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Dec 3 (The following statement was released by the rating agency)
Fitch Ratings has affirmed Sweden-based
Telefonaktiebolaget LM Ericsson's (Ericsson) Issuer Default Rating (IDR) and
senior unsecured rating at 'BBB+.' The Outlook on the IDR is Negative
With a leading industry position in telecoms infrastructure, importantly
including the market number one position in mobile networks, along with a well-
established and growing position in managed services, Ericsson's well
dimensioned and solid operating profile is accompanied by acceptable financial
performance and a strong balance sheet.
Although margins have been through a protracted period of weakness, Fitch
expects them to improve. However, margin headroom remains tight in the context
of the ratings, underpinning the Negative Outlook, and Fitch would like to see
further evidence of improving trends before taking any positive rating action.
KEY RATING DRIVERS
Gradual Margin Recovery
After a protracted period of margin weakness, Ericsson is guiding to a period of
more stable and improving operating margins. A revenue mix that has seen the
company's largest division (Networks) derive a significant proportion of sales
from replacement and coverage contracts has weighed heavily on margins. The
weighting of revenues and the order book now appears to be gradually shifting
away from this lower margin mix and is starting to ease ratings pressure,
although this is at an early stage.
Business Mix Driving Gross Margin
Ericsson signalled at an early stage that success in gaining network
modernisation contracts as far back as 2010 would lead to margin pressure, which
subsequently materialised. However, at its November 2013 investor day, it
highlighted that year-on-year gross margin gains in 9M13 included roughly 400bp
of positive revenue mix and efficiency gains. While Fitch does not expect the
company to recover historical margin highs, we assume a gradual improvement
within the networks division.
A more recent margin impact has been the negative effect of currency movements,
driven by the Swedish krona strengthening against both the US dollar and
emerging market currencies. This volatility is likely to continue in the short
term and the company estimates it has had an approximate 200bp impact on the
gross margin (9M13 year-on-year). With 46% of sales US dollar-based and the
company active in 180 countries, flat 9M13 reported revenues would otherwise
have been up 5% on an organic FX adjusted basis.
Ambitious Long-Term Targets
The company laid out its targets (under its executive performance stock plan) at
the group level at the investor day. These include ambitions to grow revenues at
a CAGR of between 2% and 8% between 2012 and 2015; growth that Fitch believes is
achievable at least at the lower end of the range. More ambitious are plans to
improve operating income by a CAGR of 5% to 15% over the same period. Fitch
acknowledges the improving business mix and operating efficiencies will deliver
margin gains. However, competitive and FX pressures are likely to continue.
Fitch previously had concerns that the push for network replacement and coverage
contracts and an extended working capital cycle would weaken cash flow
generation. Although some weakness has been evident, cash flow generation
remains good, with an LTM September 2013 CFO margin of 8.1%
Negative: Future developments that may, individually or collectively, lead to
negative rating action include:
Consolidated operating margins that failed to trend consistently towards high
single digits and a pre-dividend free cash flow margin below 5% would likely
prompt a downgrade to 'BBB'.
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
Positive: A stabilisation of the Outlook would be likely once the company has
shown a consistent delivery of group operating margins in the high single digit
range along with continued pre-dividend free cash flow margin above 5%. Fitch
considers the 'BBB' rating category as the natural territory for Ericsson's
rating, with an upgrade into the 'A' category deemed unlikely given the
company's current operating and financial profile.