On Feb. 10, 2021, S&P Global Ratings placed its ratings on Canada-based satellite service provider Telesat Canada (Telesat; BB-/Watch Neg/--) on CreditWatch with negative implications following the company's announcement that it would proceed with Lightspeed, a US$5 billion low earth orbit (LEO) broadband satellite constellation. The company expects to sign a definitive agreement with its prime manufacturing partner soon, pending the completion of various capital raises currently in progress.

S&P Global Ratings believes it would be useful to provide additional context about its approach to resolving the CreditWatch placement and to discuss analytical considerations that will determine its issuer credit rating on Telesat, and the issue-level and recovery ratings on the company's debt.

Frequently Asked Questions

How will S&P Global Ratings determine the rating on Telesat, given the Lightspeed investment?

Our ratings on Telesat would likely reflect the consolidation of Lightspeed given its ownership, strategic significance, and management. Although our ratings will be largely influenced by the meaningful increase in gross leverage to support the investment, consideration of the relative merits (and risks) of the LEO opportunity and Lightspeed's competitiveness will weigh on our initial rating assessment. Partners, ecosystem development progress, and revenue backlog buildup would be other factors that we would consider. We expect to stress test the company's financials to risks pertaining to project cost overruns and delays that could alter the economics of the business, and evaluate the company's liquidity through the project's peak spend. Our view will likely evolve as the company demonstrates project execution and Lightspeed's commercial viability is proven, which would take a few years.

Separate from the LEO opportunity, we also expect to review the risk profile of the company's existing geostationary earth orbit (GEO) fixed-satellite operations, which could experience increased competition (from both LEO and GEO), and examine the potential medium- to long-term impact on the segment from limited reinvestment and arguably less management attention.

Because we believe the receipt of definitive credit agreements with certain export credit agencies and other parties would spur the execution of a definitive agreement for satellite construction, we expect to resolve the CreditWatch placement when this happens or soon after. We understand this should occur within the next few months.

What factors underscore Telesat's pursuit of Lightspeed?

We view Telesat's strategy to pursue Lightspeed primarily as an opportunity to seek growth in a new market with a differentiated offering. Lightspeed complements Telesat's existing fixed-satellite services (FSS) business and provides the company with a path to leverage legacy (i.e., the broadcast segment, which largely consists of direct-to-home (DTH) satellite video; about 50% of existing GEO revenue) cash flows into LEO growth verticals with possibly less competition than in the mature GEO segment, which is burdened by significant new capacity. Telesat would also be able to migrate some (as much as 50% of the non-broadcast [enterprise] business, according to management) of its GEO business to the LEO network, mitigating transition risks related to these connectivity customers. More specifically, the company aims to target growth areas, like enterprise customers with use cases such as aviation, maritime, government services, and terrestrial mobile backhaul (in particular 5G), exploiting the benefits of low latency, high bandwidth, and speeds (given access to Ka band spectrum) that a LEO network would offer. We also believe that management has the expertise to provide an attractive offering, supporting Lightspeed's long-term growth potential. If Telesat is able to contract Lightspeed satellite capacity, either with anchor tenants or by contracting a majority of its system capacity, it would provide strong visibility and stability of cash flow. At the same time, a successful transition of the company's enterprise customers from its legacy business to the LEO constellation, along with improvements in profitability and return on capital, could support our assessment of the company's overall business risk profile.

How does S&P Global Ratings view the competitive positioning of Lightspeed?

Multiple LEO constellations are being deployed worldwide. The satellite networks are differentiated by the number and type of satellites and their positioning, spectrum band utilized, technological enhancements, and end markets; as well as business operating models and economics. Lightspeed's initial constellation is expected to comprise 298 satellites with an estimated operational life of about 10 years. These lower-altitude satellites will be interconnected with optical links, and through a meshed network of polar and inclined satellites will support superior bandwidth and network reliability. Competition includes other LEO constellations like Starlink (SpaceX), Project Kuiper (Amazon), and OneWeb, as well as SES/O3b, a MEO (Medium Earth Orbit) network. These constellations have larger fleets, and the much advanced Starlink buildout is focusing on the potentially more competitive consumer broadband market. In our view, OneWeb could be a direct competitor, focusing on enterprise and government customers targeting terrestrial, aviation, and maritime markets, similar to Lightspeed, although it is likely that the other providers could ultimately compete for similar customers and applications (in particular, Amazon). We understand that Telesat aims to differentiate itself from others by offering carrier-grade end-to-end services and targeting a largely wholesale business model with term contracts, as it has with much of its GEO business. While Lightspeed's technological merits appear comparatively attractive, and its commercial viability and economic success are unknown.

What does S&P Global Ratings view as the major risks for Telesat?

