Fitch Ratings has affirmed Telefonica SA's (TEF) Long-Term Issuer Default Rating (IDR) at 'BBB' with a Stable Outlook.

A full list of rating actions is detailed below.

TEF's rating reflects its broad geographic spread of leading telecommunications businesses, solid cash flow, advanced infrastructure investment and improving financial performance. A prudent financial policy, including a sizeable reduction in gross debt and the effective adoption of capital-light structures in its Latin American (Hispam) operations, have been hampered by negative currency impacts, in particular a weak Brazilian real (BRL).

Management actions to reshape portfolio operations, effective currency strategies and cuts in shareholder distributions, have been supportive of the rating and helped build leverage headroom to its rating downgrade thresholds. Positive operating trends and stronger Latin American currencies are forecast to increase headroom further.

Our rating case forecasts net debt/EBITDA of 2.9x in 2022 and 2.7x by 2024, compared with upgrade / downgrade thresholds of 2.7x and 3.2x, respectively. Macro-economic uncertainty and its associated operational impacts and the sustainability of foreign-exchange (FX) rates are downside risks.

Key Rating Drivers

Improved Rating Headroom: TEF's funds from operations (FFO) net leverage of 3.4x at end-2021, versus our previous rating-case forecast of 3.6x, reflected better-than-forecast cash flow generation and debt reduction and, to a lesser extent, positive FX movement. Our current rating case forecasts 3.3x for 2022, on continuing cash flow improvement and the positive effects of stronger FX rates in Latin America, notably the Brazilian real. This should lead to better leverage headroom. Ability to sustain its operational performance in the face of weakening global economic conditions and better visibility over FX rates may be positive for its credit profile.

Businesses Performing Well: TEF's key consolidated markets of Spain, Germany and Brazil delivered stable to strong organic performance in 1H22. Hispam (excluding Brazil) which management continue to deem as less strategic, has been through a turnaround and is also performing well. Organic revenue growth of 4.2% included strong performance in Germany (+5.5%) and Brazil (+7.8%), with full-year guidance upgraded modestly for both revenue and EBITDA.

Market Consolidation: Spain's telecom market is highly competitive with four fully convergent operators (i.e. offering fixed-mobile converged services) and a well-developed alternative service provider market in both fixed and mobile. A deflationary price environment should ease over the medium term as the proposed merger of MasMovil (Lorca; B+/Stable) and Orange Spain would create a stronger market number two with an estimated 37% of revenues behind TEF's 44%. However, ahead of the merger's expected close in 2023 we expect pressure to remain as operators jostle for market share.

Consolidation in Brazil Also Positive: A four-to-three operator consolidation of the Brazilian mobile market, which completed in 1H22 is positive for both the market and TEF. Brazil is a high-growth and high-margin business for TEF, roughly equal in size to Spain and therefore one of its two largest markets. TEF's Vivo brand is the market leader and reported revenue growth of close to 27% (in euro terms) in 1H22, benefiting significantly from positive FX movements and 7.8% organic growth.

Sizeable VMO2 Dividend: The creation of the VMED O2 UK Limited (VMO2; BB-/Stable) joint venture (combining the Virgin Media cable network and TEF's UK mobile business) in 2021 was the UK's second largest convergent network operator with the scale and cash flow to compete more effectively with BT Group plc's (BBB/Stable) incumbent business. A JV dividend of GBP1.6 billion to be paid in 2022 was partly a recapitalisation given a leverage target at the upper end of a 4x to 5x range. Although it is not a level we expect to be repeated consistently, the dividend demonstrates the significant cash flow potential of the JV.

UK Fibre JV: VMO2's recent fibre JV announcement will ease the capex budget at the UK operator and over the medium term support free cash flow (FCF) and therefore dividend potential at VMO2. The fibre JV is a greenfield project targeting 5 million-7 million new fibre homes. With VMO2 as anchor tenant the JV is also expected to provide fibre wholesale access to service provider customers and therefore offer the potential to compete with BT's Openreach network. In the near term it should capitalise on convergence and revenue synergies, while sharing risk in a larger fibre roll-out.

Positive Currency Effects: Currency depreciation has been weighing heavily on leverage for a number of years despite TEF's sizeable debt paydown, most notably the fall in the value of the Brazilian real and the translation effect this has had on reported cash flows. The real and Latin American currencies, however, have generally strengthened in 2022 and our base case forecast of BRL5.2/EUR compares with 6.4 in our previous rating case. This has the potential to reduce leverage by 0.2x in 2022.

Longer-Term EM Currency Effects: Over the longer term Fitch typically expects emerging-market (EM) currencies to follow a negative trend. Management aim to continue growing revenue faster than inflation in its Latin American markets to counter these currency effects. Treasury management, including increasing local currency debt (at both the opco and holdco levels), has also been used effectively to mute the impact of currency depreciation. Bringing financial leverage at the local level more closely in line with the group metric is an effective way of balancing these risks.

Derivation Summary

TEF is rated broadly in line with other geographically diversified European telecom operators, such as Orange, Deutsche Telekom and Vodafone. Its higher exposure to EM with sub-investment-grade sovereign ratings and associated currency risk results in a moderately tighter leverage sensitivity per rating band compared with that of peers.

TEF and its peer group combine strong positions in fixed or mobile markets with substantial and diverse cashflow operations. Operators with a single-market focus, such as Royal KPN N.V. and BT Group plc, both rated 'BBB'/Stable, have tighter leverage thresholds for their respective ratings.

Key Assumptions

Revenue to decline about 1% in 2022 (reflecting negative impact from the deconsolidation of UK operations since mid-2021 and positive impact from the EUR/BRL exchange rate), and growing at low single digits for 2023-2025

Fitch-defined EBITDA margin at 26%-27% in 2022-2025

Cash capex (including spectrum payments) averaging at about 15% of revenue in 2022-2025

Annual pre-retirement obligations included in FFO of about EUR900 million in 2022, and of about EUR800 million in 2023-2025

Annual cash dividends of about EUR1.1 billion in 2022 and EUR1.8 billion in 2023-2025

M&A at around EUR0.6 billion in 2022

EUR/BRL exchange rate of 5.2 in 2022-2025

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

FFO net leverage falling sustainably below 3.1x (equivalent to net debt/EBITDA below 2.7x)

Improved competitive position in TEF's domestic and key international markets combined with strong growth in pre-dividend FCF

Cash flow from operations (CFO) less capex/gross debt expected to be consistently above 15% (excluding one-off spectrum costs)

Factors that could, individually or collectively, lead to negative rating action/downgrade:

FFO net leverage trending above 3.6x on a sustained basis (equivalent to net debt/EBITDA above 3.2x)

Pressure on FCF driven by EBITDA erosion, FX and capital repatriation constraints, higher capex and shareholder distribution, or significant underperformance in core domestic and international markets

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

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