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Fitch Ratings Assign B+ to Silknet on Rating Watch Positive

Fitch Ratings has placed Georgian-based telecoms company JSC Silknet’s Long-Term Issuer Default Rating (IDR) of ‘B+’ on Rating Watch Positive following the company’s announced acquisition of Geocell, Georgia’s second-largest mobile operator.

The ratings are likely to be affirmed at the current level of ‘B+’, with the assignment of a Positive or Stable Outlook, depending on the terms of the transaction’s financing package. The Watch may be resolved once the transaction receives regulatory clearance, which we do not expect before March 2018, and there is more clarity on the financial structure post-deal.

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. Silknet’s small absolute size is a strategic weakness; it services fewer than 350,000 fixed lines and generated GEL63 million (about USD27 million) EBITDA in 2016.

Silknet has reached an agreement to acquire Geocell from Telia Company AB (A-/Stable) and Turkcell (BBB-/Negative). Silknet announced its intention to finance the acquisition, which values Geocell at USD153 million, through a combination of debt and equity. Silknet is planning to start offering convergent broadband, pay TV, mobile and fixed telephony services.

KEY RATING DRIVERS

Improving Operating Profile: The acquisition of the second-largest mobile operator in Georgia has a strong strategic rationale. Silknet would obtain flexibility to start offering bundled fixed and mobile services, addressing its current weakness versus its key domestic rival Magticom, which is fully four-play-enabled. Geocell has been able to sustainably maintain its market shares, and is likely to improve its competitive positions after significant network investments already consummated in 2015-2016 and expected in 2017-2018.

Substantial Merger Synergies: We believe the acquisition will allow Silknet to achieve significant operating and revenue synergies. The networks of the two merging operators are likely to be, to a large degree, complimentary. The extensive broadband network of Silknet would allow it to more efficiently carry rapidly growing data traffic generated in Geocell’s newly-built 4G network.

Execution Risks in Bundling Strategy: Silknet’s strategy of promoting bundling services after the acquisition entails significant execution risks, in our view. Aggressive marketing moves, including through offering significant discounts on bundled services, are likely to trigger competitive moves. Nevertheless, Silknet would be better-positioned versus smaller competitors without bundled services.

Lower churn, typically associated with bundled offers, may allow Silknet to achieve substantial subscriber acquisition and retention savings. However, an active bundling strategy may also lead to an aggressive price competition with other fixed-mobile converged market participants.

Higher FX Risk Possible: The transaction’s financing may significantly increase the share of FX debt in Silknet’s total, which would be a risk. Fitch typically reflects higher FX risk in tighter downgrade leverage triggers.

Leverage Increase Moderate: We do not expect funds from operations (FFO) adjusted net leverage to exceed 3x assuming tangible equity contribution. This means net leverage may become consistent with a higher rating level within the 18 to 24 months.

DERIVATION SUMMARY

Silknet benefits from its established customer franchise and the wide network of a telecoms incumbent, similar to its higher-rated emerging markets peers such as Kazakhtelecom JSC (BB+/Stable) and PJSC Tattelecom (BB/Stable). However, Silknet is smaller in size with revenue of less than EUR100 million. Its corporate governance is shaped by dominant shareholder influence.

KEY ASSUMPTIONS

Fitch’s key assumptions within the rating case for Silknet include:

– Continuing voice revenue reduction, at 10% per annum on average;

– Broadband revenue growth in mid-single digits;

– Double-digit growth in pay-TV revenue in 2017 and 2018;

– GEL3 million of indefeasible rights of use proceeds are treated as recurring and included into FFO, with the rest treated as one-offs;

– Tangible equity injection for Geocell acquisition

RATING SENSITIVITIES

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

-Improved market positions, stronger FCF generation post Geocell acquisition, alongside comfortable liquidity and a track record of improved corporate governance, and

-FFO adjusted net leverage sustainably below 2.5x in the presence of significant FX risks.

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

-FFO-adjusted net leverage rising above 3x on a sustained basis without a clear path for deleveraging in the presence of significant FX risks, and

-A rise in corporate governance risks due to, among other things, related-party transactions or up-streaming excessive distributions to shareholders.

LIQUIDITY

Silknet’s liquidity may be stretched by the Geocell acquisition. The company heavily relies on TBC Bank (BB-/Stable), its largest creditor and key relationship bank, for refinancing.