The FINANCIAL — Fitch Ratings has affirmed JSC Silknet’s Long-Term Issuer Default Rating (IDR) at ‘B+’ with a Stable Outlook.
Silknet is the incumbent fixed-line telecoms operator in Georgia with an extensive backbone and last-mile infrastructure across the country. The company holds sustainably strong market positions of above 40% in both fixed-voice and broadband services, and is the largest provider of pay-TV services by revenue. Its lack of significant mobile operations is a strategic weakness, as is its small absolute scale – Silknet services fewer than 350,000 fixed lines and it generated GEL63 million (about USD27 million) EBITDA in 2016.
KEY RATING DRIVERS
Fibre Strategy: Silknet’s fibre strategy improves the company’s growth outlook and strengthens its competitive position. However, it also entails execution risks and may lead to a slight increase in leverage. Silknet is undertaking a wide-scale upgrade of its last-mile infrastructure, aiming to rapidly mass-migrate its ADSL customers to fibre. To a degree, this is a defensive strategy, protecting the existing franchise from competition, which is primarily fibre in large cities.
Management’s plans to increase broadband ARPU and grow revenue from pay-TV services from wider fibre coverage may be challenged by the relatively low disposable income in Georgia (GDP per capita was estimated at USD3,615 in 2016, equal to 37% of the emerging Europe median). ADSL customers typically benefit from lower tariffs, and may be reluctant to pay extra for higher quality and additional services, particularly outside large cities.
Modest Growth Outlook: “We expect revenue growth to remain in the low-to-mid single digit positive territory, supported by subscriber additions in pay-TV and to a lesser degree, broadband. Voice revenue declines will likely continue unabated, diluting the headline growth. Broadband is the largest segment by far (bringing in close to 50% of Silknet revenues) and we forecast it will see mid-single digit expansion. Revenue growth across the Georgian internet market slowed to 4% yoy in 1H17, from 6% yoy in 2016, and a much higher 16% yoy in 2015 (estimates of the national regulator, GNCC),” Fitch Ratings reported.
Strategy May Face Challenges: Urban broadband penetration has reached 70% by household, limiting further growth in the most commercially attractive areas. Management’s strategy of growing revenue on the back of higher ARPU from fibre customers may be challenged by competition. Silknet’s residential internet ARPU has reached parity with the market, suggesting that the company no longer has a relative price advantage.
Threat From Bundled Competition: Silknet is facing the threat of bundled competition, which it would not be able to directly match. Magticom, Silknet’s largest rival, keeps on consolidating smaller broadband operators and is capable of bundling broadband, pay-TV and mobile services. Bundled offers have not been actively promoted so far, but significant changes in the market shares of either operator risk their wider use.
Improving Profitability: “We expect Silknet’s profitability to continue steadily improving, as a result of the management’s focus on cost cutting, but also the growing contribution from high margin Pay-TV and premium fibre services. The company is unlikely to replicate the step-change in profitability reported in 2016, with EBITDA margin jumping to 39% compared with 32% in 2015. To a large degree, the 2016 improvement was a result of a change in the accounting treatment of installation and other support services, which were spun off into a separate subsidiary, with a significant portion of expenses capitalised,” Fitch Ratings said.
Mobile Lack a Strategic Disadvantage
“Silknet does not have any significant mobile operations, which we view as a strategic disadvantage. The Georgian mobile market is mature, making an organic entry into the market a less feasible option. The company therefore may explore options to team up or merge with one of the existing mobile operators. Fitch would treat acquisition of an existing mobile operator as event risk.
Stable Leverage: A spike in infrastructure investment but also continuing regular dividends, expected by Fitch at above GEL10 million per year, on par with 2016 distributions, will likely push FCF into break-even-to-slightly-negative territory in 2017-2018. We expect that this weakness will be largely compensated by moderately growing EBITDA, leading to stable FFO adjusted net leverage of 2.0x over the period.
Dominant Shareholder Influence: The company’s 100% shareholder Silk Road Group can exercise significant influence on the company and has access to its cash flows, as demonstrated by bypassing formal restrictions on dividends – Silknet guaranteed GEL35 million of its shareholder’s loan in 2016. We treat this guarantee as off-balance sheet debt, and include it in all leverage calculations. Silknet’s governance situation is commensurate with its ‘B’-range rating category. Silk Road Group does not publicly disclose its financial results,” Fitch Ratings reported.
DERIVATION SUMMARY
Silknet benefits from its established customer franchise and wide network of a telecoms incumbent, similar to its higher rated emerging markets peers such as Kazakhtelecom (BB+/Stable) and Tattelecom (BB/Stable). However, Silknet is smaller in size with revenue of less than EUR100 million. Unlike its higher rated peers, the company lacks any mobile operations and faces a strong four-play-enabled competitor. Its corporate governance situation is commensurate with a rating in the ‘B’ category.
KEY ASSUMPTIONS
Fitch’s key assumptions within the rating case for Silknet include:
– continuing voice revenue contraction, at 10% per year on average;
– broadband revenue growth in the mid-single digit range;
– double-digit Pay-TV revenue growth in 2017 and 2018;
– GEL3 million of IRU proceeds are treated as recurring and included into FFO, with the rest treated as one-offs;
– EBITDA margin modestly improving from the 2016 level;
– high capex of above 25% of revenues in both 2017 and 2018 moderating to below 20% of revenues by 2020;
– regular dividends moderately growing from 2016 level in both 2017 and 2018
RATING SENSITIVITIES
Positive: developments that may, individually or collectively, lead to positive rating action include:
– stronger FCF generation on a sustained basis, alongside stable operating performance, comfortable liquidity and a track record of improved corporate governance.
Negative: developments that may, individually or collectively, lead to negative rating action include:
– leverage rising to and sustainably above 3x FFO-adjusted net leverage without a clear path for deleveraging; and
– a rise in corporate governance risks due to, among other things, related-party transactions or up-streaming excessive distributions to shareholders.
LIQUIDITY
As of end-2016 Silknet did not have sufficient liquidity to repay its amortising debt of approximately GEL25 million in 2017. However, the company extended the maturity of its long-term bank debt to 2024 from 2021 reducing its annual refinancing exposure. The same positive impact is likely to be achieved from the GEL34 million bond due in 2022 issued in August 2017, assuming that most proceeds are applied to refinancing the existing bank debt. Silknet relies heavily on TBC (BB-/Stable), its largest creditor and key relationship bank, for refinancing. High refinancing risk is mitigated by Silknet’s moderate leverage.
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