Ericsson (Telefonaktiebolaget L.M.)

Transcription

1 Primary Credit Analyst: Thierry Guermann, Stockholm (46) ; Secondary Contact: Lukas Paul, Frankfurt (49) ; Table Of Contents Rationale Outlook Our Base-Case Scenario Company Description Business Risk Financial Risk Liquidity Other Credit Considerations Ratings Score Snapshot Recovery Analysis Reconciliation Related Criteria Related Research SEPTEMBER 18,

2 Business Risk: FAIR Vulnerable Excellent CORPORATE CREDIT RATING bbbbb+ bb+ Financial Risk: MODEST BB+/Stable/A-3 Highly leveraged Minimal Anchor Modifiers Group/Gov't Nordic Regional Scale --/--/K-4 Rationale Business Risk: Fair Volatile and cyclical demand in the telecommunications equipment market. Strong position in mobile networks and related services, albeit weakening in recent years, to a 28% market share in the mobile radio access network in 2016 from 34% in Fierce competition in core markets putting pressure on prices and margins. High restructuring costs and provisions of about Swedish krona (SEK) 18 billion ( 1.9 billion) in 2017, contributing to negative adjusted EBITDA before gradual recovery in following years. Broad geographic and customer diversification, with the 10 largest customers accounting for less than half of revenues. Strong research and development (R&D) budget and large patent portfolio of 42,000 patents. Financial Risk: Modest Strong balance sheet with our estimated reported net cash position exceeding SEK20 billion ($2.5 billion) in 2017 and 2018, and well-spread debt maturities. Volatile cash flow generation over the industry cycle with potentially significant working capital swings. Negative discretionary cash flow (DCF) in 2017 and 2018, close to break even in 2017, but worsening to about SEK4 billion in SEPTEMBER 18,

3 Outlook: Stable The stable outlook reflects our expectation that Ericsson will continue to execute its transformation strategy, helping to slow its revenue decline to 2%-5%, and improve its adjusted EBITDA margins to comfortably more than 5%, in At the same time, we expect that cash outflows for restructuring and other provisions will result in about breakeven or modestly negative free operating cash flow (FOCF) next year. We expect Ericsson will maintain a very conservative balance sheet, with reported net cash of at least SEK20 billion. Downside scenario We could lower the ratings if continued weak demand, strong price competition, market share losses, or higher-than-expected nonrecurring costs prevented Ericsson from improving adjusted EBITDA margins to at least 5% in In addition, continued significant negative DCF generation or a meaningful deterioration in the group's reported net cash position below SEK20 billion could lead to a downgrade. Upside scenario We could raise the rating if Ericsson's operating performance strengthened sustainably. This could be reflected in the adjusted EBITDA margin improving to about 10% or more and stabilizing revenues, accompanied by sustainable annual FOCF of about SEK9 billion. In addition, we would expect Ericsson to preserve an adjusted debt-to-ebitda ratio of below 1.5x and FFO to debt above 60%. Our Base-Case Scenario SEPTEMBER 18,

4 Assumptions Planned capital expenditures (capex) of telecom operators are the primary driver Ericsson's revenues. In our view, operators' spending plans are in turn strongly influenced by major network technology upgrade cycles, such as the roll-out of 4G mobile, which is well advanced in many countries; structural trends, such as continuously rising data consumption; the competitive and regulatory situation; and, to some extent, macroeconomic conditions. We anticipate global GDP growth of 3.6% in 2017 and 2018, compared with 3.1% in Consolidated revenues to decline by a high-single-digit percentage in 2017 (after 9% year-on-year in the first half of 2017), and by 2%-5% in 2018, primarily driven by slower radio access network investments and continued price pressure, and by a SEK10 billion sales decline for managed services and network roll-out. Declining information technology (IT) and cloud infrastructure sales in 2017, but stabilization in following years because we understand Ericsson is investing in new products. Annual restructuring costs of about SEK8 billion in 2017 and SEK3 billion SEK5 billion in 2018, compared with SEK7.6 billion in We assume the cash flow impact for 2017 charges to be equally split over 2017 and Provisions related to the realignment of existing customer projects of SEK9.5 billion SEK11.5 billion in 2017, decreasing to SEK1.0 billion-sek3.0 billion in A meaningful portion of these will affect cash flows over Significant cash inflows from better working capital management in 2017 and to a lesser extent also in Annual capex of about 3% of revenues. Annual dividend payment of SEK3.3 billion in We assume similar dividends in Key Metrics 2016A 2017E 2018E EBITDA margin (%) * 6.3 Negative Reported net cash (SEK bil.) Debt to EBITDA (x)* 0.8 Negative FOCF (unadjusted) (SEK bil.) (0.5)-0 DCF (unadjusted) (SEK bil.) (8.8) (0.3)-0 (3.8)-(3.3) *S&P Global Ratings adjusted ratios. A--Actual. E--Estimate. FOCF--Free operating cash flow. DCF--Discretionary cash flow defined as FOCF minus dividends. SEPTEMBER 18,

