British Telecommunications Plc -- Moody's changes outlook on BT ratings to positive from stable

RATINGS RATIONALE

"Changing the outlook to positive reflects our expectation that BT's credit metrics will continue to improve over the medium term, driven by a resilient operating performance, its focus on cash flow generation to reduce debt, and its efforts in bringing its pension deficit under control," says Iván Palacios, a Moody's Vice President - Senior Credit Officer and lead analyst for BT. "We believe that BT's strong track record in executing its business plan and its conservative financial policies will play a part in improving its credit metrics further," adds Mr. Palacios.

BT continues to report a resilient operating performance, with consistent growth in EBITDA over the past three years despite the challenging operating environment, which is exerting pressure on the group's revenues. While Moody's expects BT's revenues to continue declining over the medium term, the rating agency notes that some of the revenue lost is low-margin, while also deriving comfort from the group's demonstrated capacity to cut costs in order to improve margins, to be sustained into the future.

Moody's expects that BT's operating performance will benefit from rising consumer demand for bandwidth capacity. In order to defend its strong market position from cable competition and the threat of mobile broadband, BT is successfully increasing its fibre footprint while upgrading its content through TV bundles and acquiring premium sports rights.

Going forward, BT is also likely to benefit from some of the favourable structural features of the UK market compared with other European countries, such as relatively stronger GDP growth prospects, better demographics and price inflation in its telecom sector.

Nevertheless, Moody's cautions that the sustained decline in revenues is a concern given that there is no visibility as to when this trend will reverse. If this trend accelerates over time, the company's ability to continue cutting costs to mitigate pressure on cash flow might be challenged.

BT has a conservative financial policy aimed at balancing shareholder remuneration with bondholder protection. Given BT's stable cash flow generation and a predictable dividend policy, which promises 10%-15% growth in dividends per share over the next three years, Moody's expects that the group will use excess cash to reduce its GBP9.1 billion of reported net debt (as of June 2012). As a result, the rating agency would expect BT's key credit metrics to strengthen over time such that adjusted retained cash flow (RCF)/adjusted net debt raises sustainably above 25%, and adjusted total debt/EBITDA falls sustainably below 2.5x. These ratio levels are consistent with a Baa1 rating for BT, the medium-term rating target stated in the group's financial policies.

The improvement in BT's adjusted credit metrics will also benefit from structural improvements in the group's pension deficit position. Such structural changes include the use of the Consumer Prices Index (CPI), rather than Retail Prices Index (RPI), which reduced BT's pension deficit by around GBP2.9 billion as at September 2010, and the GBP2 billion extraordinary contribution that the group made to its pension plan in March 2012. These changes helped to reduce BT's pension deficit to GBP2.5 billion as of June 2012 from the GBP7.9 billion reported in FY March 2010.

BT's Baa2 rating reflects the group's position as the largest communications service provider to the residential and business markets in the UK. The rating also takes into consideration BT's strong underlying operating performance, particularly the substantial improvement in the group's EBITDA margin. These improvements continue to support BT's free cash flow generation, ongoing debt reductions and an amelioration in financial metrics. However the rating also reflects the group's lack of a mobile business, the impact of deregulation and competition on the group's market position and BT's large and volatile accounting pension deficit which remains a drag on the group's credit metrics.

The positive outlook incorporates Moody's expectation of a continued improvement in BT's credit metrics and leverage reduction.

WHAT COULD CHANGE THE RATING UP/DOWN

Upward rating pressure could develop over the next 18 months if BT demonstrates that it can sustainably maintain an adjusted RCF/net adjusted debt ratio of more than 25%, an adjusted total debt/EBITDA ratio below 2.5x and solid free cash flow metrics. Better visibility as to the reversal of the declining trend in revenues would also support upward pressure on the rating.

Downward pressure on the rating is unlikely given the positive outlook. However, the outlook could be stabilised if the expected improvement in credit metrics is delayed as a result of competitive, regulatory or macroeconomic pressures, leading to ratios such as adjusted RCF/net adjusted debt in the 20-25% range and adjusted total debt/EBITDA in the 2.5x-3.5x range. Downward rating pressure could emerge if BT's cash flow measures weaken as a result of operating performance shortfalls. Specifically, negative rating pressure could result from BT's adjusted RCF/net adjusted debt ratio declining towards 20%, or its adjusted total debt/EBITDA ratio moving towards 3.5x, combined with the group failing to deliver sustainable positive free cash flow.

PRINCIPAL METHODOLOGY

The principal methodology used in rating BT Group Plc was the Global Telecommunications Industry Methodology published in December 2010. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

BT Group Plc, which operates principally through its 100%-owned subsidiary British Telecommunications plc, is the leading provider of local, long-distance and international telecommunications services in the UK and one of the world's leading providers of communication solutions and services, operating in 170 countries. In the year ended 31 March 2012, BT Group plc reported revenue of GBP19.3 billion and EBITDA of GBP6.1 billion.

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Ivan Palacios VP - Senior Credit Officer Corporate Finance Group Moody's Investors Service Espana, S.A. Calle Principe de Vergara, 131, 6 Planta Madrid 28002 Spain JOURNALISTS: 44 20 7772 5456 SUBSCRIBERS: 44 20 7772 5454 Paloma San Valentin MD - Corporate Finance Corporate Finance Group JOURNALISTS: 44 20 7772 5456 SUBSCRIBERS: 44 20 7772 5454 Releasing Office: Moody's Investors Service Espana, S.A. Calle Principe de Vergara, 131, 6 Planta Madrid 28002 Spain JOURNALISTS: 44 20 7772 5456 SUBSCRIBERS: 44 20 7772 5454 (C) 2012 Moody's Investors Service, Inc. and/or its licensors and affiliates (collectively, "MOODY'S"). All rights reserved.

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