(The following was released by the rating agency)
SYDNEY/SEOUL, February 13 (Fitch) This week Matt Jamieson spoke with Steve Durose, Fitch’s Head of Asia Pacific TMT ratings, about Fitch’s recent rating downgrades in the Japanese technology sector. Mr Jamieson is Head of APAC Research in Fitch’s Corporate Ratings Group.
In addition to the appreciation of the yen and a faltering global economy, Steve emphasised the Japanese tech giants’ loss of product leadership as a major reason for the erosion of their profitability and rating downgrades. Following further downgrades in February 2012, Fitch now rates Panasonic Corporation (Panasonic), Sharp Corporation (Sharp), Sony Corporation (Sony) and Toshiba Corporation (Toshiba) ‘BBB-', the lowest investment-grade rating, and has Negative Outlooks on the first three. Toshiba is on Stable Outlook. Mr Durose said that without any improvement in their financial performance over the next 18-24 months, they are likely to be downgraded to speculative grade.
Matt: Focusing on Panasonic, Sharp, Sony and Toshiba, can you tell us how far Fitch’s ratings have fallen for these companies since the global financial crises hit in mid 2008?
Steve: Since mid-2008, Panasonic has fallen six notches, from ‘AA-', Sharp five notches from ‘A+', Sony three notches from ‘A-’ and Toshiba a single notch from ‘BBB’.
Matt: To what extent has their profitability and cash generation fallen during this period?
Steve: In the financial year to March 2008, the average EBIT margin for the four tech companies was 4.8%. This deteriorated to an average EBIT loss of 4.3% in FY09, followed by average EBIT margins of just 0.4% in FY10 and 2.6% in FY11. In FY12 Fitch expects Toshiba to make an EBIT margin of around 2.5%-3%; however, the agency expects other three companies will record EBIT margins around or below 0%.
Similarly, the four companies’ aggregate free cash flow was JPY329bn in FY07 and marginally negative in FY08 at JPY49bn. Over the next three years to FY11 they accumulated JPY1.4trn in negative free cash flow. Consequently, their credit metrics have deteriorated.
Matt: What are they key reasons for this?
Steve: It is a combination of global macro conditions working against them and company-specific factors. Since the global financial crisis began to bite hardest in the autumn of 2008, the yen has appreciated by 42% against the US dollar and placed downward pressure on both sales volumes and operating margins. With margins under pressure, companies have less scope for sales discounting to regain lost market share.
Matt: Clearly the strong yen continues to work against them. Can you also elaborate on some of the company-specific reasons for their profitability drop?
Steve: Simply it is because they have lost their technology leadership in many areas. Ten years ago these companies were major technology innovators, the creators or leading developers of many electronic products and trend-setting devices such as televisions, digital cameras, portable music players and games consoles. Today, however, the number of products remaining where they can boast undisputed global leadership has narrowed significantly, having being usurped or equaled by the likes of Apple and Samsung Electronics, which is rated ‘A+/Stable. Notably they have been slow to gain traction in the burgeoning smartphone and PC tablet market, and this is a clear weakness for them at the moment.
Also, generally speaking, the quality of other Asian manufacturers’ products has caught up; for example the Korean manufactures have taken the lead in important segments including flat panel displays and DRAM. In the current economic environment, global consumers are increasingly price-sensitive, and not prepared to pay a premium for a product with the Sony, Sharp or Panasonic name if it is not matched by a corresponding premium in quality. At the same time, the brand strength and recognition of major Korean competitors, Samsung and LG Electronics, which is rated ‘BBB’/Negative, has grown significantly.
Importantly for Sony, Sharp and Panasonic, exposure to the TV and flat panel display markets remains a key risk given the ongoing oversupply in this market and the strong technological and price competition from Korean manufacturers, particularly Samsung, which have less exposure to weaker developed economies than the Japanese manufacturers. Sharp, in particular, faces a number of risks associated with its tenth generation super-large 60+inch display panel strategy, at a time when European and North American consumer confidence remains fragile.
Matt: With so many things working against them, what can they do to turn their profitability around?
Steve: To some extent these businesses are hamstrung by the strong yen and the weak global economy. However, most of the companies are adopting the correct strategies to reduce exposure to unprofitable business lines and to cut capacity and fixed costs. For example, Hitachi Ltd, which we rate at ‘BBB’/Stable, Sony and Toshiba are pooling their small display panel businesses into a joint venture. Nevertheless, unless the companies can develop new market-leading products at competitive prices, their credit quality will remain under pressure.
Matt: What are some of the main factors Fitch will be monitoring to determine whether Sony, Sharp and Panasonic remain investment grade or are downgraded to speculative grade?
Steve: We will be concentrating on where we think these companies will be over the next two years, particularly in terms of market positions for their major business lines, overall operating margins and financial leverage. Should these companies’ EBIT margins improve to 1.5% and funds flow from operations-adjusted leverage improve to around 3.5x, the leverage ratio the three companies achieved on average in FY11, the Outlooks are likely to be revised to Stable. Without any improvement in their financial performance the companies are likely to be downgraded.
It is worth noting that Fitch’s ratings for these companies do incorporate the benefit of their size, strong access to capital and the low cost of funds in Japan. However, at the same time Fitch expects investment grade technology companies on a global basis to retain strong technology leadership for their major business segments, generate operating margins above 5%, and maintain FFO adjusted leverage of less than 3.25x.