Fitch Ratings has affirmed Kcell JSC's Long-Term Issuer Default Rating (IDR) at 'BB+' with a Stable Outlook.

A full list of rating actions is at the end of this commentary.

Kcell's ratings benefit from its moderate to strong parent-subsidiary linkage to its parent, Kazakhtelecom JSC (Kaztel, BBB-/Stable). Kcell has a Standalone Credit Profile (SCP) of 'bb'. The one-notch rating differential between Kcell's SCP and Kaztel reflects Kcell's standalone status as a public company with a significant minority shareholding, the parent's commitment to running Kcell as a separate entity and minimal parental guarantees.

Key Rating Drivers

Sound Financial Performance: Kcell demonstrated solid operating results in 2021 and 9M22. Its revenue grew by 12.3% in 2021 and 18.4% in 9M22 and the Fitch-defined EBITDA margin was sustained at 37-38%. Service revenues increased by 10.7% in 2021 and 12.3% in 9M22, compared with only 1.8% in 2020. Acceleration in service revenues growth in 9M22 was supported by the expiration of a three-year tariff freeze in December 2021. This was imposed by the regulator as a condition for Kaztel's acquisition of Kcell. We expect this positive revenue trend to continue in 4Q22 and 2023.

Market Share Attrition: Kcell is the second-largest mobile operator in Kazakhstan with a subscriber market share of around 32% at end-3Q22. Its market share has been steadily declining for at least the past seven years, mainly driven by the company's underinvestment in 4G. As of end-3Q22, its 4G/LTE coverage was only 68% of the Kazakhstan's population, compared with 86% for VEON (mobile market leader in Kazakhstan).

Abating Competition: Competition has become more rational in 2022, evidenced by the absence of inexpensive unlimited data packages and price increases for tariffs by all three mobile network operators. We expect the mobile operators to compete by network quality or other services offers rather than pricing. VEON has invested extensively in its network in 2019-2021 and will likely want to monetise its investments.

5G Spectrum Auction Uncertainties: 5G spectrum auction in Kazakhstan is expected to take place at end-December 2022, with only two 100 MHz spectrum slots in 3.6-3.7 GHz and 3.7-3.8GHz bands available for sale. There are three mobile network operators in Kazakhstan and other operators satisfying the bid's terms can participate in the auction. At the same time, two or more operators can submit a joint bid for one spectrum slot. This creates some uncertainties about the auction outcome.

High Capex, Negative FCF: Following a period of underinvestment, we anticipate Kcell's cash capex to peak at 30-31% of revenues in 2022-2023, gradually decreasing to 23% in 2025. High capex will be driven by the need to upgrade infrastructure and roll out of the integrated network with its sister company. Fitch assumes in its forecasts that a 5G spectrum payment will be made in a lump sum in 2022. As a result of high capex, we expect free cash flow (FCF) to be negative in 2022-2023.

Low Leverage, Financial Flexibility: Kcell's funds from operations (FFO) net leverage was 0.6x at end-2021. Fitch expects it to increase to about 0.7x in 2022-2023 as a result of significant capex investments. This gives the company more than two turns of leverage headroom and provides sizeable financial flexibility. Its dividend policy of paying between 50% and 100% of FCF (defined by Kcell as a sum of operating and investing cash flows) helps align shareholder distributions with the company's longer-term goals.

PSL-Driven Rating: We rate Kcell using a top-down approach, one notch below Kaztel's consolidated credit profile. We assess the overall parent-subsidiary linkage between Kcell and its parent Kaztel as moderate to strong, with the parent the stronger entity, given Kcell's 'bb' SCP.

High Strategic Incentive: We view the strategic incentive (as defined by our Parent and Subsidiary Linkage Rating Criteria) for Kaztel to support Kcell as high. Kcell contributes roughly 30% of Kaztel's consolidated revenues and control over Kcell allows Kaztel to have leading market positions in the Kazakh mobile market. We expect that the mobile segment will be one of Kaztel's major growth drivers.

