We are lowering our issue ratings on the group's existing unsecured debt to 'CCC+' from 'B'. We are revising our recovery ratings on these debt instruments to '6' from '4', to reflect our expectation of negligible (0%-10%) recovery for debtholders in the event of a payment default.
At the same time, we are placing all of our issue ratings on Alcatel-Lucent's debt, including our 'CCC' issue ratings on the preferred stock issued by Alcatel-Lucent USA, on CreditWatch with negative implications.
We placed the ratings on CreditWatch to reflect our opinion that the positive near-term liquidity impact of Alcatel-Lucent's proposed, fully underwritten, issuance of EUR1.6 billion (equivalent) in senior secured facilities--through its subsidiary Alcatel-Lucent USA--could be offset, in our view, by continued negative free operating cash flow (FOCF) in 2013 and 2014 and allocation of the issuance proceeds to repay medium-term debt maturities. The group faces significant debt maturities of about EUR2.1 billion over the next 24 months, but has indicated that it might also use the refinancing proceeds to repay debt maturities after 2014. As a result, we forecast that the group's currently solid cash balances of EUR4.7 billion could decline meaningfully over the next two years, absent sizable asset disposals and proceeds from the announced monetization of its patent portfolio.
In our updated base-case scenario, we forecast weaker revenues, margins, and FOCF in 2012-2014 than in our previous base case from August 2012. This is primarily due the group's weaker-than-expected results in the first nine months of this year, our anticipation of telecom carriers' continued cautious or delayed spending in light of high economic uncertainty, particularly in Europe, and fierce ongoing competitive pressure. In our view, these factors are likely to at least partly erode the expected improvement in margins from the group's restructuring efforts.
We forecast Alcatel-Lucent to report a year-on-year revenue decline of about 4% in 2012, followed by relatively flat revenues in 2013 and 2014. In addition, we expect the group's operating margin (as adjusted by Alcatel-Lucent) to drop to about negative 2% in 2012, compared with positive 3.4% in 2011. In 2013 and 2014, we expect the group's operating margins to improve gradually to positive low-to-mid-single digit levels, chiefly on the back of a better revenue mix, the exiting or restructuring of unprofitable managed services contracts and geographies, and significant cost-cutting efforts.
We forecast negative FOCF of about EUR0.8 billion to EUR0.9 billion in 2012 and continued significantly negative FOCF in 2013, and to a lesser extent also in 2014. In the first nine months of 2012, the group reported negative FOCF of EUR1.0 billion. Despite an expected increase in operating income in 2013-2014, we anticipate that the group's FOCF will remain constrained by high restructuring costs and higher interest payments following the refinancing. Our updated FOCF forecast excludes, however, any potential proceeds from asset disposals or the sale of intellectual property.
The ratings on Alcatel-Lucent continue to reflect our assessment of the company's business risk profile as "weak" and its financial risk profile as "highly leveraged". Our assessment of the group's management and governance is "fair".
The short-term rating on Alcatel-Lucent is 'B'. We view the group's liquidity as "adequate," as defined in our criteria, and calculate that liquidity sources should exceed liquidity needs by about 1.6x in the 12 months from Sept. 30, 2012. Nevertheless, under our criteria we don't view the group's liquidity as "strong" primarily due to our assessment of its only "satisfactory" standing in capital markets. In addition, liquidity uses for the next 12 to 24 months could decline significantly if the group decides to use the expected issuance proceeds to repay debt maturing after 2014.
As of Sept. 30, 2012, and pro forma the issuance of the EUR1.6 billion (equivalent) senior secured facilities, we estimate the company's liquidity sources at about EUR3.8 billion for the next 12 months.
These include primarily:
-- Surplus cash, which we calculate at about EUR2.2 billion as of Sept. 30, 2012. We deduct about EUR2.5 billion from the group's reported cash and short-term marketable securities of EUR4.7 billion, which we consider to be tied to the operations and seasonal working capital needs, or held in countries subject to exchange control restrictions (about EUR1.2 billion as of June 30, 2012), mainly China. The group conducts a significant proportion of its operations via a joint venture in China (in which it owns 50% plus one share). In addition, because Alcatel-Lucent is active in many countries and has captive insurance and finance subsidiaries (both regulated), we believe that other material cash balances may not be immediately available for liquidity purposes. As of Sept. 30, 2012, the group reported cash and equivalents of EUR3.0 billion and short-term marketable securities of EUR1.7 billion; and
-- EUR1.6 billion net proceeds from the proposed debt issuance.
We estimate liquidity uses of up to EUR2.4 billion in the 12 months from Sept. 30, 2012. These include mainly:
-- Annual capital expenditures of about EUR0.6 billion;
-- Sold accounts receivable of about EUR1.0 billion (Alcatel-Lucent reported outstanding amounts of EUR952 million as of Dec. 31, 2011, and EUR958 million as of Sept. 30, 2012). While we understand the sale of such receivables to be nonrecourse to Alcatel-Lucent, we view them as essentially short-term instruments and debt-like in nature;
-- Debt repayments of EUR0.6 billion in June 2013 if holders of the group's Series B convertible bond ($765 million outstanding as of Sept. 30, 2012) exercise their put options. We understand, however, that Alcatel-Lucent could choose to repay part of the convertible bond in shares; and
-- Moderate negative funds from operations before capitalized development costs of about EUR0.2 billion.
Based on our review of the term sheet of the proposed senior secured facilities, we expect Alcatel-Lucent to have significant headroom under a financial leverage maintenance covenant. According to the documentation, Alcatel-Lucent has to use a substantial portion of the proceeds from any patent-monetization program and disposal of certain noncore assets to prepay the senior facilities. As a result, we expect only a limited positive impact on the group's liquidity profile from such disposals.
