Given France Telecom's need to refinance around EURO15 billion of long-term debt in 2003, Moody's Investors Service hit the nail on the head when it stressed the company's "continuing and significant dependency upon access to the debt capital markets." Unfortunately for France Telecom, though, a downgrade by both rating agencies -Moody's downgraded France Telecom to Baa3', while Standard & Poor's cut its ratings to BBB' - renders the prospect of capital market funding a tough gamble.

The downgrades confirm long-standing market concerns about the company's rising debt burden, which could reach EURO75 billion by the end of the year. Both agencies have also left France Telecom's ratings on negative outlook, thereby signaling doubt about the company's ability to fund its near-term refinancing needs and improve its liquidity situation.

"The company would need to get rid of its negative outlook before considering a bond issue - it would be too costly otherwise," said Felix Kaiser, telecom analyst at Goldman Sachs.

France Telecom needs to return to a stable outlook, Kaiser added, and could do this by selling assets, significantly cutting capital expenditure, raising equity, undertaking a large-scale securitization, or securing a syndicated loan facility.

Telecom ABS background

Since Telecom Italia (TI) initiated the market with its EURO700 million securitization of telephone receivables last year, market sources anticipated a significant flood of transactions from European telecom companies to follow. But so far very little has happened. Even TI, which planned a EURO2 billion securitization program, said it would hold off on further issues this year and does not expect to come to market until 2003. "Telecom Italia is currently rated in the markets without operations, so it decided to hold off on further issues until next year," said a spokesman.

Choosing to hold off is not a reflection on the success of the first deal, the spokesman added. Even with difficult markets, the overall program has proceeded very well with credit enhancement between 9% and 10%. According to sources close to the deal, the fact that they have already established a program means that costs for the next one should be cheaper. "Even if the economical cycle is not good, this type of business would never suffer, " said one market source. "The current spreads on the TI issue are trading very well."

While not significantly large when compared to its operating revenues, TI's program size was limited by the rating agencies. In general, to protect the current lending banks and/or bondholders, which finance the company, the size of the securitization must be compatible with the size of its balance sheet.

"It's not easy given the nature of the receivables which turnover quickly. The structure must offer flexibility in order not to lose the benefits of a securitization," said one market source. "And in order not to lose the benefits of the cash raised, the program should allow some reinvestment to the seller unless you have shortfalls."

Deutsche Telecom is said to currently be working on a program, and sources said that Telefonica is also considering a program. In the short term, France Telecom is working in on the conduit market, but it's likely to consider the longer-term market as well.

No easy time

"[France Telecom's] negative outlook attached to the Baa3' rating reflects the ongoing liquidity risk facing the company, with around E15 billion of debt maturing in 2003 and EURO35 billion over the next three years," said Aiden Fisher, senior analyst at Moody's.

Even before the recent ratings actions, it was no secret that France Telecom was in bad shape. While the disposal of assets such as Wind and TDF will raise some liquidity - analysts estimate that the company's current list of asset disposals could provide cash proceeds of around EURO8 billion - some feel that France Telecom will still have to tap the market in order to fill the remaining EURO5 billion gap.

"France Telecom's refinancing is quite critical at this point," said Guy Deslondes, director at S&P. "We expect France Telecom will be active in the market by the end of the year, although we acknowledge that the company's declining credit quality and current market conditions will make this more difficult."

Others are less hopeful. A downgrade, particularly in a weak market, will make it tough for France Telecom, and though a triple-B rated credit might not have too much trouble getting a EURO500 million deal done, a EURO5 billion presents a greater challenge, especially when there is no shortage of outstanding paper in the market, said Laura Winchester, high-grade telecom analyst at Barclays Capital.

The company's 10-year bonds are currently trading at a yield of 10% to 10.5% (they were yielding 5% last year), so issuing bonds at this rate would prove expensive for France Telecom.

"Refinancing at 10% yields may help the company's liquidity issues, but not its interest costs, which would rise pretty significantly," said Scott Marchakitus, TMT credit research analyst at JPMorgan (S&P acknowledges that refinancing costs will inevitably be much higher, but this has already been factored into the current rating and is a reason for the negative outlook, Deslondes said).

In the second place, France Telecom is just one step away from the high yield universe with its Baa3' rating, so it's hard to say who would buy a potential bond issue. The negative outlook increases the possibility of the company becoming a fallen angel if it is unable to solve its debt problem.

Some investment grade accounts have already started selling the paper, reluctant to hold more risky paper in current market conditions. High yield investors, on the other hand, are also wary of the credit in light of its high leverage and large debt burden. After all, fallen angels, more often than not, can prove problematic, like WorldCom.

Indeed, WorldCom recently proved just how risky these credits can be following the company's admission to a multi-billion dollar accounting fraud, which further rocked the already beleaguered telecom markets. Telecom stocks plummeted on the news and France Telecom's stock was hit hard, dropping nearly 20%. If France Telecom's ability to issue bonds was questionable beforehand, WorldCom's latest revelation and the ensuing market turmoil have effectively closed the new issue market to all telecom companies for the time being, some analysts say.

A silver lining?

Emotions have certainly been running high, but some analysts say things will look a bit brighter once the dust has settled in a couple of weeks.

"History has shown that sentiment can turn around very quickly in the high grade telecom sector," Winchester said. "A more stabilized equity back drop, improved sentiment in the telecom sector and the delivery of some asset disposals by France Telecom could lead to an improved prospect for bond issuance."

Others take the view that if management were to adopt the right tactics - sitting out the bear market and only planting a deal in the market when the right window of opportunity comes along - France Telecom might be able to get a deal done. Of course, issuing bonds at a 12% yield and offering a decent step-up in the event of a downgrade to high yield might also act as an attractive carrot to investors.

A successful bond issue might also help end the vicious circle that has traumatized the company's stock price.

"This type of concession would signal a huge shift in management's strategy," said a telecom analyst at a U.S. bank. "It would show that management is prepared to pay the money to try and solve the company's problems, and it might trigger the start of a virtuous circle."

It could also put France Telecom on the road to a stable ratings outlook, which in turn would rebuild confidence in the company.

"If France Telecom were to successfully refinance most of its EURO15 billion in financial obligations due in 2003 and execute its asset-disposal plan in line with expectations, the ratings would be affirmed," Deslondes said.

But what if continuing market volatility and poor investor sentiment make it impossible for France Telecom to raise the EURO5 billion it so desperately needs via a bond issue?

Not all would be lost, analysts say, as a quick call from the French government - which has a track record of supporting national companies - to the Central Bank could lead lending banks to extend their credit lines to the company. After all, "letting the company fall to speculative grade status would be unhelpful," Kaiser said. "It might lead to the assumption that the French government doesn't care about its companies."

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