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Rating Action:

Moody's affirms Telefonica's rating at Baa2 following announcement of E-Plus transaction; outlook negative

25 Jul 2013

Madrid, July 25, 2013 -- Moody's Investors Service has today affirmed the short- and long-term debt ratings of Telefonica S.A. (Telefonica) at Prime-2 and Baa2, respectively. Concurrently, Moody's has also affirmed the ratings of all Telefonica's guaranteed subsidiaries, including the company's Ba1 subordinated preferred stock ratings. The outlook on the ratings remains negative.

RATINGS RATIONALE

The ratings affirmation follows the recent announcement of an agreed deal for the sale of E-Plus, the German subsidiary of Koninklijke KPN N.V. (Baa2 negative), to Telefonica for a total consideration of EUR8.1 billion. Telefonica proposes to acquire E-Plus through its German subsidiary Telefonica Deutschland Holding AG. KPN will receive around EUR5.0 billion in cash and a 17.6% equity stake, worth about EUR3.1 billion, in the newly formed combined entity resulting from the merger of E-Plus and Telefonica Deutschland Holding AG. As a result of the deal's structure, Telefonica's stake in the new enlarged entity will be 65%, which represents a reduction on its 76.8% stake in the German subsidiary.

The transaction is subject to obtaining all regulatory and shareholder approvals and is not expected to close before the end of Q2 2014. Moody's expects the deal to be subject to a high degree of scrutiny by regulators, since previous precedents of mobile market consolidation in Europe have required substantial remedies to be approved.

The deal is structured in such a way that it avoids a meaningful deterioration in Telefonica's credit metrics. In fact, Moody's expects the transaction itself to have a neutral effect on the company's credit metrics in 2014. The EUR5.0 billion cash payment to KPN will be funded by a combination of (1) EUR900 million in cash from Telefonica Deutschland Holding AG's minority shareholders via a rights issue; (2) 50% to 60% through a hybrid instrument with a substantial equity component; (3) 20% to 30% through a mandatory convertible; and (4) the remaining amount will be financed with debt. As a result, Telefonica's financial ratios will be only marginally affected after globally consolidating E-Plus.

The proposed transaction is business-enhancing for Telefonica because (1) it increases the scale of Telefonica Deutschland Holding AG's operation, with the combined entity achieving a number one position in the German telecommunications market as a result of the acquisition, with a c. 37% subscriber market share, which enhances its competitive position; and (2) it provides substantial synergies, which management has estimated to be between EUR5 billion and EUR5.5 billion.

Telefonica's Baa2 rating primarily reflects (1) the group's large size and scale; (2) the diversification benefits associated with its strong positions in many different markets; (3) management's track record and ability to execute a well-defined and concise business strategy; and (4) its operating cash flow generation and management's stated commitment to maintain its reported net debt/EBITDA ratio below 2.35x.

Moody's notes that although Telefonica has taken decisive measures to mitigate the effects of the difficult operating environment in Spain, continued pressure on the group's revenues and EBITDA will continue to challenge its ability to improve its credit metrics. In this respect, Moody's now expects revenue declines with some margin compression at the group level for full year 2013. The rating agency does not expect the likely double-digit decline in Telefonica's domestic revenues in percentage terms to be completely offset by growth in its international subsidiaries, which will be affected by currency depreciation in Brazil and devaluations in Venezuela. Moody's also expects that management could only just fall short of its leverage target of reported net debt/EBITDA of 2.35x in 2013. Whilst the rating agency forecasts that Telefonica's ratios will be within the stated guidance for the current rating, including adjusted net debt/EBITDA comfortably below 3.0x and retained cash flow (RCF)/adjusted debt above 18%, operating, regulatory and competitive challenges remain.

Telefonica's Baa2 rating continues to reflect the following factors: (1) management's ability to continue to execute a strategy that offsets Spain's challenging macroeconomic environment and contraction in consumer spending, which will continue to affect Telefonica's domestic revenues; (2) the group will deliver the financial policy (including cash preservation measures and a non-core assets disposal programme) that management has publicly committed to, which supports its deleveraging and financial strengthening strategy; and (3) Telefonica will maintain its access to the debt capital markets and as such retain adequate liquidity, supported by recent bond issuances and asset sales that have enabled the group to strengthen its liquidity. Telefonica does not have the undisputed domestic strength or the geographic diversity to isolate itself completely from the current and future credit environment implied by the sovereign rating (Baa3 negative).

RATIONALE FOR NEGATIVE OUTLOOK

Moody's decision to maintain a negative outlook on the ratings reflects its expectation that the group will continue to operate in a challenging domestic market (Spain). Despite the fact that Telefonica's international diversification enhances its credit profile, the group's exposure to the Spanish market puts it at risk given the weak macroeconomic conditions in Spain, exacerbated by the contraction in consumer spending resulting from austerity measures.

WHAT COULD CHANGE THE RATING UP/DOWN

A rating downgrade could result if (1) Telefonica deviates from its financial-strengthening plan, as a result of weaker cash flow generation or the incurrence or assumption of further substantial debt in conjunction with the pursuit of acquisitions or more aggressive shareholder distribution policies; and/or (2) the group's operating performance in Spain and other key markets continues to deteriorate and there is no likelihood of an improvement in underlying trends in the short term. Resulting metrics would include deviation from management target metrics or an RCF/net adjusted debt ratio of less than 18% or a net adjusted debt/EBITDA ratio trending towards 3.0x. In addition, a rating downgrade could result if Moody's were to downgrade the sovereign rating.

Conversely, although not currently expected in light of the negative outlook, the weak macroeconomic conditions in Spain and constraints related to the sovereign rating, Moody's could consider a rating upgrade to Baa1 if Telefonica's credit metrics were to strengthen significantly as a result of improvements in its operational cash flows and a further reduction in debt. Provided sovereign-related concerns were to abate, the rating could benefit from positive pressure if it became clear that the group would achieve sustainable improvements in its debt ratios, such as an adjusted RCF/net debt ratio above the mid-twenties in percentage terms and adjusted net debt/EBITDA comfortably below 2.5x.

PRINCIPAL METHODOLOGY

The principal methodology used in these ratings was the Global Telecommunications Industry published in December 2010. Please see the Credit Policy page on www.moodys.com for a copy of these methodologies.

Telefonica S.A. is the leading integrated telecommunications provider in Spain, delivering a full range of services and products including telephony, data exchange, interactive content and information and communications technology solutions. Telefonica is also one of the world's leading telecommunications carriers, with some 264.3 million customers worldwide (excluding Spain).

As of March 2013, approximately 75% of group revenues (total reported last twelve months revenues amounted to EUR 61.0 billion) and 77% of group EBITDA (total reported last twelve months EBITDA amounted to EUR 20.3 billion) were generated outside Spain.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the rating action on the support provider and in relation to each particular rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this rating action, and whose ratings may change as a result of this rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Carlos Winzer
Senior Vice President
Corporate Finance Group
Moody's Investors Service Espana, S.A.
Calle Principe de Vergara, 131, 6 Planta
Madrid 28002
Spain
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Paloma San Valentin
MD - Corporate Finance
Corporate Finance Group
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Releasing Office:
Moody's Investors Service Espana, S.A.
Calle Principe de Vergara, 131, 6 Planta
Madrid 28002
Spain
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Moody's affirms Telefonica's rating at Baa2 following announcement of E-Plus transaction; outlook negative
No Related Data.
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