Fitch Affirms Cogeco's IDR at 'BB+'; Outlook Stable
KEY RATING DRIVERS
Diversity, Growth Offset Support Stable Core
Cogeco has diversified away from the increasingly competitive cable market in Canada through acquisitions, including cable assets in the U. S. The Canadian cable segment generates approximately 65% of EBITDA compared to roughly 90% four years ago. Total revenue for the first nine months of fiscal 2016 grew 7%, driven primarily by growth in the U. S. cable segment, including the Connecticut property acquisition, along with foreign exchange gains.
Fitch believes Cogeco's good business profile is supported primarily by the profitable Canadian cable operations, with a competitive position anchored by its high-speed Internet and triple-play offering. In addition, Cogeco's cable systems are clustered in less concentrated and less competitive suburban regions, resulting in stable revenues.
Rate Increases, TiVo
Cogeco expects to mitigate revenue pressure from competition in the Canadian cable business through leveraging its leading broadband position, increasing rates on certain products, improving its TiVo penetration and growing its market share in its 150,000 businesses footprint. Cogeco's marketing efforts also benefit from more than 90% of its territories offering 120Mbps service, and we expect the company will continue to increase broadband speeds over time in selective, more competitive markets. In the U. S., the TiVo platform has improved its competitive position and helped increase broadband service take-up rates in underpenetrated markets.
Competition will continue to increase, mainly with fiber-to-the-home overbuilds in a growing portion of Cogeco's Canadian cable regions as competitors cover approximately 45% of homes with an IPTV offering. However, the measured pace of IPTV deployment has given Cogeco time to enhance its competitive position through the TiVo platform which has been effective in stabilizing video losses as Bell expands its IPTV footprint. Cogeco views over-the-top services as complementary and has integrated Netflix into its TiVo platform. Competition in American Broadband's (ABB) footprint is more fragmented and less formidable with generally lower Internet speeds. Satellite is the primary competition in about 70% of ABB's footprint.
Canadian cable margins should remain relatively stable as price increases, continued mix shift to broadband and strong cost controls offset higher programming costs. In fact, margins increased by 80bps in the Canadian cable operations to almost 52% during the first three quarters of fiscal 2016. Overall consolidated margins were relatively flat at 45% during the period with modest margin pressure at ABB and Business ICT Services. Fitch also believes Cogeco has sufficient capability to manage recent regulatory mandates without a material negative impact on EBITDA.
Weakness in Business ICT Services
In the third quarter of fiscal 2016 (3Q16), Cogeco incurred a CAD450 million non-cash impairment charge related to goodwill and intangible assets at Cogeco Peer 1 in the business ICT services segment. Sales in the unit have not met expectations, particularly managed hosting services revenues, which represent roughly half of its revenues. Expectations are for margins to remain relatively stable in the low 30% range for fiscal 2017, supported by cost reduction and the pruning of unprofitable services. Consequently, when combined with capital spending reductions, the business ICT services segment should generate free cash flow.
Stable Credit Metrics
Cogeco's credit metrics have improved following past acquisitions as total consolidated leverage (total debt/operating EBITDA) was 3.1x at the end of 3Q16. This compares to 3.5x at the end of fiscal 2015. Absent material acquisitions, leverage should continue to decline to the upper-to-mid-2x range.
In 4Q15, ABB completed the acquisition of MetroCast Communications, LLC's cable systems in Connecticut for USD200 million. Over the long term, Fitch expects the U. S. operations could begin to approach the size of the Canadian cable operations. Fitch expects any M&A would be done within the context of maintaining its current 'BB+' IDR rating.
Fitch's key assumptions within our rating case for the issuer include:
--Consolidated revenue growth in the low 2% range;
--Consolidated leverage declining to the upper-to-mid-2x range absent any material acquisitions;
--Dividend increases over the forecast period in in the low double-digits;
--Relatively stable profitability with consolidated EBITDA margins of approximately 45% range;
--FCF (Fitch defined as cash from operations less capital spending less dividends) of approximately CAD275 million.
Future developments that may, individually or collectively, lead to a positive rating action include:
--A change in financial policy and long-term commitment to maintain consolidated leverage at mid-2x range or below;
--Stable and/or growing operating trends across its primary business segments;
--Increased operational diversification;
--Pre-dividend FCF-to-sales of greater than 10%.
Future developments that may, individually or collectively, lead to a negative rating include:
--A large transaction that increases consolidated leverage in excess of mid-3x range for an extended period of time;
--Greater than expected competition, substitution or cord-cutting/cord-shaving in Cogeco Communications territories that adversely affects operating trends and cash flow growth;
--A change in financial policy resulting in higher leverage due to increased dividends or aggressive share repurchases;
--Reduced consolidated FCF prospects as a result of competitive factors.
Cogeco's main sources of liquidity are its credit facilities, cash position and FCF. As of May 31, 2016, Cogeco had approximately CAD522 million available under its term revolving facility of CAD800 million that matures in January 2021 (extended one year in December 2015). In addition, two subsidiaries of Cogeco benefit from a revolving facility of USD150 million of which USD95 million was borrowed. Consolidated cash was CAD55 million.
Fitch expects Cogeco's FCF (defined as cash from operations less capital spending less dividends) for fiscal 2015 to be approximately CAD200 million. For fiscal 2017, Fitch expects Cogeco will generate approximately CAD275 million of FCF driven primarily by a reduction in capital spending and to a lesser extent, growth in EBITDA. In the Business ICT segment, Cogeco Peer 1 will have completed strategic investments in its Canadian data center facilities and shifted its focus to capex optimization. Cogeco will use excess liquidity generated by FCF to pay down bank credit facility borrowings. Debt maturities over the next several years are manageable with no maturities until fiscal 2018, when CAD100 million matures.
Fitch believes Cogeco's U. S. cable subsidiary should generate more than sufficient cash flows to self-fund its operations. This is supported by a substantial tax shield related to net operating losses, a competitive environment with limited triple-play competition and the expected growth from increasing its position in underpenetrated services. ABB's slight increase in capital intensity is mainly related to strategic investments in higher growth segments such as business services.
Cogeco's objective is to generate shareholder returns through capital appreciation and dividend growth. Historically, Cogeco has not generally engaged in share repurchase activity. Expectations are that Cogeco will maintain a dividend policy consistent with its current ratings. Fitch's forecast assumes Cogeco will increase dividends in a similar range as in fiscal 2016 over the next couple of years as a result of growth in excess cash flows. Thus, while Cogeco does not have a formal dividend policy, Fitch expects the company will target a dividend payout in the range of 25%-30% of FCF. Cogeco's current payout ratio is materially lower than its larger cable and telecom peers.
FULL LIST OF RATINGS
Fitch has affirmed the following ratings:
--IDR at 'BB+';
--Senior unsecured notes at 'BB+/RR4';
--Senior secured notes at 'BBB-/RR1'.
The Rating Outlook is Stable.