We expect Alcatel-Lucent's cash flow generation to remain seasonal, including more favorable working capital developments in the fourth quarter than in other quarters. However, we also expect these patterns to be somewhat influenced by revenue developments and the company's working capital management.
All of our issue ratings on Alcatel-Lucent's debt are on CreditWatch with negative implications, in line with the corporate credit rating:
-- The 'BB-' issue ratings on the proposed senior secured facilities, including the asset-sale facility, are two notches above the corporate credit rating on the company. The recovery rating on these facilities is '1', reflecting our expectation of very high (90%-100%) recovery prospects for senior secured lenders. The ratings are based on the issuance of EUR1.6 billion of senior secured facilities and subject to our review of the final documentation.
-- The lowering of our issue ratings on Alcatel-Lucent's senior notes to 'CCC+' from 'B' and revision of the recovery ratings to '6' from '4' reflect our view of negligible (0%-10%) recovery prospects. In our opinion, recovery prospects for these lenders have been weakened by the addition of senior secured loans in the company's capital structure.
-- The issue rating on the convertible preferred securities remains at 'CCC'.
Our recovery and issue ratings on the proposed senior secured facilities reflect our valuation of Alcatel-Lucent as a going concern and the security package provided to these lenders, comprising the vast majority of the company's intellectual property, which we believe would retain significant value in the event of a default. Integral to our recovery ratings is our assumption that insolvency proceedings would occur in the U.S. because the debt will be issued by Alcatel-Lucent USA and the majority of intellectual property is registered there. However, we see a risk of an insolvency filing in France if the parent company's euro-denominated debt remains outstanding at default.
The documentation for the proposed facilities requires Alcatel-Lucent to prepay these facilities, using a substantial portion of the proceeds from any patent monetization and asset disposals related to certain noncore assets. Such prepayment must first go to the $500 million asset-sale facility, followed by the remaining term loan facilities. The documentation allows for Alcatel-Lucent to raise additional senior secured debt of $250 million and, as long as the company does not exceed a certain senior secured gross leverage ratio on the date of incurrence, an additional amount of up to $500 million.
To determine recoveries, we simulate a default scenario, in which we assume that the company utilizes its cash balances to offset high operating losses in a continually weak operating environment, reflected in constrained capital expenditure budgets of telecom carriers and increased competition among telecom network equipment providers. In addition, we assume that research and development costs remain significant as the company continues to develop products to remain competitive. We also assume that the company will not make asset disposals or realize meaningful proceeds from its patent portfolio to repay the senior secured facilities. We believe that under these circumstances the company could file for bankruptcy in 2014, before the EUR1 billion convertible notes mature in 2015, to facilitate restructuring while it still has meaningful cash on its balance sheet.
We estimate the group's stressed enterprise value at the hypothetical point of default in 2014 at about EUR3.3 billion. We deduct about EUR290 million of enforcement costs and about EUR960 million of priority liabilities predominately related to discounted receivables of approximately EUR750 million. This leaves about EUR2.0 billion for lenders. We envisage EUR1.7 billion of senior secured debt outstanding at default (including six months of prepetition interest). We do not assume any additional repayments from asset disposals. We also assume that about EUR2.8 billion of senior unsecured notes would be outstanding at our hypothetical point of default.
Although we see some recovery prospects for the senior unsecured noteholders, we believe that there is a strong risk that additional prior-ranking secured facilities will be raised on the path to default, in particular the $250 million uncommitted facility allowed for under the senior secured facilities documentation. This would leave negligible (0%-10%) recovery prospects for senior unsecured noteholders, in our view.
Although we value Alcatel-Lucent as a going concern, we do not see a meaningful difference in recovery prospects using a discrete asset valuation.
We expect to resolve the CreditWatch within the next three months, after reviewing the group's liquidity profile following its refinancing.
We could lower the rating by one notch if we perceive that the company's cash balances are likely to deteriorate meaningfully over the next two years, resulting in what would we regard as a material risk of default by 2015. This could be the case if the positive liquidity impact from the proposed refinancing and potential asset disposals is offset by continued significant negative FOCF generation in light of subdued revenue prospects, continued fierce competitive pressure on operating margins, and high restructuring costs.
At this point, we do not believe that Alcatel-Lucent is considering a transaction that would qualify as a distressed exchange offer under our criteria, and therefore do not envisage a downgrade by more than one notch.
We could affirm the current ratings if we saw that Alcatel-Lucent's post-refinancing liquidity were sufficient to significantly reduce, in our view, the likelihood of a default by 2015. We expect that this could depend on actual debt amounts raised, the final pricing of the facilities, and the application of proceeds to debt repayment.
Related Criteria And Research
-- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Criteria Guidelines For Recovery Ratings On Global Industrial Issuers' Speculative-Grade Debt, Aug. 10, 2009
-- Rating Implications Of Exchange Offers And Similar Restructurings, Update, May 12, 2009
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
-- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008
Rating Affirmed; CreditWatch/Outlook Action
Corporate Credit Rating B/Watch Neg/B B/Negative/B
Alcatel-Lucent USA Inc.
Corporate Credit Rating B/Watch Neg/-- B/Negative/--
Preferred Stock CCC/Watch Neg CCC
Downgraded; CreditWatch/Outlook Action
Senior Unsecured CCC+/Watch Neg B
Recovery Rating 6 4
Alcatel-Lucent USA Inc.
Senior Unsecured CCC+/Watch Neg B
Recovery Rating 6 4
New Rating; CreditWatch/Outlook Action
Alcatel-Lucent USA Inc.
Senior Secured BB-/Watch Neg
Recovery Rating 1