OREANDA-NEWS. Fitch Ratings has affirmed Sky plc's (Sky) Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB-'. The Outlook on the IDR is Stable.

Sky's ratings take into account its leading market position and consistent delivery of strong operating results in its core operations. In a competitive UK telecommunications market, the company has established a strong brand, market leading content and service quality and a competitive triple-play offer. Its German and Italian businesses offer diversification and solid growth potential, although Fitch expects operating cash flows to remain concentrated around its core UK and Ireland business in the medium term.

Near-term risks reflect the potential for ongoing content rights inflation, while TV audience fragmentation, over the top (OTT) content and shifting media ownership pose longer-term risks, at least in terms of the overall growth of the business. Leverage is high relative to downgrade sensitivities; exacerbated by sterling weakness in the run-up to the UK's EU referendum.

KEY RATING DRIVERS
Brand, Service Quality, Content
Sky has established a strong pay-TV business in the UK and Ireland built around premium content, in particular a leading share of sports programming and strengths in drama and the arts. In an increasingly competitive and shifting UK market, it retains strong brand leadership, driven by content, service quality and product innovation; qualities that it expects to help drive growth in its European businesses. Revenue and cash flow growth continue to be driven by the UK, where the overall pay-TV market is growing at around 4% a year (2015: 3.9% according to Ofcom data); Sky's 9M16 UK and Ireland revenues were up 6%.

Rights Inflation, Margin Pressure
Sky has proven effective in constructing content portfolios of the highest quality, generating strong mass-market demand for its pay-TV businesses. It is by far the largest pay-TV operator in each of its markets.

Programming costs and rights inflation, particularly in sports, remain the largest part of operating costs and the area where Fitch considers most operating risk exists. Its new English Premier League (EPL) contract will add roughly GBP630m to programming costs from FY17, while Bundesliga rights for the seasons starting 2018 are being re-auctioned this summer. Series A rights in Italy expire in 2018. Inflation in these markets may prove less dramatic. In Fitch's view, football rights will continue to inflate and football leagues look to the experience of the EPL when conducting auctions. Shifting media ownership may add further pressure. Sky continues to grow revenues and find cost savings but we expect these to lead to margin and leverage pressure in 2017.

OTT and Audience Fragmentation
Sky's business relies on its ability to continue to grow absolute subscribers and up-sell its base with additional products. It has been particularly successful in this regard in the UK and Ireland, where in addition to its leading TV position, it competes effectively in broadband and telephony, and is expected to launch a mobile offer in the UK by the end of 2016. These markets are both crowded and competitive. Sky continues to deliver strong results from both.

TV habits are nonetheless changing, with each of Sky's markets subject to a growing presence of OTT content providers such as Netflix, Amazon and others. While Fitch does not view OTT as fundamentally altering the appeal of the traditional pay-TV platforms, it does present a threat. Sky has its own OTT offer and has successfully grown OTT subscriptions and transactional revenues. Cord cutting has so far proven more a US phenomenon with more than a million pay-TV subscriptions disconnected in 2015. Over the longer term, OTT offers the consumer the ability to be more selective in their pay-TV choices, reducing the growth potential of linear TV, risking ARPU dilution and higher churn. Future TV audiences, at least at the margins, are less likely to subscribe to large all-inclusive content packages. Recent churn increases across all of Sky's businesses highlight the competition it faces, and may be a sign of these effects.

Shifting Media Landscape
TV and telecoms landscapes are becoming increasingly blurred across Europe. BT's entry to the content market in 2012, including its acquisition of a significant share of European sports rights, has been the most significant market entry. In Italy, Vivendi has announced its acquisition of Mediaset Premium, Sky's main competitor, a business that has roughly 2.1 million customers compared with Sky's 4.7 million, and is delivering strong subscriber growth. Vivendi is also incumbent Telecom Italia's leading shareholder. Both ownership changes could impact the relative position of the competing TV platforms. In Germany, Vodafone and Deutsche Telecom have a significant and growing pay-TV presence. With rights inflation a key area of risk for Sky's operating margins, these competing platforms would both be well placed financially to participate in the upcoming Bundesliga rights auctions, if they chose to.

