Winner: Telefonica

Every month Credit recognises the most innovative financing solutions in the debt capital markets. This month Telefonica, Axa Investment Managers' Opus CDO I and Oracle Corp

Taking the accolades for the best transaction in January was the €5.8 billion blowout offering launched by Spanish telecom operator Telefónica, a deal that brings back memories of the heady days around the turn of the millennium when telecoms operators ruled the primary markets.

The deal forms part of the overall financing for the £17.7 billion acquisition of UK cellular operator O2 and is the first step in refinancing the £18 billion syndicated loan taken out to fund the purchase. The bridge facility, underwritten by Citigroup,Goldman Sachs and Royal Bank of Scotland, is the largest syndicated loan in Europe since France Télécom borrowed around €30 billion in bank debt in 2000 to acquire Orange.

Telefónica aims to refinance one-third of the first tranche of the loan (worth £12 billion) with the bond financing. The maturity of the bank financing can be extended to two, two and a half and three years, says John Pearce, telecoms analyst at Dresdner Kleinwort Wasserstein in London, and the whole £18 billion is expected to be refinanced in various capital markets over time.

In addition to the euro and sterling deals, the borrower will tap the dollar market, up to $4 billion is possible say analysts, and this total borrowing could exceed half of Telefónica's target amount for the first year. The firm has left its fund-raising options open for the second half of 2006 and says it will consider other currencies, instruments and markets for additional liquidity. Pearce expects €6-10 billion of normal bond issuance from Telefónica in 2006, plus smaller euro floaters and private placements.

The acquisition itself was a bolt from the blue for the market as Telefónica chief executive César Alierta had told attendees at a telecom conference
in Santander in September 2005 that O2 was not a target, only to put in a bid the following month. Buying O2 was, in the words of Telefónica chief financial officer Santiago Fernandez Valbuena, something bondholders gave him "hell" for, after ratings downgrades widened the firm's bond spreads.

Nonetheless, the success of the firm's debt capital markets issuance has won back some favour among the bondholder community. After rejecting Telefónica's initial price guidance, investors racked up €9 billion of total orders under the revised terms. Moreover, the overriding factor in buying O2 was the favourable bank lending rates in the market at that time which meant the acquisition made great business sense for Telefónica. The arrangers provided Telefónica with loans priced at 32.5bp (tranche A) and 37.5bp (tranche B), which compared favourably to France Télécom's rates in 2000.

There are numerous strategic benefits for Telefónica by acquiring O2, such as owning the fastest-growing network operator with over 27 million customers and gaining important access to the UK and Germany, Europe's largest telecoms markets. In addition, O2 has seen revenue growth of 21% annually since it was spun off by British Telecom in 2001 and by March last year this had risen to the £7 billion mark. Analysts predict that free cashflow over the next three years could rise by 32%.

Globally, Telefónica's mobile customer levels are set to rise to about 120 million, thereby displacing T-Mobile as the world's second-largest mobile operator, while its number of European customers is set to double.

The acquisition complements Telefónica's other substantial interests in Spain and South and Central America, plus Morocco and Czech Republic, where only last June the firm completed the €2.7 billion acquisition of a 51.1% majority stake in Cesky Telecom, the country's largest telecommunications operator.

After the acquisitions, Telefónica has stated that it intends to pursue a course of financial responsibility and conservatism for the next 12-18 months and has set itself rigorous financial guidelines, says a spokesperson for Telefónica in Madrid. "The company has established BBB+/Baa1 as its minimum desirable credit rating and secondly, commits to a debt ratio plus cash commitment equal to or less than 2.5 times OIBDA [operating income before depreciation and amortisation] in the medium term," says the spokesperson.

Analysts are confident the company's strong fundamentals will drive cashflow generation in the future. "We see the underlying story as strong: Telefónica is the only one of Europe's top seven telecom companies that did not disappoint in the third-quarter results season in terms of organic growth," says DrKW's Pearce."It also reminds us of the company's ambitions: it already has the highest equity market value of any European integrated telco," he adds, "and we think that management is genuine in saying that it wants to consolidate for the next year or more, and does not expect to pursue material acquisitions any time soon."

