Fitch affirms Sri Lanka Telecom at ‘AA-(lka)’; outlook stable

Fitch Ratings has affirmed Sir Lanka Telecom PLC’s (SLT) National Long-Term Rating at ‘AA-(Ika)’. The Outlook is Stable. We have also affirmed the ‘AA-(Ika)’ national rating on the company’s LKR7 billion of senior unsecured debt.

SLT’s ratings are constrained by the sovereign’s ratings as 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 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, its ownership of an extensive optical-fibre network, and a solid financial profile.

KEY RATING DRIVERS

Constrained By Sovereign: SLT’s ratings are constrained by the sovereign’s, 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 a 44.9% stake, has no special provisions in its shareholder agreement to dilute the government’s significant influence over SLT.

Strong State Linkages: Fitch sees SLT’s status, ownership and control by the Sri Lankan sovereign as ‘Strong’. The state’s ownership gives it significant influence over operating and financial policies. We view the support track record and likelihood of future 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 healthy 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 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 reduce the availability and increase the cost of financing options for other government-related entities.

Capex to Rise in 2021: We expect SLT’s capex to increase to LKR22 billion-23 billion (2020 estimate: LKR14 billion-16 billion) in 2021 as we expect the company to resume investments to expand fibre infrastructure and 4G network coverage. The company’s capex deployment was disrupted in 2020 by the Covid-19 pandemic, which we expect led to free cash flow (FCF) margin of 3%-5%. However, FCF will turn negative in 2021 as capex rises. We expect SLT’s FFO net leverage to remain stable at around 2.0x in 2021 (2020 estimate: 1.9x-2.0x)

SLT aims to add fibre to about 400,000 homes during 2021 to expand its existing fibre coverage of around 450,000 homes. We expect 5G network roll-out to be delayed in Sri Lanka to beyond 2022. Dividends are likely to remain around LKR2 billion in the next two to three years.

Higher Growth in 2021: We expect revenue and EBITDA to grow by mid-to-high single-digit percentages in 2021 (2020 estimate: 4%-5%) driven by higher mobile data and fixed-broadband usage. We expect 4G smartphone penetration to rise by 4%-6% annually from 60% at end-2020 with the proliferation of cheaper China-made phones. We also forecast EBITDA margin to remain stable at 32%-33% in 2021 (2020 estimate: 32%-33%) as 3G users migrate to higher-tariff 4G networks. Profitability will also improve as users gradually upgrade to fibre networks from copper-based networks.

We estimate SLT’s group revenue grew by 4%-5% in 2020, led by rising mobile data usage and subscriber additions in fixed-broadband. Revenue was also boosted by the government’s reduction of the tax on telecommunication tariffs by 25%, VAT to 8% from 15% and removal of the 2% of nation building tax.

Stable Sector Outlook: Fitch expects mean FFO net leverage for SLT and mobile leader, Dialog Axiata PLC (AAA(lka)/Stable), to be stable at around 1.5x in 2021 (2020 estimate: 1.6x). We expect further sector consolidation and believe Airtel Lanka, a subsidiary of Bharti Airtel Limited (BBB-/Negative), may seek M&A due to mobile competition and higher taxes amid high capex requirements. Airtel Lanka acquired the 900MHz spectrum that was surrendered when Etisalat Lanka and Hutch Lanka merged in 2018. We expect telcos to focus on profitability and do not expect price-based competition to intensify.

DERIVATION SUMMARY

SLT’s unconstrained standalone credit profile benefits from its market leadership in fixed-line services and second-largest position in mobile, along with its ownership of an extensive optical-fibre network. SLT’s financial profile is strong with prospects of mid-single-digit revenue growth, moderate 2020 FFO net leverage of around 2.0x, and stable operating EBITDA margins.

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

SLT has a larger operating scale than leading alcoholic-beverage manufacturer Melstacorp PLC (AAA(lka)/Stable), which distributes spirits in Sri Lanka through its subsidiary, Distilleries Company of Sri Lanka (DIST: AAA(lka)/Stable). Melstacorp is exposed to more regulatory risk in its spirits business due to increases in the excise tax, but this is counterbalanced by its entrenched market position and high entry barriers. Consequently, the company is able to pass on cost inflation and maintain operating EBITDA margins, supporting substantially stronger FCF generation than SLT.

KEY ASSUMPTIONS

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

– Revenue increased by 4% in 2020 and will rise by 6% in 2021 driven by fixed-broadband and mobile data service growth.

– SLT group’s capex/revenue fell to around 18% in 2020 before climbing back to 23%-25% in 2021 on capex to expand fibre and 4G networks.

– Operating EBITDA margin to remain stable at 32%-33%.

– Effective tax rate of 21%-23% during 2021-23.

– Annual dividend pay-out of LKR2 billion.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade: – An upgrade of the Sri Lankan sovereign’s Long-Term Issuer Default Rating (CCC) could result in an upgrade of SLT’s National Long-Term Ratings Factors that could, individually or collectively, lead to negative rating action/downgrade: – A downgrade of the Sri Lankan sovereign’s Long-Term Issuer Default Rating could result in a downgrade of SLT’s National Long-Term Rating For the sovereign rating of Sri Lanka, the following sensitivities were outlined by Fitch in the agency’s Rating Action Commentary of 27 November 2020: The main factors that could, individually or collectively, lead to positive rating action/upgrade are: – External Finances: Improvement in external finances, supported by higher non-debt inflows or a reduction in external sovereign refinancing risks from an improved liability profile. – Public Finances: Stronger public finances, accompanied by a sustained decline in the general government debt to GDP ratio, closer to the ‘B’ median, underpinned by a credible medium-term fiscal consolidation strategy – Structural: Improved policy coherence and credibility, leading to more sustainable public and external finances and a reduction in the risk of debt distress The main factors that could, individually or collectively, lead to negative rating action/downgrade: – Increased signs of a probable default event, for instance from severe external liquidity stress, potentially reflected in an ongoing erosion of foreign exchange reserves and reduced capacity of the government to access external financing.

LIQUIDITY AND DEBT STRUCTURE

Reliant on Refinancing: At end-September 2020, SLT’s cash balance of LKR10 billion was insufficient to cover its short-term debt of LKR11 billion. SLT has about LKR14 billion in undrawn facilities which are uncommitted. We expect SLT to roll over its maturing short-term debt given its solid access to local banks. It has a solid history of accessing capital from local banks and capital markets.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

PUBLIC RATINGS WITH CREDIT LINKAGE TO OTHER RATINGS

SLT’s ratings are capped by the sovereign’s credit profile, in line with Fitch’s Government-Related Entities Rating Criteria.