December 17, 2014 / 12:56 PM / 3 years ago

Fitch Revises Ericsson's Outlook to Stable; Affirms at 'BBB+'

(The following statement was released by the rating agency) LONDON, December 17 (Fitch) Fitch Ratings has revised the Outlook on Sweden-based Telefonaktiebolaget LM Ericsson's (Ericsson) Issuer Default Rating (IDR) to Stable from Negative and affirmed the IDR and senior unsecured rating at 'BBB+.' The network modernisation strategy the company embarked upon in 2010 has improved its market position and the revenue mix has shifted in favour of margin accretive capacity expansion and upgrade business. Cash flow performance has materially improved. The company is consistently delivering its own cash conversion (cash flow from operations after working capital/funds from operations) target of 70%. An ongoing commitment to a strong balance sheet evident in a material net cash position is an important supporting factor. Fitch considers the growth prospects for telecom equipment and services are positive, with Ericsson's leading position in mobile infrastructure and professional services positioning the company to benefit in particular from operators continued investment in LTE technology and the anticipated acceleration in video driven data traffic. Earnings are expected to benefit from the discontinuation of the modems business, a legacy of the previously discontinued ST-Ericsson JV, which generated EBITA losses of SEK2.3bn (equivalent to 10% of consolidated EBITA) over the 12 months to September 2014. KEY RATING DRIVERS Margin Recovery, Stable Outlook Having signalled at an early stage that gross margin would be materially affected by a strategy to shore up its market position, particularly among European operators, by replacing and building out 3G networks originally built in the early 2000s, Ericsson's gross margin has shown a consistent improvement over the past four quarters. Margin performance along with management guidance over the improvement in the revenue mix and the positive impact on earnings from the discontinuation of the modems business, underpin Fitch's rating case, which assumes high single digit group operating margins and mid-single digit pre-dividend free cash flow (FCF) margin. These metrics support the revision of the Outlook to Stable. Leading Market Position, Industry Outlook Ericsson holds the leading market position in the provision of mobile infrastructure, ahead of Huawei and Nokia Networks. Industry competition is tough, particularly given the presence of government sponsored vendors from China, who have grown their international franchises aggressively over the past years and exerted significant pricing pressure on more established vendors in Europe and the US. Ericsson's position in network services (network rollout, consultancy, network operations, systems integration and support) is equally strong, and a business that has become increasingly important. Fitch considers the industry outlook in both infrastructure and services to be positive and that Ericsson's shift in focus to services and software based solutions looks to have been the right one. Monetisation of IP A key development in 2014 has been a focus on better exploiting the company's intellectual property (IP). A cross licensing agreement signed with Samsung at the start of 2014, has boosted performance both in the Networks and Managed Solutions divisions materially. Although details of the recurring benefit of the contract remain confidential, it suggests a more effective approach to monetising the strength of the company's IP portfolio and could provide greater margin visibility as the recurring nature of these revenues become clearer. FX Pressures Eased Ericsson reports in Swedish krona (SEK) and faces FX transaction exposure given the mix of currencies in which sales are denominated. 42% of 2013 revenues were dollar based while the euro and Japanese yen are also significant in the mix. Currency effects have therefore been material in dampening underlying growth and earnings in the past. However, US dollar strength has been far more favourable through 2014 and dollar-based sales relatively stable. Currency exposure does not in any event give rise to cash repatriation or debt currency mismatch risks given the conservative approach taken towards the balance sheet (3Q14 net cash of SEK29.4bn). Medium-Term Targets Ericsson does not provide public revenue or earnings guidance. However, it publishes its broad medium-term expectations at both an industry and company level. At its November 2014 capital markets day, the company said it expects its addressable market will grow at a compound rate of 3%-5% between 2013 and 2017 and that it expects to grow faster than the market. At the same time it is targeting cost savings of SEK9bn to be delivered during 2017 with associated restructuring costs of SEK3bn-SEK4Bn. Fitch considers the transparency with which the company conveyed margin pressures and expectations associated with the network coverage strategy to have been well managed. Fitch's base case assumes low-to mid-single digit revenue growth and modestly improving margins over this period. Cash Conversion Ericsson targets a cash conversion rate (the ratio of cash flow from operations after working capital to pre-working capital operating cash flow) of 70%. The key to this metric is management's desire to manage the capital intensive effects of network builds. Performance in the metric has improved materially following weakness in 2011 - with the metric in 2013 at 79% and a trailing 12 month metric of 93% at 9M14. The improving mix of capacity upgrades and expansion business verses coverage projects in the revenue mix suggests cash conversion rates should be more visible and remain relatively strong. Fitch's key measure of cash flow performance - pre-dividend FCF to sales - has performed well and in line with our expectations for the company's 'BBB+' rating despite the network coverage pressures described - 2013A: FCF margin of 5.3%. RATING SENSITIVITIES Negative: Future developments that may, individually or collectively, lead to negative rating action include: - A consolidated operating margin which fails to trend consistently to high single digits in the near to medium term, particularly if accompanied by weak cash flow generation, would likely prompt a downgrade to 'BBB'. - Pre-dividend FCF margin expected to be consistently below 5%. - A change in financial policy leading to a balance sheet that was expected to be managed consistently on a net debt basis would also be likely to prompt a downgrade. Positive: Future developments that may, individually or collectively, lead to positive rating action include: - Further material improvements in the consolidated operating and FCF margin reflecting an ongoing shift in the proportion of revenues derived from software and service based solutions. - A positive action would depend on a material improvement in the predictability of cash flows; most likely achieved with an easing in competitive pressures, ongoing growth prospects for the industry and long term demand trends for software based revenues and managed services. Contact: Principal Analyst Slava Bunkov Associate Director +7 495 956 9931 Supervisory Analyst Stuart Reid Senior Director +44 20 3530 1085 Fitch Ratings Limited 30 North Colonnade London E14 5GN Committee Chairperson Damien Chew, CFA Senior Director +44 20 3530 1424 Media Relations: Elaine Bailey, London, Tel: +44 203 530 1153, Email: elaine.bailey@fitchratings.com. Additional information is available on www.fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary. THE ISSUER DID NOT PARTICIPATE IN THE RATING PROCESS OTHER THAN THROUGH THE MEDIUM OF ITS PUBLIC DISCLOSURE Applicable criteria, 'Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage', dated August 2014 available on www.fitchratings.com. Applicable Criteria and Related Research: Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage here Additional Disclosure Solicitation Status here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

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