Fitch affirmed long-term issuer default rating of Kazakhtelecom at “BB” and upgraded company national long-term rating to “A+(kaz)”; outlook positive

December 30. KASE. Fitch Ratings. Moscow

Fitch affirmed long-term issuer default rating of Kazakhtelecom at "BB" and upgraded company national long-term rating to "A+(kaz)"; outlook positiveFitch Ratings has revised the Outlook on Kazakhtelecom JSC’s (Kaztel) Long-Term Issuer Default Rating (IDR) to Positive from Stable and affirmed the IDR at ‘BB’. The agency has  also upgraded the National Long-term rating to ‘A+(kaz)’ from ‘A(kaz)’ and assigned a Positive Outlook. A full list of rating actions is available at the end of  this commentary.

The Outlook revision to Positive reflects the company’s improving liquidity, narrowing mismatch between predominantly domestic revenues and FX debt, improving cash flow, a successful launch of mobile operations and therefore lower  execution risks associated with further mobile expansion.

Kaztel is a strong fixed-line incumbent, with a near monopoly position in the traditional telephony and high broadband market share, operating in a benign regulatory environment. The company re-entered the mobile mass market with its LTE service in 2014, providing it with a quad-play capability. Mobile roll-out and  shareholder distributions have pushed funds from operations (FFO) adjusted gross  leverage higher but we do not expect this to significantly exceed 2x.

KEY RATING DRIVERS

Strong Incumbent Positions

Kaztel is likely to maintain its dominant positions in the fixed-line segment, helped  by benign regulation and a shortage of alternative networks. Kaztel estimated its  fixed-line telephony market share at a high 93% at end-2013. Fixed-to-mobile  substitution is a key threat, and this will drive modest fixed-line disconnections and  pricing pressures in the voice segment, in our view. Expected interconnect rate  cuts may exert additional pressure on traditional fixed-line revenue in the medium  term but should not trigger any significant changes in the competitive environment.

Positive Broadband Prospects

The Kazakh broadband market still retains strong growth potential, driven by fairly  low broadband penetration in the country (31% of households as of end-2013).  The company remains an absolute broadband leader with over a 70% market  share. Kaztel has completed its fibre infrastructure roll-out in key cities,  strengthening its technological advantage over peers. Key large rival Vimpelcom  significantly slowed down its broadband expansion in the country in 2014, which  should lead to less aggressive competition for Kaztel.

Successful Mobile Entry

The company is facing reasonably positive prospects in the mobile market with its  LTE service. Kaztel remains the only 4G operator in the country, which gives it a  significant competitive advantage over peers in terms of broadband speed that it  can offer to its customers. New subscriber additions in the data-only (dongles)  segment have been strong, implying that the company has been able to convert its  technological advantage into market share gains. An expected decline in low- ARPU CDMA voice subscribers has been largely offset by new higher-paying GSM  customers.

Execution risks are notably higher in the mass mobile segment. The Kazakh market is well-penetrated with 3G data and GSM voice services and is highly competitive.

Capex Declines Drive Cash Flow Improvements

The end of Kaztel’s active fibre development project, the completion of the first  stage of mobile roll-out and a strategic decision to smooth out further mobile  investments will result in a substantial decrease in capex spend, both in absolute  and relative terms. As a proportion of revenues, capex is expected to drop to  approximately 20% in 2015-2017, compared with slightly above 30% in 2012-2014.  Kaztel’s capex peaked in 2014.

We expect that 2015 cash flow generation would remain fairly depressed, reflecting the impact of continuing mobile development, one-off roll-out costs and  sign-up subscriber promotions. We project pre-dividend free cash flow margin to  recover to mid-high single digits in 2016-2017, from negative territory in 2014.

Leverage to Stabilise

Kaztel is likely see a peak in its FFO adjusted gross leverage at slightly above 2x,  before stabilising below this level. The increase in leverage in 2015 will be driven  by a decline of reported EBITDA and FFO margins, and by sluggish cash flow  generation. EBITDA and FFO will be under pressure from substantial one-off mobile roll-out and promotional costs in 2015. We expect pre-dividend free cash flow to remain in a marginally negative territory during that year.

We project Kaztel’s deleveraging flexibility to improve from 2016. However, we expect that leverage to be managed in conjunction with shareholder remuneration needs. Although the company does not have public targets, leverage is likely to remain sustainably below 2x FFO adjusted gross leverage but above 1.5x, in our view.

Improving Liquidity; Lower FX Risks

Kaztel’s access to credit lines notably improved while FX risks subsided in 2014.  Sustainably strong liquidity and further reduction in FX risks may result in moderate  relaxation of our leverage triggers.

The company’s credit profile is likely to be resilient to potential foreign currency  exchange rate volatility. By our estimates, stressing the metrics for a 50% tenge  devaluation would only increase leverage by 0.4x total debt/EBITDA, which can be  accommodated within the current rating level.

Fitch expects that FX debt as a share of total debt is likely to drop to approximately  68% by end-2014 from 87% at end-2013, and management has an intention to  further reduce it. Arrangements with key vendors suggest that continuing large  capex, including on imported telecom equipment, is unlikely to increase FX  liabilities.

Kaztel has a few untapped credit lines from foreign banks, which provides it with  access to substantial FX liquidity, in case of need. In addition, Development Bank  of Kazakhstan (BBB/Stable) has a 10-year tenge credit line of approximately  KZT37bn with Kaztel for funding mobile development. Kaztel’s debt profile is well  spread with no medium-term debt redemption peaks.

Weak Domestic Banking System

The Kazakh domestic banking system is weak, implying scarcity of local funding, few committed credit facilities and potentially limited access to deposits. The company holds a significant amount of its cash liquidity with low-rated domestic banks. Consequently, our analysis primarily focuses on the company’s gross debt metrics.

Weak Parent-Subsidiary Linkage

Kaztel’s ratings reflect its standalone credit profile. Kaztel is of only limited strategic  importance for Kazakhstan, while operating and legal ties with its controlling  shareholder, government-controlled Samruk-Kazyna, are weak. Although indirect  government control is a positive credit factor, it does not justify a rating uplift, in our  view.

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to a negative rating action include:

– A protracted rise in gross leverage to above 2.5x total debt/EBITDA and 3x funds  from operations (FFO)-adjusted leverage (end-2013: 1.4x), and/or a material  increase in refinancing risks

Positive: Future developments that may, individually or collectively, lead to a positive rating action include:

– A sustained decrease in gross leverage to below 1.0x total debt/EBITDA and 1.5x  FFO-adjusted leverage and successful development of the mobile segment demonstrating strong operating and financial performance

FULL LIST OF RATING ACTIONS:

Long-Term IDR: affirmed at ‘BB’, Outlook revised to Positive from Stable

Short-Term IDR: affirmed at ‘B’

Local currency Long-Term IDR: affirmed at ‘BB’, Outlook revised to Positive from Stable

National Long-Term Rating: upgraded to ‘A+(kaz) from A(kaz)’, Outlook Positive

Senior unsecured debt in foreign and local currency: affirmed at ‘BB’

Senior unsecured debt in local currency: upgraded to ‘A+(kaz)’ from ‘A(kaz)’

Proposed KZT 90bn programme including the first KZT 21bn tranche: affirmed at ‘BB(EXP)’; upgraded to ‘A+(kaz)(EXP)’ from ‘A(kaz)(EXP)’

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