Fitch Ratings has kept its negative outlook on Sri Lanka’s telecommunications sector, based on uncertainty over proposal to increase taxes that are likely to lower profitability and increase leverage for telcos, if implemented. The original proposals were to impose a one-off "super gains" tax of 25% on profits, and a tax of LKR250m (USD1.8m) on each telco; they also shift the burden of a recurring telecom levy of 25% and 10% on prepaid voice and data revenue, respectively, onto telcos from consumers.
These tax proposals were originally introduced in February 2015, and the government withdrew only the recurring taxes in October 2015. The government may still re-introduce recurring taxes in part, or full, in 4Q15.
Taxes Would Squeeze Margins: We believe the operating EBITDAR margin of Sri Lanka Telecom PLC (SLT) and Dialog Axiata PLC (Dialog) will fall to 26% and 24%, respectively (year-to-date 2015: 31% and 33%), if the recurring tax were reintroduced.
Changing Revenue Mix: Barring the tax impact, SLT’s and Dialog’s operating EBITDAR margins (average of 33%; 2014: 30%) may still decline by around 100bp-200bp in 2016 as low-margin data services replace traditional, more profitable voice/text revenue. Furthermore, telcos’ profitable international call revenue is threatened by the increased use of Over-The-Top (OTT) applications, such as Facebook and WhatsApp.
Industry to Consolidate: We expect two smaller unprofitable telcos – Hutchison Lanka and Bharti Airtel Limited's (BBB-/Stable) Sri Lankan subsidiary, Airtel Lanka – to exit the industry amid competition and the uncertain tax regime. Their business model is unviable, given the small addressable population (20.5 million) and the presence of a regulatory tariff floor on voice services that limits their ability to boost their market share.
Strong Data Growth: We expect the industry’s 2016 revenue to increase by the mid-single-digit percentage, driven by data services, as cheaper smartphones proliferate. Data revenue contribution will rise to around 16%-18% (2015: 12%). Sri Lankan data tariffs – currently among the lowest in the world – could rise if the regulator introduces a tariff floor for data services. Data tariffs could also rise following consolidation and arrest the pace of telcos’ profitability decline and prevent capex duplication.
Moderate Ratings Headroom: Fitch expects the credit profiles of SLT and Dialog to remain stable, in light of their moderate ratings headroom, and despite a decline in profitability and continued large capex needs. We expect both SLT and Dialog to invest around 22%-25% of their revenue on capex. Both are exposed to the risk of Sri Lankan rupee depreciation, given that 95% (USD180m) and 81% (USD170m) of their respective debts are US dollar- denominated, while we estimate each generates only around 15% of revenue in dollars.
We may revise the outlook back to stable in the absence of recurring taxes that impair sector profitability.
Debt-Funded M&A: Large debt-funded M&A by SLT and Dialog or a reintroduction of recurring taxes could reduce ratings headroom for both companies. - Fitch
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