S&P Reports on European Telcos

MILAN -- The two-and-a-half-year credit recovery of Europe's investment-grade telecoms sector now appears mostly over, with the "last hurrah" having possibly been the first-quarter 2005 high-profile upgrades of the German and French incumbents Deutsche Telekom AG and France Telecom S.A., said Standard & Poor's Ratings Services in a report published today. "Industry Report Card: Investment-Grade Telecoms In Europe, Middle East, And Africa" discusses important trends in the sector, while also providing an overview of individual issuers rated by Standard & Poor's.

For the first time in months, the number of negative outlooks and CreditWatch listings within the group now outweighs, albeit only modestly, the number of positive outlooks, notably following the CreditWatch placements of Swedish operator TeliaSonera AB and Spain's Telefónica S.A. at the end of March. In addition, similar to the situation in the first quarter of 2004, leveraged deals have taken their annual toll among the European investment-grade telecoms population, with French satellite operator Eutelsat S.A. relegated to high-yield status on March 17, 2005, upon announcement of a €2.6 billion ($3.4 billion) LBO.

"Nevertheless, we have not yet seen any clear signs of a steady, general deterioration in credit quality for the European investment-grade telecoms sector," said Standard & Poor's credit analyst Guy Deslondes. "Most of the telecoms operators in the group are prudent regarding their need to maintain a solid capital structure, and acquisitions are mostly focusing on cash-generative targets and established business positions."

On balance, Standard & Poor's expects fewer rating changes in 2005 than in 2004, and those that occur are likely to be fairly evenly spread between upgrades and downgrades. As always, financial policies and business performance will be key.

The beginning of the year has been marked by a level of M&A activity unseen since 2001. Although deal execution has been particularly lengthy and uncertain compared with the previous boom, a growing crowd of eager buyers has made the European M&A market more buoyant--particularly in telecoms.

Beyond just the number of deals, Standard & Poor's notes two important features of the current M&A frenzy. First, all transactions have been primarily cash or debt financed. Second, it has become very obvious that some large European telecoms operators are desperately on the lookout for acquisitions, either to improve their growth profile, leverage their balance sheet and reduce the average cost of capital, or use up excess cash (to acquire asset rather than buy back shares).

"Although the financial flexibility accumulated by many European operators should enable them to maintain consolidated credit measures in line with their current rating categories--even in the event of large cash-financed transactions--most acquisitions will bring to the acquirer more volatile earnings in the face of material debt, as well as weak business positions," said Mr. Deslondes. "In addition, bidders are gradually becoming more price aggressive--the Cesky Telecom privatization process being a case in point--at the risk of overpaying."

At the same time, however, Standard & Poor's recognizes the potential long-term financial and business benefits of diversifying the earnings base and improving growth prospects.

"If accompanied by prudence with respect to the capital structure and moderation in existing share buyback programs, these factors should limit credit pressures," added Mr. Deslondes. "Consequently, in most cases, any negative rating actions associated with current M&A activity would likely be limited to one notch."

The report also raises the issue of accelerating technology transition, which poses considerable medium-term challenges for fixed-line operators. That is why Standard & Poor's sees increased underlying business risks in operating in the telecoms industry.

The remaining utility-like features of the telecoms industry are progressively disappearing, meaning that more conservative capital structures will increasingly be needed to support existing ratings. Demonstrated conservative financial policies and substantial underlying cash flow generation will be viewed as the principal hedge against impairments in business positions.

Standard & Poor’s