July 8 (The following statement was released by the rating agency)
Fitch Ratings has downgraded STMicroelectronics NV's (ST) Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'BBB-' from 'BBB'. The Outlook is Negative.
The downgrade and Negative Outlook are driven by persistently weak operating performance, portfolio and cost restructuring that is rarely interrupted and the lasting effects of the revenue concentration to Nokia Corporation (BB-/Negative), formerly its largest customer. A sound balance sheet - strong cash balances, low debt maturities and solid liquidity - and an improving operating environment provide some balance. Exit from the ST-Ericsson (STE) wireless JV - to be completed by Q313 - will bring to a close an extremely challenging period and offers the potential for far stronger margin performance from 2014.
KEY RATING DRIVERS
ST has invariably failed to deliver margin ambitions. It has also had a persistent history of portfolio restructuring, cost cutting and business impairments, the latter most recently related to STE. The inevitability of a constantly changing reporting structure, and inconsistency in the way revenues and earnings are reported, leads to a lack of visibility and obliqueness in predicting future performance.
While the dissolution of STE is a welcome acknowledgment of the failure of a capital intensive and unsustainably loss making part of the group, management continue to face challenges across some parts of the product portfolio.
Cost Cuts Achievable, Revenue Challenge
ST is targeting a medium term operating margin of 10% or more and guided verbally that annual sales of USD9.0bn to USD9.2bn (USD2.25bn - USD2.3bn per quarter) will be necessary to achieve this target. Fitch estimates ST will need to produce a gross margin of between 36.5% and 37% if this target is to be met; a level that low capacity utilisation has failed to deliver for the past seven quarters.
A quarterly opex target of USD600m to USD650m by Q114 does seem achievable, particularly given the roadmap outlined for dissolving STE. Meeting USD9.0bn or more of sales from a 2012 base of USD7.1bn (excluding wireless) is far less predictable.
STE Exit Credit Positive
USD3.1bn of operating losses over 2009-2012 and a consistent failure to improve the top-line at STE makes the decision to exit the wireless JV and a clear roadmap to exit by Q313, welcome and a strong credit positive. While the JV's problems have their roots in the accelerated decline of Nokia Corporation, a promising industrial idea, proved quickly the difficulty of turning design wins with multiple tier one handset vendors into any kind of tangible revenue momentum. In an industry where product life cycles are measured in matters of months, management appeared consistently unable to deliver on time.
The Good Disguised
Losses within wireless and weakness in other parts of the portfolio have tended to hide the fact that parts of ST's product portfolio are market leading, have acceptable margins and offer some growth potential. ST is the market leader in micro-electro-mechanical systems (MEMs) motion sensors for consumer electronics and mobile handsets accelerometers and gyroscopes and has a strong supplier position with Apple in each. MEMs revenue has grown 20 fold in the past five years - estimated at close to USD800m in 2012.
Management has set a medium term operating margin target of 10%. Historic experience has however been that targets are rarely met with any kind of consistency. Fitch therefore takes a cautious view of this ambition and we are not currently assuming this target is achieved over our three year rating case.
Positive: Future developments that could lead to positive rating actions include:
Consolidated operating margins trending consistently in the mid-single digit range (once the effects of the STE dissolution have worked through). Clean operating results to be judged from Q114.
Neutral to low-single digit free cash flow margin (post dividend cash flow to sales). Fitch's rating case currently assumes very modest negative free cash flow in 2014 and 2015 - a metric that underscores the Negative Outlook. Negative: Future developments that could lead to negative rating action include: A failure to generate anything more than zero to low-single digit operating margins on a consolidated basis post 2013.
Free Cash Flow - a failure to generate positive free cash flow on a sustainable basis will be cause for concern and would likely lead to a downgrade in the absence of management action (ie. capex and or dividend cuts).