Fitch said leverage could increase to over 1.5 times if the acquisition is funded by debt, and operating cash margins would also narrow because of losses at Hutch.
But SLT will gain spectrum and save on future capital expenditure.
SLT's international rating of 'BB' would be unlikely to be downgraded post-acquisition Fitch said.
The full statement is reproduced below:-
Fitch Affirms Sri Lanka Telecom at 'BB-'/'AAA(lka)'/Stable
Fitch Ratings-Singapore/Colombo-03 March 2014: Fitch Ratings has affirmed Sri Lanka Telecom PLC's (SLT) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at 'BB-'. The agency also affirmed SLT's National Long-Term Rating at 'AAA(lka)'. The Outlook is Stable.
KEY RATING DRIVERS
Acquisition Risk: SLT's potential debt-funded acquisition of Hutchison Telecommunications Lanka (Pvt) Ltd. (Hutchison Lanka) could increase its leverage over 1.5x (2013: 1.0x) and would lead to a downgrade of its National Long-Term Rating to 'AA+(lka)'. The acquisition would be negative for SLT's credit profile as it would double its net debt and dilute operating EBITDAR margin because Hutchison Lanka has EBITDA losses. However, SLT will gain 800,000 subscribers and key spectrum assets in 900MHz/1800MHz, and will save on capex in 2014/15 following the acquisition.
Strong Balance Sheet: SLT's IDRs at 'BB-' have relatively high rating headroom given its 2013 funds flow from operations (FFO)-adjusted net leverage of just 1.0x, its market-leading position in fixed-line and position as the second-largest mobile service provider. SLT's IDRs are unlikely to be downgraded in the medium term despite our expectations of negative free cash flow (FCF) of LKR2bn-LKR3bn for the next three years and the potential Hutchison Lanka acquisition.
Profitability to Decline: Fitch expects SLT's 2014 revenue to rise by 5%, driven by mobile data and fixed-broadband services, which will more than offset declines in fixed-voice and international revenue. Fitch forecasts operating EBITDAR margin to fall by 50bps-100bps each year during 2014-17 (2013: 31.5%) due to changes in the revenue mix as low-margin data services replace relatively higher-margin voice and text revenue. However, profitability will be supported by an imminent industry consolidation and a regulatory tariff floor on voice services.
Negative FCF to Continue: FCF will be negative during 2014-17 as SLT's ratio of capex to revenue will remain high at around 28%-30% as it will invest LKR18bn-LKR20bn each year to expand its fibre broadband and 3G/4G mobile infrastructure. Dividends would likely remain similar to the 2012 level at LKR1.5bn.
Industry to Consolidate: The number of industry participants will likely reduce to three from five as it is likely that SLT will acquire Hutchison Lanka and third-largest operator Etisalat could acquire Bharti Airtel Limited's (BBB-/Stable) unprofitable Sri Lanka subsidiary, Airtel Lanka, which is the fourth-largest operator. The regulatory tariff floor on voice services has prevented smaller operators from competing on price and has left them unviable in the medium term.
RATING SENSITIVITIES
Negative: Future developments that may individually, or collectively, lead to negative rating action include:
-A debt-funded acquisition of Hutchison Lanka is likely to lead to a downgrade of SLT's National Long-Term Rating by one notch.
-A downgrade in the rating on the Sri Lanka sovereign (BB-/Stable) will result in a corresponding action on SLT's IDRs as the government directly and indirectly holds a majority stake in SLT.
-FFO-adjusted net leverage increasing to above 2.5x on a sustained basis would lead to a downgrade of SLT's Foreign-Currency IDR. Fitch currently expects FFO- adjusted leverage to remain below 2.0x even after the Hutchison Lanka acquisition in the medium term.
Positive: Future developments that may individually or collectively lead to a positive rating action include:
-An upgrade in the rating on the Sri Lanka sovereign is likely to lead to a corresponding upgrade in SLT's IDRs.
-As the ratings are currently constrained by government ownership, the weakening of links with 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 the Country Ceiling of 'BB-'.
-If the debt-funded acquisition of Hutchison Lanka goes ahead, it is likely that we will no longer consider SLT to be constrained by the sovereign. In this case, these positive rating triggers will no longer apply.