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Dec 3 (Reuters) - (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.
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 downgrade.
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.