Medium Operational Incentive: We assess operational incentive as medium. This is supported by considerable cost savings at a group level, counterbalanced by the absence of common management and sharing of the same brand. Kcell lacks ubiquitous network coverage across Kazakhstan, and relies heavily on Kaztel for this connectivity. We expect this relationship to continue, and also expect Kcell to more actively share mobile infrastructure with its mobile sister company. Management commonality is likely to remain low, and we expect Kcell to maintain its independent treasury functions.

Low Legal Incentive: We view legal incentives as low, given the lack of parental guarantees on a significant amount of the Kcell's debt. Only 4% of Kcell's debt (excluding leases) was guaranteed by Kaztel at end-September 2021. A guarantee provided by Kcell to its parent in 2020 on one of Kaztel's loans accounts for just less than 10% of Kaztel's standalone debt. Any intercompany loans to the parent would need approval from Kcell's independent directors, which limits the parent's ability to tap cash flows of its subsidiary.

Derivation Summary

Kcell's peer group includes Turkish mobile-focused operator Turkcell Iletisim Hizmetleri A.S. (Tcell; B/Negative) and German mobile operator Telefonica Deutschland Holding AG's (TEF DE; BBB/Stable).

Kcell's ratings benefit from its moderate to strong parent-subsidiary linkage to its parent Kaztel; its SCP is 'bb'. Similar to Tcell and TEF DE, Kcell has a sound mobile market positions, relatively low leverage and good cash flow generation outside of the investment peak cycles. However, Kcell is significantly smaller than its peers, lacks proprietary backbone network infrastructure and wide 4G network coverage, and has limited access to international capital markets. Unlike Tcell, whose ratings are constrained by Turkiye's Country Ceiling, Kcell operates in a more stable operating environment and is not exposed to FX risks. At the same time, Tcell also offers fixed line services in Turkiye and owns its fixed-line infrastructure.

Key Assumptions

Medium double-digit revenue growth in 2022, easing to high to medium single digits in 2023-2025

Fitch-defined EBITDA margin at 37-38% in 2022-2025

Working capital cash outflows of KZT6 billion per year in 2022-2025

Cash capex at 31% of revenues in 2022 (including spectrum payments), 30% in 2023 and gradually easing to 23% in 2025.

Dividends at KZT10 billion per year in 2022; KZT5 billion per year in 2023-2024; KZT15 billion in 2025

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

An upgrade of Kaztel, provided parent-subsidiary linkage is unchanged

Stronger linkage to Kaztel, including through shareholder funding or guarantees provided by Kaztel on a significant amount of Kcell's debt

Factors that could, individually or collectively, lead to negative rating action/downgrade:

A downgrade of Kaztel, provided parent-subsidiary linkage is unchanged

Weaker linkage to Kaztel, including from higher FFO net leverage above 3.3x on a sustained basis (equivalent to net debt-to-EBITDA sustainably above 3.1x) without a clear path for deleveraging and no commitment by the parent to provide financial support

The sensitivities for Kaztel's rating can be found at

www.fitchratings.com/research/corporate-finance/fitch-affirms-kazakhtelecom-at-bbb-outlook-stable-08-12-2022

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Satisfactory Liquidity: We view Kcell's liquidity as satisfactory, with KZT51 billion of cash and cash equivalents (including around KZT20 billion of cash at banks with ratings below BB-) and KZT11 billion undrawn revolving credit facility available for draw down until mid-2024. This liquidity should be sufficient to cover the company's negative pre-dividend FCF and KZT47 billion of debt maturing in the next two years.

Issuer Profile

Kcell is the second-largest mobile operator in Kazakhstan. At end-2018, 75% of the company's share capital was acquired by a state-owned fixed-line incumbent operator Kaztel from Telia. Kaztel sold 24% of Kcell in September 2021 on KASE (Kazakh stock exchange) retaining a controlling 51% stake in the company.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

Public Ratings with Credit Linkage to other ratings

Kcell's ratings are linked to its parent Kaztel.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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