Growth Diversification; Cash Flow Concentration
Germany and Italy both provide market diversification and growth potential; markets which are underdeveloped relative to the UK. Fitch believes Sky will successfully exploit these opportunities given its strengths in programming, rights management and market leading services. We estimate that pay-TV penetration, excluding basic cable, in Germany is in the high 20% region; and slightly higher in Italy - at the end of 2015. The German market is growing well. Fitch estimates overall market subscribers grew by around 9% in 2015 and around 4% in Italy. Sky is expected to benefit from this growth, although its retail base in Italy has remained flat at around 4.7 million for the past eight quarters.

Fitch expects that management emphasis will be on growing these businesses over the next two to three years, while rights inflation is likely in Germany from 2018, given the upcoming Bundesliga auction. Cash flows in the near to medium term are therefore likely to remain concentrated around its core UK and Ireland business.

Transponder Costs, Revised Rating Guidelines
Fitch has not traditionally included satellite transponder lease costs in Sky's lease adjusted debt calculations; but will now do so to apply greater consistency across our portfolio of direct-to-home TV ratings. In our current forecasts, transponder lease costs add up to 0.2x of incremental lease adjusted leverage and our upgrade/downgrade sensitivities have therefore been widened to take account of this more conservative approach. The downgrade guidelines have been revised to include funds from operations (FFO) lease adjusted net leverage of more than 3.2x; a threshold previously set at 3.0x. Upgrade guidelines include FFO net leverage below 2.7x; formerly set at 2.5x.

Leverage, FX Impacts
Despite the strength of cash flows from its core UK and Irish operations leverage remains somewhat high following the acquisition of the German and Italian businesses in 2014; a position exacerbated by sterling's current weakness in the run-up to the UK's EU referendum. This was reported to have added roughly GBP500m in FX related debt movements to Sky's net debt at March 2016; Fitch estimates equivalent to 0.20x to 0.25x in net debt / EBITDA leverage. Including FX hedges, Sky's long-term debt was weighted 70% in euros; 30% sterling at FY15, highlighting a currency mismatch with underlying cash flows. Given the proximity to the referendum, Fitch recognises the potential for this impact to dissipate if sterling strengthens after the UK referendum vote on EU membership.

Adjusting our forecasts for this effect our central rating case envisages FFO lease adjusted net leverage peaking at 3.3x in FY17, mainly reflecting the cash flow pressures of the new EPL contract in that year; with the metric reducing gradually thereafter and settling at around 2.7x-2.8x by FY19. With a downgrade guideline of 3.2x, ratings headroom is expected to be limited through 2018. Management's stated intention to reduce leverage over the medium term is an important rating factor given the current high levels of leverage.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Sky include:
- Low single digit group revenue growth between 3-4%.
- Adjusted EBITDA margin falling to around 16-17% in FY17 due to the step up in rights costs for the EPL.
- Moderate margin expansion thereafter due to cost savings and the realisation of economies of scale in Germany and Italy.
- Group capex to remain at around 7% of sales.
- Single- digit dividend growth through FY18.

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively lead to negative rating action include:
-FFO net leverage that was expected to remain consistently above 3.2x (including transponder costs).
- Expectations that free cash flow margin were likely to be consistently below 4%.
- Material deterioration in Sky's operating environment and key performance indicators; including the impact of content rights inflation, material weakening in reported churn, average revenue per user or evidence that OTT is becoming a more significant threat to its traditional pay-TV business.

Near-term variables including the outcome of the UK's EU referendum, given the likely impact on FX related debt, as well as the upcoming Bundesliga auction will be monitored closely.

Positive: Future developments that may, individually or collectively lead to positive rating action include:
-FFO net leverage that was expected to remain consistently below 2.7x (including transponder costs).
- Free cash flow margin consistently in high single digits.
- Evidence of the ongoing resilience of the company's operating environment and core pay-TV business.

LIQUIDITY
Liquidity is sound. The company has access to a GBP1bn undrawn revolving credit facility and reported cash of GBP1.7bn at March 2016. Bond maturities are well spread out.