Fitch Ratings has downgraded all of Telefonica del Peru's S.A.A.'s (TdP) ratings, to 'BB+' from 'BBB-'.

The rating action applies to the Long Term (LT) Foreign Currency (FC) Issuer Default Rating (IDR), the LT Local Currency (LC) IDR, and the PEN1.7 billion notes due 2027. The Outlook on the IDRs remains Negative.

The downgrade of TdP's ratings reflect a deterioration in the company's financial profile, resulting from an intense competitive environment and cost inflation pressures. While TdP benefits from its scale as the largest operator in Peru as well as its diversified product portfolio, the company's cash flow has weakened to a level more in line with non-investment-grade issuers.

Improvement in the company's cash flow is dependent on successful cost reduction efforts, as revenue is not expected to recover to pre-pandemic levels in the near term. Increasing profitability along with an improvement in subscriber trends and clarity regarding tax liabilities could result in a stabilization of the ratings.

Key Rating Drivers

Tax Liability Uncertainty: As of Dec. 31, 2021, the total tax liability on the company's balance sheet was PEN2.8 billion. Pre-pandemic, Fitch expected additional clarity from the Peruvian tax authority on the timing and size of the payments; however, this was largely put on pause as a result of the pandemic. At present, the timing and structure of the liability remain unclear and could have negative implications for the rating. Other Peruvian companies facing tax liabilities have reached negotiations that resulted in large cash outlfows with relatively short instalment periods. Any near-term, material payments would drastically pressure the company's financial profile.

Weak Profitability, Negative FCF Trends: Fitch expects FCF to gradually improve over the rating horizon, but will remain negative and continue to weigh on the company's financial profile. Despite experiencing a partial recovery in mobile revenues off of pandemic lows, EBITDA margins continued to deteriorate in 2021 as cost inflation pressures have mounted. The company experienced flat yoy growth in revenues in its fixed segment in 2021, driven by slow rollout of its fiber network and intense competition.

Fitch expects an acceleration of fiber rollout and low single digit ARPU growth to offset declining demand for fixed voice, generating revenue growth in the low single digits for the fixed business over the rating horizon. A more stable mobile competitive environment, growing demand for broadband, and cost containment efforts should result in modest EBITDA margin expansion over the rating horizon, albeit below historic levels and below that of investment-grade peers.

Leverage Expected to Remain Elevated: EBITDA compression resulted in net debt/EBITDA of 3.1x in 2021. Fitch forecasts capital intensity of roughly 10% while margins will likely only improve marginally as competition spurs network investments, limiting FCF improvement. As a result, Fitch expects the company's net leverage to remain near 3.0x in the medium term as gradually improving EBITDA is offset by capex needs.

Positively, proceeds from asset sales could mitigate the need for debt financing in the near term. Fitch forecasts net and gross leverage of around 3.0x and 3.2x, respectively, commensurate with a 'BB+' rating. A steadily improving Peruvian economy should help drive better operating performance, which will be offset by the high level of competition in mobile and fixed.

Strong Market Shares and Diversification: TdP's business profile, particularly in terms of market share and diversification, remains solid. TdP is well-diversified between fixed and mobile service offerings despite market share losses in recent years due to intense competition, most notably on the mobile side as Entel and Bitel (Viettel Group) continue to attract customers.

Fitch estimates TdP has a mobile subscriber share of approximately 30% and a fixed-line subscriber share of over 60%. The company plans to focus on expanding and improving its fixed services over the medium term, mainly through the acceleration of fiber deployment. Fitch expects marginal improvement in ARPUs on price increases as consumer spending improves and the product portfolio shifts to higher value services.

Uncertain Prospects for Strategy: TDP has so far been largely unable to execute its growth strategy to offer quad-play services through its Movistar Total offering and the company has fallen behind competitors in postpaid mobile. Expanding 4G coverage and fiber deployment have failed to translate into sufficient revenue growth to offset cost pressures. In particular, stubbornly low broadband penetration in Peru and high competition have impacted the company's ability to profit from increased demand for data packages.

