TalkTalk banking on B2B Direct divestment; cost cuts underway amid contraction in client base - FY23 Credit Report

Report 3 October

TalkTalk banking on B2B Direct divestment; cost cuts underway amid contraction in client base - FY23 Credit Report

By Nidhi Negandhi

TalkTalk Telecom Group (TalkTalk), a UK-based telecommunications enterprise, is currently in talks to dispose of its ‘Direct B2B’ business, which would help the group with its plans to de‑leverage. The company is also seeking fresh investment, as borrowings of GBP 825m (92% of total debt) are set to mature by February 2025. Cash upstreaming to the parent entity (holdco) has strained liquidity although lenders of TalkTalk’s GBP 330m revolving credit facility (RCF) granted a relaxation of the net leverage covenant. Moreover, in the company’s FY23 report, independent auditors highlighted material uncertainty about the business as a going concern, emphasizing the need for shareholder funding in case of a lapse in the proposed divestment.

In FY23, revenue remained stable at GBP 1.45bn, but inflation dented headline EBITDA by 24% year-on-year (YoY) to GBP 297m. Inflow from working capital aided free cash flow (FCF), which eased to negative GBP 24m (FY22: negative GBP 69m) after accounting for advances to the holdco. On 7 August, Fitch downgraded TalkTalk to B- from B, while placing it on ratings watch negative, citing operational risks leading to concerns over refinancing. As at 29 September, the company’s GBP 685m senior unsecured notes (SUNs) were trading at 76 (yield: 26%), having fallen from 84 (yield: 11.5%) a year ago.

Sale of B2B wing: as detailed on the FY23 earnings call on 11 July, the company is in the final stages of discussions for the sale of ’TalkTalk Business Direct’, its direct business-to-business (B2B) operations (contributing 6% to FY23 EBITDA) offering fixed-line and voice services. Proceeds are earmarked for debt repayment and to improve the company’s liquidity position. TalkTalk tapped Houlihan Lokey to advise on the sale, which is valued at approximately GBP 150m (an estimated EBITDA multiple of 8.6x), lower than a previous estimate of GBP 200m. Currently, Sky (a unit of Comcast) is one of the leading potential buyers, while Daisy Group is also in contention. Management says that in the event the sale lapses in the near term, the main shareholders of the holdco (undisclosed) would provide funding until completion of the sale. Management also hinted at a possible sale of ‘TalkTalk Business Direct’ to shareholders at fair market value (FMV), which underscores the uncertainty over the proposed divestment.

Demerger of wholesale from consumer: in July, TalkTalk announced the completion of the demerger of its consumer business from the wholesale platform (see business description below). Management said this would help with cutting central costs and expanding options for strategic mergers and acquisitions (details undisclosed). The company aims to bring in new investment for the wholesale business (equity or debt), and is considering other options with shareholders for the consumer business.

Increasing leverage: as of FY23, net debt had swollen to GBP 892m (FY22: GBP 859m), while net leverage jumped to 3x from 2.2x at FY22. This was driven by the erosion of cash to GBP 7m (FY22: GBP 20m), resulting from negative FCF of GBP 24m (accounting for GBP 62m of advance payments to the parent) in FY23. TalkTalk also borrowed a GBP 22m supplier working capital facility during the year. Payments to the parent include PIK, M&A costs, inter-company trading and interest expenses, OVO acquisition funding (acquired for GBP 23m in October 2022), and other fees. The PIK is applicable to the PIK notes of GBP 380m as of July 2023 (FY22: GBP 291m) issued by the parent entity, outside the scope of consolidation. In FY23, the company made a GBP 3m PIK payment to its parent, well down on a payment of GBP 84m in FY22. According to Fitch, the PIK could exert structural leverage pressure, noting other instances of holdco PIKs being refinanced at restricted group level. If GBP 380m PIK notes are included in TalkTalk’s borrowings, covenant net debt (excl. leases) balloons to GBP 1.3bn, while the corresponding leverage rises to 5.2x.

Covenant relaxation: despite the reduction in cash balances, liquidity was stable at GBP 209m as of FY23 (FY22: GBP 211m), aided by RCF availability and a receivables securitisation facility. However, the revolver agreement has covenants capping net leverage at 3.75x for FY23, which would have then stepped down to 3.5x for FY24, but has been relaxed to 4.95x for FY24. As of FY23, covenant net leverage stood at 3.66x, based on covenant net debt of GBP 882m and covenant EBITDA of GBP 241m. TalkTalk is also required to maintain minimum liquidity (amount undisclosed) under the revolver agreement. On 5 September, GBP 20m of the GBP 330m RCF was sold at auction, trading in the high 70% to par, as lenders opted to offload the debt during the refinancing efforts.

