EBITDAR margin than the fixed-line market leader, SLT, but this is offset by Dialog's higher exposure to the crowded mobile market. Dialog has a larger operating scale compared with hard-liquor market leader Distilleries Company of Sri Lanka PLC (DIST, AAA(lka)/Rating Watch Negative), given the fragmented nature of the alcoholic beverage industry. DIST is also exposed to more regulatory risk in the form of recurrent increases in indirect taxation, but these risks are counterbalanced by its substantially stronger FCF Dialog has a larger operating scale and a wider operating 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 pharmaceuticals distributor in the country and second-largest home care and personal care manufacturer. Hemas's FFO adjusted net leverage is likely to be similar to that of Dialog over the medium term. KEY ASSUMPTIONS Fitch's Key Assumptions Within the Rating Case Include: - High-single-digit revenue growth during 2018-2019 (2017: 8.5%) - Operating EBITDAR margin to remain stable at around 35%- 37% during 2018-2019 (2017:37.8%). - Capex/revenue to remain high at around 28%-30% (2017: 32%). - Dividend pay-out to increase to LKR3.7 billion-4.3 billion during 2018-2019 (2017: LKR3.2 billion) - Proposed mobile tower taxes are not implemented. - Deconsolidated CTF's financials from Dialog. RATING SENSITIVITIES Developments That May, Individually or Collectively, Lead to Positive Rating Action Include: - There is no scope for an upgrade as Dialog is at the highest rating on the Sri Lankan National Ratings scale Developments That May, Individually or Collectively, Lead to Negative Rating Action Include: - FFO adjusted net leverage above 3.5x, provided there is no further strengthening of rating linkages with the parent, Axiata. LIQUIDITY Solid Liquidity: At end-2017, Dialog had sufficient unrestricted cash balance of LKR7.9 billion and undrawn committed bank facilities of LKR13.6 billion to pay for its short-term debt maturities of about LKR11 billion. Dialog has strong access to local banks, being among the largest corporates in Sri Lanka. Debt consists mainly of a USD149 million syndicated facility and LKR10 billion bank loan.