Pearce's one reservation is that acquisition opportunities sometimes emerge to tempt acquisitive corporates such as Telefónica. If for example KPN's German E-Plus operation or even Portugal Telecom were to come into play, Telefónica might be expected to respond. Neither of these seems likely any time soon, but both are possible during 2006 or 2007 in Pearce's view.

Issuer: Telefónica Emisiones

Date of issue: January 19, 2006

Underwriters: Barclays Capital, BNP Paribas, RBS (sterling tranches); ABN Amro, Barclays Capital, BBVA, Société Générale (euro tranches)

Total size of deal: €5.8bn

First tranche: €2.25bn 2011, priced at 75bp over Bunds; Second tranche: €1.75bn 2016, priced at 112.8bp over Bunds; Third tranche: £750m 2018, priced at 130bp over gilts; Fourth tranche: £500m 2026 142bp over gilts

Ratings: Moody's Baa1, S&P BBB+, Fitch A-, DBRS BBB high

BUYERS' VERDICT

Weeks before launch and without even price guidance or a term sheet in sight, investors were already eyeing up the possibility of participating in Telefónica's jumbo bond issue. Volker Marnet-Islinger, head of corporate bonds at Cominvest in Frankfurt, points to the stature of the bond issue as being a big lure for buying the paper. "This could be the only chance to participate in a huge Telefónica bond issue in 2006 and I do not anticipate another benchmark deal in euros from the issuer this year. The name is quite a rarity in euros, which attracted huge demand for the deal," he says.

The sterling tranche of the deal is the borrower's debut in the UK market. Simon Surtees, head of credit research at Gartmore Asset Management, says: "Telefónica offers some issuer diversification for sterling telecom investors and the company priced the bonds to clear, which resulted in robust demand for the sterling tranche at least," he says.

Investors concur that favourable pricing was an important driver in the placement of the bonds, believing that theattractive terms were some compensation for seeing such a large volume of debt flood the market. In addition, bondholders are still wary of Telefónica's future acquisition policy and want to make sure they are adequately compensated for M&A risk, although one investor felt he was not compensated enough.

Overall, European investors welcomed the explosion of bonds into a stagnant primary market and their compatriots across the Atlantic may not have long to wait to take Telefónica exposure. The firm is set to follow its European escapade with a dollar-denominated issue during the first half of the year. One investor believes that the borrower could tap the currently strong hybrid capital market, which is doing well on both sides of the Atlantic.

RATING AGENCY COMMENT

In their actions towards Telefónica, the rating agencies are all singing from the same hymn sheet by downgrading the Spanish telecom operator one notch after its acquisition of O2. Fitch gives Telefónica the highest rating out of the four incumbents and has left the firm hanging on its single-A status with a rating of A- down from A. Standard & Poor's downgraded Telefónica to BBB+ from A- and upgraded O2 to BBB+ from BBB. At Moody's the firm dropped to Baa1 from A3, while Dominion Bond Rating Service (DBRS) left the company with a BBB (high) rating, down from A (high).

The rating agencies' use of similar rhetoric backs this unified approach: S&P cites the borrower's "aggressive nature", Fitch describes the firm's "more proactive approach" to acquisition activity, while Moody's cites the increased financial risk that has led to the downgrade. For DBRS, a more aggressive growth strategy at Telefónica, beyond its previous focus on telecom operations in Spain and Latin America, have meant "debt levels at Telefónica will increase substantially, resulting in credit metrics that will no longer be indicative of an incumbent telco even in the lower part of the 'A' category."

On a comforting note, the agencies have left the firm with a stable outlook. For Moody's, this is based on its expectation that management will maintain a strong liquidity profile, despite the huge refinancing needs, and that the integration of O2 within Telefónica will be smooth. While Fitch believes that Telefónica is committed to its revised leverage target of 2.5x net debt to Ebitda.

Credit says... After coming into the deal with aggressive pricing, Telefónica was forced to relax the terms of the bond to assuage investors in a nervous market. In the end, investors upped their bids after price guidance was widened.