Liquidity: the company’s short-term borrowing stood at GBP 71m as of FY23, including GBP 75m of receivables securitisation facility due in September (GBP 63m outstanding as of FY23), which was refinanced with a GBP 75m non-recourse financing facility due 2026. TalkTalk’s Debtwire-estimated next twelve months expected (NTME) liquidity (before working capital changes) is estimated at GBP 311m, including proceeds of GBP 150m from asset disposals, but excluding payments to the parent entity (GBP 62m paid to parent in FY23). Management does not expect a significant outflow towards working capital in FY24. It plans to complete the ongoing asset sale prior to refinancing the GBP 330m RCF due 2024 and GBP 685m SUNs due February 2025. However, we feel this could prove challenging, given liquidity risk and rising interest rates.

Financial performance recap: despite implementing price hikes and acquiring Virtual1 in May 2022 and OVO in October 2022, TalkTalk’s revenue remained steady at GBP 1.45bn in FY23, affected by weakness in voice services and a 2% contraction in the customer base. Inflation bloated the cost of sales and operating expenses (largely power costs and wages) by 7% YoY to GBP 1.2bn (FY22: GBP 1.1bn). Consequently, headline EBITDA plunged 24% YoY to GBP 297m from GBP 390m in FY22, while the corresponding margin declined to 20% (FY22: 27%). During the period, capex jumped 22% YoY to GBP 118m on account of a transition to full-fibre broadband from copper infrastructure. In addition, interest costs soared 42% YoY to GBP 102m, with the average interest rate rising 300 basis points (bps) to 7.2% in FY23. However, positive negotiations with suppliers led to a working capital release of GBP 88m (FY22: cash outflow of GBP 66m), producing higher FCF of GBP 38m versus GBP 20m in FY22.

Outlook for FY24: management expects the impact of inflation-linked price hikes to be evident in 1Q24, with a significant rise in average revenue per user (ARPU) in each segment. However, the company can only pass on costs to approximately 1.6 million of its total 2.5 million consumer direct customers because of fixed-price contracts and vulnerable customers. While TalkTalk’s customer base shrank to 3.8 million in 1Q24 from 3.9 million in FY23, its ethernet (wholesale segment) base expanded to 72k in 1Q24 from 69k in FY23. Management plans to cut customer acquisition costs (consumer direct segment) by 40% YoY to around GBP 108m in FY24, while aiming to lower the churn rate of 1.7%. However, the ongoing transition to a full-fibre platform, likely to take three to four years, would inflate capex because of the duality of costs, as the company would continue to incur the cost of copper infrastructure, while at the same time building the fibre platform. Thereafter, management anticipates lower costs, as TalkTalk would exit unprofitable telecommunications exchanges. The company expects a cash outflow towards historical marketing expenditure to continue in FY24.

Recovery analysis: TalkTalk underperforms its peers with an EBITDA margin of 20%, significantly below the peer average of 37%, while its net leverage is 3x compared with a peer average of 3.5x. For recovery analysis, we assume an enterprise value (EV) multiple of 2.5x, lower than the peer average of 5x, taking into account refinancing risk, covenant compliance risk, the contraction in the customer base and uncertainty over the B2B Direct divestment.

Scenario 1 (assuming B2B Direct is sold)

We assume B2B Direct is sold for a cash consideration of GBP 150m. In this situation, senior secured debt of GBP 899m receives 93% coverage.

Scenario 2 (assuming no asset sale): we assume estimated FCF of negative GBP 22m for FY24 is funded by the revolver, resulting in an increase in senior secured debt to GBP 921m. In this scenario, senior secured borrowing would receive 84% coverage.

Business description: TalkTalk Telecom Group is a UK-based telecommunications company providing competitively priced fibre, broadband, landline, television and mobile services. Its fixed-line network covers 96% of UK homes, while broadband services cater for approximately 4 million users. TalkTalk largely operates across three inter-connected business lines: wholesale platform; consumer direct business (internet access); and B2B direct business (up for sale). The wholesale business aggregates the incumbent and alternative networks (AltNet) full fibre network. The customer direct business provides affordable fixed-line connectivity to residential customers, while B2B Direct caters for business enterprises. Consumer Direct and B2B Direct are anchor customers of the wholesale platform. The wholesale platform represents 75% of group EBITDA and GBP 1.2bn of revenue (following the de‑merger of Consumer Direct). According to its FY23 annual report, TalkTalk is a subsidiary of TalkTalk Finco Limited (previously Tosca ION Finco Limited), while the ultimate parent is TalkTalk Holding Company (formerly Tosca IOM Limited).

Organisational structure:

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