Mixed outlook for Sri Lanka telcos in 2012, says Fitch

Fitch Ratings yesterday said in a special report released today that the 2012 outlook for incumbent Sri Lankan telecommunications operators (telcos) is stable, but that for smaller operators is negative.

“Despite tariff pressure, revenue growth for 2012 should be in the mid-single-digit percentage points, driven by rising demand for voice and data services,” said Hasira De Silva Assistant Vice-President in Fitch’s Corporates rating team.

“Further, any consolidation among smaller operators is likely to prove positive for the industry, although acquirers face the usual financial and integration risks,” added De Silva.

The report highlights Fitch’s views on increasing capex, profitability pressures, regulatory risk and industry fragmentation.

Following are excerpts from the report.

Rating outlook

Incumbents stable, challenges negative: Fitch Ratings expects the outlook for incumbents to be stable, but that for smaller operators to be negative. Despite tariff pressure, the agency sees revenue growth for 2012 in the mid-single-digit percentage points, driven by rising demand for voice and data services since the end of Sri Lanka‟s civil war in 2009. However, the rate of new wireless subscriber additions is likely to continue to be slow, due to high telephony penetration at end-September 2011 (mobile: 84% of population).

Capex to increase: The agency is forecasting capex to rise in 2012 and beyond, driven by a rapid increase in demand for voice and data services. For Sri Lanka Telecom PLC (SLT, B−‟/Stable) and Dialog Axiata PLC (Dialog, AAA(lka)‟/Stable), a significant proportion of 2012 capex is likely to be invested in enhanced optical fibre capabilities and next-generation network rollout – to improve data capacity.

Pressure on industry profitability: Competition and higher subscriber acquisition and retention costs (SARC) are likely to pressure margins. Fitch expects this will affect smaller operators disproportionately, as off-net calls (local calls to other networks) are generally priced higher than on-net (same-network) calls which are at the current regulatory floor of Rs. 1 (about half the market rate for off-net calls). This should drive subscribers to larger networks.

Flat or weaker FCF: Overall, 2012 profit and pre-dividend free cash flow margins are unlikely to grow due to SARC and comparatively higher capex. Despite these pressures, Fitch does not anticipate any downgrades of its rated entities – in the light of their comfortable ratings headroom.

Consolidation is beneficial: Consolidated would be beneficial for the overcrowded Sri Lankan telecoms industry. However, M&A is a credit risk, as the impairment of metrics from a debt-funded acquisition may offset the benefits of rationalisation.

Regulatory risk remains: The regulator‟s introduction of tariff floors and an interconnection framework in 2010-2011 has brought greater stability. However, Fitch still considers regulatory risk to be high – given the regulator‟s limited independence from the political framework, and relatively low transparency of procedures and policies versus most Asia-Pacific markets.

Infrastructure-sharing: Infrastructure-sharing is positive for incumbents which receive lease charges from newer entrants with developing infrastructure footprints. This lease income cushions an incumbent‟s profitability. For smaller operators, infrastructure-sharing enables them to access markets without fully funding the network capex, although lease costs can exert pressure on profit margins for emerging competitors in the short term.

What could change the outlook

Adverse regulation: Although positive decisions have been made in the last two years, Fitch believes that regulatory risk remains high, and any significantly adverse regulatory imposition has the potential to turn the sector‟s outlook to negative.

Price war: A sustained price war with tariffs at the regulatory floor would be likely to place extreme stress on the smallest companies and weaken the largest, although SLT and Dialog can sustain a significant downturn in their financial profiles before they would be downgraded.