Despite the promise of a large total addressable market (US$365 billion by 2023, according to Telesat), revenue diversity and significant growth prospects, we view the LEO investment as higher risk than Telesat's mature fixed-satellite business. In our view, LEO is a new technology where the business model and prospects for return on capital are still uncertain compared with that of a space-tested and technologically proven FSS. Cash flow visibility and capital return from the FSS business are well established. While we are cognizant of pressure from the transitioning DTH video business, we believe GEO broadband can remain competitive for some time in many consumer and enterprise applications. In contrast, we view the LEO project as carrying higher business risks relative to that of Telesat's existing business, reflecting uncertainty about the evolution of technology, ecosystems, and scaled use cases, as well as limited cash flow visibility. At the same time, we do not anticipate Telesat will invest significantly in launching new GEO satellites, as the industry faces weakening secular fundamentals led by oversupply along with a declining backlog of contracted revenues and its focus on scaling its LEO program. In the absence of sustaining the contracted backlog, in our opinion, Telesat's legacy business could face a steady decline in EBITDA. As a result, we expect Telesat's existing operations' profitability to be pressured as it faces substantial competition from several new and existing providers.

What are the potential financial implications for Telesat?

Telesat anticipates investing about US$5 billion over three-four years to build and deploy its LEO constellation (space and ground infrastructure). The company has indicated that it is targeting a funding mix of 60% debt and 40% equity at the Lightspeed subsidiary. We expect a major portion of the capital investment will be back-end loaded and the company will have meaningful cash burn over the next few years. Based on the company's public disclosures, the LEO constellation could provide a full service offering in 2024. We do not expect Lightspeed to reach break-even cash flow for a few years after the launch. As a result, we project consolidated Telesat's free cash flow will be negative for at least the next three-four years, pressuring the company's debt-repayment capacity and elevating its adjusted gross debt-to-EBITDA ratio. Furthermore, if there are project delays or significant launch failures, the already elevated credit measures could make the company vulnerable to further credit pressure.

Increased equity funding for Lightspeed would alleviate pressure on the company's credit measures. For our forecasts, we project the company will build-up a substantial cash balance from different equity sources. These include, an initial public offering, partner funding and asset monetization. Other sources of funding could be excess cash from the GEO business, although we understand the magnitude of this is currently constrained by financial covenants at the restricted GEO subsidiary. Nevertheless, we have not netted this cash against debt, as we expect the company will use the cash for LEO investments instead of debt repayment. In the event the company is able to raise more equity to fund the LEO constellation (currently assumed at 40%), debt leverage could improve, but still remain in the low double-digit area.

What are the potential rating implications for Telesat?

On resolution of the CreditWatch, we believe the ICR on Telesat could be in the single 'B' rating category. This primarily reflects the company's adjusted debt leverage (expected to peak in the low-teens area) being significantly higher than our rating downside target of 6x and for consolidated free cash flow to remain negative for the foreseeable future. Mitigating considerations will be the company's liquidity strength (Lightspeed potentially funded through peak capex), positive cash flow from the GEO business, and our preliminary assessment of the value creation prospects of Lightspeed.

What recourse will Telesat Canada credit facility lenders and senior secured noteholders have to the LEO project and is it part of the guarantee and collateral package?

The credit facility lenders and secured noteholders will not have direct recourse to any LEO project assets because they are held in unrestricted subsidiaries holding the LEO project assets. However, Telesat Canada, as the parent company, is an obligor and guarantor of the credit facility and secured notes. Therefore, if there is any residual value from the unrestricted subsidiary, after liabilities and debt owed at the unrestricted subsidiary level, we believe that it will flow up to the parent and then to the creditors as unencumbered residual value. We note that the LEO project is expected to incur a substantial amount of debt to finance the US$5 billion project, which would very likely have direct recourse to the LEO project assets as a priority claim.

From a collateral or recovery perspective, how should we view the US$1.6 billion in aggregate assets that were already transferred from the restricted group of subsidiaries to the unrestricted subsidiary holding the LEO project?

We understand that US$1.6 billion in aggregate assets (including cash and C-band spectrum assets) were transferred from the restricted group of subsidiaries into an unrestricted subsidiary (in the form of equity capital and contribution investment). The unrestricted subsidiary will house the LEO project, and the recent US$500 million debt issuance by Telesat will also be transferred to the unrestricted subsidiary as equity capital. We anticipate that proceeds from the transferred cash and assets will be used to fund the equity portion of the US$5 billion LEO project. In our view, there is currently limited availability under the applicable basket for additional contributions to be made from the restricted subsidiary to the unrestricted subsidiary.

Given the significant scale of the project and the inherent risks due to potential delays, cost overruns, and execution risk, in addition to the project not having obtained full financing, we have excluded the LEO unrestricted subsidiary from our recovery analysis. We will review our recovery analysis once the company obtains fully committed financing for the project and thereafter we will consider the various stages of completion of the project phases.

Our recovery rating on Telesat's credit facility and senior secured notes is '3', reflecting meaningful (50%-70%, rounded estimate: 60%) recovery in the event of a payment default. Our recovery rating on the unsecured notes is '6', reflecting negligible (0%-10%, rounded estimate: 0%) recovery in the event of a payment default.