Europe: a borrower be

During the big network build-outs of the 1990s, operators borrowed billions to fund network expansion and M & A--billions that some did not pay back. Ebone, KPN-Qwest and Viatel are high-profile examples of alternative operators that filed for administration--but they were not alone in taking a bullish stance. All of the major European incumbents plunged just as gaily into the red. Deutsche Telekom, for example, had net debt of [euro]71 bn at the end of June 2001, against revenues of [euro]22.4bn in the first half of that year. It could be argued that a partially state-owned incumbent with a firm grip on telecom provision in a major European country has little to worry about. It won't be allowed to go bust. However, over the full year 2001, DT had net interest payments of [euro]4.3 bn--no small sum. Further, this was a number that DT could net necessarily control. Many bonds contain clauses that trigger increases in interest payments if the issuer debt rating slips. Companies tend not to advertise the details of their financing arrangements, so it is not clear what a ratings downgrade costs DT, or its incumbent peers.

"When it comes to DT an upgrade to A-from BBB+ by S & P should not have an initial large impact on actual coupon payments made by DT as DT's bonds with coupon step-up language requires either the company to be upgraded both to A- by S & P and to A3 by Moody's, or to BBB+ by S & P and Baa1 by Moody's. In other words, as long as the company stays Baa2 rated by Moody's the coupons on the bonds should stay the same. But obviously, over time one would think that DT's refinancing costs should decrease with higher ratings (although again the market tends to focus more on the lower of two ratings)," says Louis Landeman, a high yield analyst at SEB Merchant Banking in Stock-holm. However, though DT now has net debt of around [euro]46.3 bn, much of its debt--[euro]51.6 bn--is still in bonds and debentures. This number in 2001 was [euro]58.3 bn, which would suggest that gaining a strong credit rating is a matter of no small importance to DT. Like its fellow incumbents, it is working its way back to the sunny uplands of an 'A' debt rating. (Moody's currently rates DT Baa2/P-2.)

The main reasons for the recent improvement that the incumbents have seen--they are all now safely back in BBB territory--is that the new management at these companies "adopted conservative financial policies and strategy", says Guy Deslondes, head of European telecom research at S & P. This, in turn, meant that they focused on improving their operating performance, increasing free operating cash flow and cutting debt.

The European incumbents are expected to continue to toe the line of financial prudence in 2004. Dividends to shareholders and share buy-backs will "be contained within 'excess' cash flow generation", says Deslondes. This 'excess' cash flow being what is left after planned capex, including that required for market acceleration in broadband or 3G. Deslondes considers that capex will continue to be conservative for the European incumbents, viewing 3G as unlikely to have a massive launch prior to 2005 "at best", and ADSL--though "clearly a hot spot in the market"--as a niche that the incumbents largely control. The ADSL market share for most European incumbents is 50-75 per cent, Deslondes points out. Other threats to the incumbents, such as VoIP and competition from cable, are not considered by S & P to have short-term implications. Deslondes says that VoIP impact, for example, is "mitigated by broadband access subscriptions". He gives the example of BT as an incumbent that has embraced VoIP because of the access charges it drives.

A focus on good debt ratings will not make the incumbents shun the capital markets, however. "We continue to expect the largest telecom operators to be active in the capital markets--most notably in the debt markets--to refinance debt maturities, secure long-term funding and retain adequate financial flexibility over the next few years. However, the situation varies significantly on a case by case basis, says Deslondes."

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