CHICAGO--(BUSINESS WIRE)--Fitch Ratings has downgraded Oi S.A.'s (Oi) long-term foreign and local currency Issuer Default Ratings (IDR) and Portugal Telecom SGPS's (PT) long-term IDR to 'BB+' from 'BBB-'. Fitch has also downgraded Oi's national long-term rating and national long-term debentures to 'AA(bra)' from 'AA+(bra)'. The Rating Outlook on the IDRs and national long-term ratings is Stable. Fitch has also downgraded Oi's senior unsecured and secured debt, and the senior unsecured notes issued by Portugal Telecom International Finance BV to 'BB+' from 'BBB-'. The Rating Watch Negative on all ratings has been removed.
KEY RATING DRIVERS
High Risk Investment Strategy:
The downgrade follows Oi's announcement on July 16, 2014, that PT's EUR847 million commercial paper (CP) investment issued by Rio Forte Investments S.A., was not paid on the due date of July 15, 2014 and the recovery value is highly uncertain. Based on the assumption that Oi does not recover any cash from the defaulted Rio Forte CP, net leverage for the merged entity will increase a modest 0.2x-0.3x. While the increase in net leverage is not alone sufficient to warrant a ratings downgrade, PT's decision to invest a significant amount of cash, close to 40% of its total cash and equivalents at end-2013, into the debt security of a 10% shareholder raises several concerns, and may indicate a higher risk tolerance for its investments, and a more aggressive management strategy that are not in line with an investment grade category risk profile.
Despite this event, Fitch believes that the proposed merger between Oi and PT will proceed given Oi and PT signed a new agreement to slightly adjust the economics of the merger agreement by which PT will transfer Oi's shares to Oi in the amount equivalent to the face value of the CP. In return, Oi will transfer the CP to PT, with an option for PT to purchase back the shares. Further, the merger process is substantially complete with Oi already completing its capital increase, PT's operating assets have been transferred to Oi, Oi has guaranteed for PT's debt, and approvals by the shareholders and the regulatory bodies for the merger have been received.
Weak Financial Profile:
The downgrade primarily reflects the financial profile of the post-merger entity between Oi and PT that is not able to initially support an investment grade rating given the operational challenges faced in both Brazil and Portugal. Further, any material or immediate improvement in the financial profiles of the pro forma merged entity may prove challenging despite the management's intention to delever. Due to the forecast negative free cash flow (FCF), net leverage of the merged entity is likely to hover around 4.0x in the short to medium term and that the merger synergy may not be strong enough to curb weakening operating trends.
Domestic Pressure Ongoing:
For Oi, profitability erosion was evident in 2013 due to the competitive pressure in the Brazil telecom market with its recurring EBITDA margin falling to 28.5% from 31.5% in 2012. In addition, any meaningful deleveraging in the short term is unlikely based on Fitch's expectation of negative FCF generation in 2014 due to high capex, other investment cash outflows including judicial deposits, and falling margins. The company has taken on a series of asset disposals to raise cash since late 2012 but the impact on its net debt has been small.
While PT's domestic businesses performed in line with Fitch's 2013 expectations, financial pressures remain - Portuguese EBITDA was down by 9.1%. The company's residential fixed-line operations perform more strongly than most European incumbent businesses, benefiting from an early investment in fibre, and TV and bundled services that have proven attractive and popular with consumers. Its mobile and enterprise divisions nonetheless remain under pressure and further negative trends are expected.
Given the different operational geographies, operational integration that could lead to an immediate improvement of the competitive positions of Oi and PT in their respective markets will prove challenging. Positively, the merged entity's credit profile should benefit from increased scale with an over-100 million subscriber base and geographic diversification of cash flows, as well as some merger synergies in terms of cost savings and sharing of best practices over the medium to long term. In addition, the rights issue in May 2014, of which over BRL3 billion could be used for deleveraging, will support its high capex plans in 2014 and 2015.
The merger will also substantially improve the new company's corporate governance structure by eliminating Oi's current complex shareholding structure and restructuring it with one class of shares of one listed entity, Telemar (Corpco), with same voting rights and dividends.
The company has disclosed that it expects to achieve BRL5.5 billion of synergy on a net-present-value basis, of which the majority should come from the improved efficiency of its operations. In addition, the company expects to gain some fiscal benefits, mainly tax credits, from the merger, although these benefits could prove to be one-off items and eventually be exhausted.
Fitch expects the merged entity to be able to generate positive FCF and improve leverage during 2016 and onward. A further downgrade of the ratings could occur if the net leverage ratio remains above 4.0x over the medium to long term and in the absence of any meaningful improvement in key operating metrics.
While any positive rating action is unlikely at this time, Fitch would consider a positive rating action should the company's net leverage improve to below 3.5x along with improvements in key operating metrics on a sustained basis.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology', May 28, 2014.
Applicable Criteria and Related Research:
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage