Global rating agency Fitch Ratings has affirmed Sky’s Long-term Issuer Default Rating (IDR) and senior unsecured ratings at ‘BBB-‘ following the announcement of the latest English Premier League (EPL) rights auction. The Rating Outlook on the IDR is Stable.
The rating affirmation takes into account the material programming cost inflation Sky faces from FY17, the first year of the newly agreed EPL contract, and the potential this has for weakened free cash flow generation from that year. At the same time, Fitch recognises management has time to achieve targeted cost savings and improve ARPU in its core UK business. The delivery of these broad ambitions will be important in ensuring downward ratings pressure does not materialise.
Among the key rating drivers considered by Fitch in affirming its rating:
Free Cash Flow Risk
In Fitch’s view, Sky faces the risk of weakened free cash flow beyond FY16, the last year of the existing EPL deal, given the scale of the new EPL deal combined with the increased uncertainty the latest auction creates over future sports rights inflation. The November 2014 acquisition of pay-TV businesses in Germany and Italy has improved business diversification, with the German business in particular in Fitch’s view offering the potential of strong revenue and EBITDA growth. The evolution of these factors as well as management’s ability to find cost savings in the core UK operations will be important between now and 2017 if ratings pressure is not to develop. Targeted efficiencies and growth of its European operations will be important factors if current cash flow strength is to be sustained beyond 2016.
EPL Cost Inflation
Sky has agreed to pay £1.392 billion per year for the right to broadcast a total of 126 matches each season. Fitch acknowledges that the schedule of games – including packages played at Saturday and Sunday lunchtimes and a new Friday night schedule is strong and will appeal to sports fans. The 83 per cent rights inflation however equates to GBP630m of additional content costs per annum – costs that will be assumed from FY17. Fitch recognises that there will be some revenue benefits from an enhanced portfolio of rights, and that management will be able to manage opex elsewhere in the cost base. Programming nonetheless represented 41 per cent of the operating cost base and increased by 7 per cent in FY14 (8.2 per cent increase in FY13). The new EPL contract is estimated to increase programming costs by 24 per cent relative to existing UK programming costs.
Auction Underlines Cost Concentration
The scale of cost inflation and the concentration of costs associated with one key area of content highlight how important English premiership football is to the company’s business model. Fitch estimates that programming costs as a percentage of operating expenses could rise to around 48 per cent for the core UK operations under the new EPL contract structure, in the absence of material changes to other programming rights and ignoring targeted cost savings.
Consumer appetite for pay-TV and the bundled telecom service approach taken by Sky in its core UK business differentiates the UK from many European TV markets. Sky has established a premium quality service and has proven consistently able to generate improving ARPU. Top-line growth in the UK has slowed however and in Fitch’s view ARPU unlikely to accelerate due to the improved EPL portfolio, albeit some upside is envisaged.
Rights Inflation Not Direct Pass-Through
Fitch has adjusted its operating assumptions in its forecasts to reflect the auction outcome. Fitch recognises that management should deliver some revenue upside from the enhanced portfolio of games. It should be able to pass on some of the increased EPL costs to consumers as well as potentially increase pricing to UK pubs and clubs, revenues which should attract an incrementally higher margin than if they were being generated by new customers. Management is reported to be targeting cost savings of £200 million per annum.
Free Cash Flow Risk and Leverage
Fitch’s previous (November 2014) base case envisaged FFO (Funds From Operations) net leverage falling below 3.0x by FY16 – a level considered important to support an investment grade rating. Since then the company has announced the disposal of Sky Bet – generating estimated debt relief of GBP800m – and the outcome of the EPL auction. Given the pressure on cash flow described, Fitch now expects leverage to fall to around 2.9x in 2016 before spiking above 3.0x in FY17. Management are committed to reducing leverage and protecting Sky’s investment grade ratings; they also have time to deliver targeted efficiencies and the potential for top-line growth.
It remains the case that ratings headroom has been reduced, with the EPL outcome signalling the risk of free cash flow erosion from 2017 and highlighting the heightened competitive market for key content rights. Future concerns over the sustainability of cash flow generation and an ability to maintain leverage below 3.0x are likely to put pressure on the ratings.
Among Fitch’s key assumptions:
FY15 to include the consolidation and margin dilution driven by the Sky Deutschland / Italia acquisitions – with pro forma EBITDA margin falling to around 16 per cent – 17 per cent.
Margins from the acquired businesses to expand gradually given targeted cost synergies and top-line growth in Germany.
FY15 net debt to benefit from the effective GBP800m disposal of Sky Bet, along with associated loss of revenues and earnings.
Full impact of the new EPL contract from FY17. Opex synergies of £100 million compared with management’s target of £200 million per year.
FFO net adjusted leverage forecast at around 3.3x in FY17 and free cash flow margin to fall to low single digits in that year. Leverage to fall to around 3.0x in FY18.
Rating sensitivities observed by Fitch:
FFO net leverage sustainably above 3.0x would be likely to lead to a downgrade from ‘BBB-.’ Fitch’s rating case, envisages the metric falling to around 2.9x in 2016 but increasing again to above 3.0x in 2017 given the impact of the new rights contract.
Operationally, adverse changes to industry dynamics including price erosion, further significant content rights inflation, capital intensity and increasing regulatory pressure, leading to downward pressure on EBITDA and free cash flow (FCF), beyond our current base case would pressure ratings.
A material weakening in key performance indicators such as customer churn, net customer growth (particularly in Germany) and an ongoing ability to increase ARPUs are likely to create downward pressure.
FFO net leverage sustainably at or below 2.5x along with consistently strong FCF could support a ‘BBB’ rating.
Operational performance and delivery of targeted synergies would be important measures of management execution. Improved visibility over the likely direction of key content rights renewals is considered important.