Linkages with Telefonica S.A.: Fitch rates TdP on a standalone basis, and does not factor in any expectation of support from parent Telefonica SA (TEF, BBB/Stable). TEF has indicated its intention to divest its Hispano-American operations, including TdP, Telefonica Moviles Chile SA (BBB+/Stable), and Colombia Telecomunicaciones SA ESP (BBB-/Stable), and nonrated entities in Mexico, Argentina and elsewhere. Fitch rates TDP on a standalone basis, given the stronger financial profile of parent Telefonica SA relative to TdP, while legal, strategic, and operational incentives for support from the parent are deemed low.

Derivation Summary

In comparison to other regional peers in the 'BBB' rating category, TDP's business position is toward the lower end of the category given its still-leading, but weakening market positions in the highly competitive Peruvian telecom industry. The company's financial profile has deteriorated since 2016 due to intense competition. This has caused a decline in operating margins and cash flow generation, which are more in line with 'BB' category issuers. Total debt/EBITDA at the company, above 3.5x, is at the upper end of investment grade.

TdP's business position is roughly in line with sister company Telefonica Chile (BBB+/Stable) in terms of service diversification and market position, although TCH is stronger financially, supported by lower leverage and consistently positive FCF. TdP's business profile is comparable to Colombian peers UNE EPM Telecomunicaciones S.A. (Tigo UNE) (BBB-/Stable) and Colombia Telecomunicaciones S.A. E.S.P. (BBB-/Stable) with respect to market shares in fixed and mobile, although Tigo UNE and ColTel have higher margins and lower leverage metrics that are more in line with investment-grade issuers.

TdP is rated one notch below competitor Empresa Nacional de Telecomunicaciones S.A. (Entel) (BBB/Stable), which was recently upgraded by Fitch as Entel has been able to capitalize on its improved scale in Peru and sustained its strong operational performance in Chile. Although TdP's large fixed-line presence supports its business position in Peru, Entel has a superior financial profile due to the continued strength in its Chilean operations and improving profitability metrics in Peru.

Key Assumptions

Fitch's Key Assumptions Within the Rating Case for the Issuer:

Mobile revenues growing from PEN3.5 billion to PEN3.9 billion over the rating horizon;

Low single-digit growth in mobile subscribers, with modest ARPU growth and handset sales resuming their pre-pandemic trend as consumer spending improves;

Fixed revenues growing from PEN3.6 billion to PEN3.8 billion over the rating horizon;

Continued double digit declines in fixed-line voice subscribers, partially offset by broadband and pay-tv subscribers growing in the low single digits, with fixed ARPUs growing in the low single digit percentage range;

EBITDA margins gradually improving to around 13.5% with an improved pricing environment offset by mix-shift and cost inflation;

Capital intensity in the low double-digits percentage range;

Fitch does not factor in a payment of the tax liability in the base case, due to uncertainties.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Stabilization of the ratings is dependent on attaining greater clarity on manageability of tax liability payments and the company achieving stability in market position and margin expansion materially above forecasts.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Continued deterioration of margins and competitive position regardless of credit metrics;

Total debt/EBITDA sustained above 3.5x or net debt/EBITDA above 3.0x;

Materialization of large debt-funded tax liability payments could result in a multiple notch downgrade.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Adequate Liquidity Supports Flexibility: As of Dec. 31, 2021, the company had PEN299 million in short-term debt, and readily available cash of PEN610 million. TdP benefits from its manageable amortization schedule, with PEN2.1 billion of its PEN2.7 billion long-term debt, maturing beyond 2025. However, projected negative FCF implies that the company with continue to depend on asset sales to fund scheduled amortizations in 2022-2024 of around PEN250 million, in the absence of debt. The company's debt consists primarily of long-term bonds (PEN3.0 billion). TDP has a PEN1.7 billion note due 2027. The company's debt is completely payable in PEN, limiting FX risk for the company.

Issuer Profile

Telefonica del Peru S.A.A. (TDP) is the largest integrated telecom operator in Peru in terms of revenue share. The company provides mobile and fixed-line telephony, broadband and Pay-TV though its Movistar brand, as well as IT solution services for corporate clients. TDP has leading market positions in the highly competitive Peruvian mobile and fixed markets, with subscriber market shares in each segment accounting for around 30% and 65%, respectively, of the total industry. However, the company's 30% mobile market share is a decline from 52% in 2015, caused by intense competition within Peru.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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