Fitch Ratings has downgraded Sri Lanka Telecom PLC's (SLT) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to 'B+ from 'BB-'. The Outlook on the IDRs is Negative. The agency has affirmed SLT's National LongTerm Rating at 'AAA(lka)' with a Stable Outlook.

The rating action follows Fitch's downgrade of Sri Lanka's Long-Term Foreign- and Local Currency IDRs to 'B+' from 'BB-' and assignment of a Negative Outlook (see "Fitch Downgrades Sri Lanka to 'B+'; Outlook Negative," dated 29 February 2016 on www.fitchratings.com).

SLT's IDRs are constrained by Sri Lanka's IDRs as the government directly and indirectly holds a majority stake in SLT and exercise significant influence on its operating and financial profile.

Also, SLT's second-biggest shareholder, Malaysia's Usaha Tegas - which owns 44.9% of SLT - does not have any special provisions in its shareholder agreement to dilute the government's significant influence over SLT.

KEY RATING DRIVERS

Recurring Taxes Scrapped: We revised the outlook on Sri-Lanka's telco sector to stable from negative on 18 January 2016 following the new government budget, which scrapped the recurring taxes that could have diluted the industry's EBITDA margin significantly. We believe that SLT's standalone credit profile will remain strong despite a gradual increase in FFO adjusted net leverage during 2016-2018 (2015: 1.2x). SLT's current ratings have sufficient headroom to absorb a small decline in profitability and small FCF deficits on high capex requirements.

Acquisition Risk: SLT's National Rating could be threatened if it were to do a debt-funded acquisition of a smaller operator. However, a rating action would depend on the acquisition price, funding mix and forecast financial profile of the combined entity. We believe that SLT could acquire one of the two unprofitable operators willing to exit the industry. Hutchison Lanka and Bharti Airtel Limited's (BBB-/Stable) Sri Lankan subsidiary, Airtel Lanka, are struggling to gain market share and could sell their operations. The international ratings have
sufficient headroom to absorb any acquisition.

Solid Market Position: SLT's ratings are underpinned by its market-leading position in fixed-line, second-largest position in the mobile market and its ownership of a large optical fibre network.SLT's market position will strengthen as it plans to expand its mobile and fibre infrastructure. We also believe that the industry will consolidate, with two telcos exiting during 2016-17 to leave three remaining operators.

Mild Profit Dilution: We forecast SLT's EBITDA margin to narrow by 50bp each year during 201617 as rising fixed-broadband and mobile internet usage will only partly offset margin dilution due to a change in revenue mix and higher international telecom taxes. SLT's EBITDA margin will narrow as less profitable data revenue replaces more profitable fixed-voice and international revenue. The government budget announced in January 2016 doubled the
international telco levy to USD0.06 per minute from USD0.03.

We also forecast SLT's 2016 revenue to rise by mid-single-digit percentage driven mainly by mobile data and fixed-broadband services.

Negative FCF to Continue: We forecast SLT to have negative FCF during 2016-2018 as cash flow from operations will not be enough to fund its ongoing large capex plan. SLT will continue to invest about 28%-30% of its revenue in capex each year to expand its optical fibre infrastructure and 3G/4G mobile networks. Dividends are likely to remain similar to the historical levels at LKR1.5bn-1.6bn.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Revenue to rise by mid-single-digit driven by fixed-broadband and mobile data services.
- Operating EBITDAR margin to dilute by about 50bp in 2016-2017.
- Capex/revenue to remain high around 28%-30% as SLT expands it fibre and 3G/4G networks.
- FCF deficit during 2016-2018 resulting in gradual increase in FFO-adjusted net leverage.

RATING SENSITIVITIES
Negative: Future developments that may individually, or collectively, lead to negative rating
action include:
-A downgrade in the rating on the Sri Lanka sovereign (B+/Negative) will result in a corresponding action on SLT's IDRs.
-A debt-funded acquisition of a smaller operator could threaten SLT's National Long-Term Rating, depending on the acquisition price and the financial profile of the combined entity.

Positive: Future developments that may individually or collectively lead to the Outlook on SLT's
IDRs being revised to Stable include:
-A revision in Sri Lanka's Outlook to Stable from Negative.
- An upgrade of Sri Lanka's IDRs will result in a corresponding action on SLT's IDRs.
-A weakening of links between SLT and the sovereign could result in SLT's Local-Currency IDR being upgraded above Sri Lanka's Local-Currency IDR of 'B+'. However, SLT's Foreign-Currency IDR will remain constrained by the Country Ceiling of 'B+'.

LIQUIDITY
Liquidity was adequate at end-2015, with cash and equivalents along with committed undrawn bank lines comfortably covering its short-term debt.