5 Company Description Ericsson is the world's second-largest provider of wireless telecommunications network equipment and related services. Its three segments consist of: Networks (74% of total 2016 revenues), which includes hardware, software, and related services for radio access and transport. IT & Cloud (22% of 2016 revenues), which includes operating and business support systems software, telecom core products, and IT cloud products. Media (4% of 2016 revenues), which includes products and services for content owners, broadcasters, TV service providers, and network operators. We continue to include this segment in our base case, although we understand that management is exploring strategic opportunities for the media segment. Business Risk: Fair Ericsson's business risk profile primarily reflects poor industry conditions and intense competition, resulting in the need for significant restructuring activities. As a result, we think Ericsson's operating margins will be below our expectations for the current rating in 2017, before recovering gradually in 2018 and 2019 once restructuring activities are completed, and supported by better prospects for the radio access network market. We think that the global radio access network equipment market will decline by low-single digits in 2018, after a high-single-digit percentage decline in 2017 and a decline by more than 10% in In following years, the market could gradually stabilize before returning to growth, thanks to further investments in 4G and some deployments of 5G, but the timing and magnitude of the recovery is uncertain. At the same time, we think competition will remain fierce, primarily from Huawei and Nokia, leading to continued price erosion. Ericsson's market position has declined in recent years. According to market research group Dell'Oro, Ericsson's market share in the mobile radio access network was 28% in 2016 compared with 34% in However, the decline is primarily due to the fast growth in China, where Ericsson has limited presence compared with Chinese competitors and holds only a 10% to 15% market share. Ericsson has had a long track record of relatively modest restructuring activities. However, following weak industry conditions and management changes since 2016, Ericsson recently accelerated its cost-cutting efforts and now targets doubling its company-adjusted operating margin (excluding restructuring activities) of 6% in 2016 beyond Moreover, the company is projecting charges in connection with adjustments to certain large customer contracts. While we think Ericsson could improve its profitability over time, we expect these costs will weigh negatively on margins at least in 2017 and These weaknesses are partly offset by Ericsson's No. 2 position in mobile networks and related services behind Huawei (30%) but ahead of Nokia (24%), a large installed base with about 40% of the world's mobile traffic running through its networks, and a broad geographic diversity with a presence in all major telecom markets worldwide, focusing on the largest operators in each market. It also has a strong presence in the world's most advanced markets (including the U.S., Korea, and Japan) and most populated areas. Other strengths include a strong R&D budget (about SEK31.6 billion in 2016) and a large patent portfolio of 42,000 patents. SEPTEMBER 18,

6 Our Base-Case Operating Scenario A 10% decline for the networks segment in 2017, following a 11% decline in 2016, and a 3%-5% decline in Continued revenue decline in IT & Cloud in 2017 but stabilization in Gradual recovery of the gross margin in the second half of 2017, to about 30% for the full year, compared with 29.8% in Gradual improvement in following years on the back of efficiency measures, the exiting, renegotiating, or transforming of unprofitable managed services contracts, as well as a continued ramp-up of the Ericsson radio system and new product portfolio in IT & Cloud. Annual restructuring costs of about SEK8 billion in 2017 and SEK3 billion-sek5 billion in 2018, compared with SEK7.6 billion in We include these costs into our EBITDA calculation. Provisions related to customer projects totaling SEK9.5 billion SEK11.5 billion in 2017, decreasing to SEK1.0 billion-sek3.0 billion in Peer comparison We think Ericsson business and financial risk profiles are relatively similar to Nokia's. Nokia has a broader product offering after the acquisition of Alcatel-Lucent, notably within core networks products, but generates better profitability as it has already completed heavy restructuring activities in past years. However, Nokia is still in the process of integrating Alcatel-Lucent, which entails some remaining execution risks. On the other hand, Ericsson has a larger and geographically more diversified installed base within the mobile telecom equipment market, thanks to long-term relationships with the world's largest mobile operators. We also think that Ericsson has a somewhat more conservative stance with respect to shareholder remuneration. Table 1 Ericsson (Telefonaktiebolaget L.M.) -- Peer Comparison Industry Sector: High Tech Equipment Ericsson (Telefonaktiebolaget L.M.) Nokia Corp. Motorola Solutions Inc. STMicroelectronics N.V. Rating as of Sept. 18, 2017 BB+/Stable/A-3 BB+/Stable/A-3 BBB-/Stable/NR BBB-/Stable/A-3 (Mil. ) --Fiscal year ended Dec. 31, Revenues 23, , , ,608.0 EBITDA 1, , ,042.7 Funds from operations (FFO) , Net income from cont. oper (751.0) Cash flow from operations 1,104.0 (1,325.9) ,059.5 Capital expenditures Free operating cash flow (1,802.9) Discretionary cash flow (814.6) (3,317.9) Cash and short-term investments 5, , , ,861.2 Debt 1, , Equity 14, ,975.0 (902.2) 4, SEPTEMBER 18,

7 Table 1 Ericsson (Telefonaktiebolaget L.M.) -- Peer Comparison (cont.) Adjusted ratios EBITDA margin (%) Return on capital (%) 3.2 (4.6) EBITDA interest coverage (x) FFO cash int. cov. (X) Debt/EBITDA (x) FFO/debt (%) 66.3 N.M N.M. Cash flow from operations/debt (%) Free operating cash flow/debt (%) Discretionary cash flow/debt (%) N.M.--Not meaningful N.M N.M N.M N.M. (67.8) N.M. 8.9 N.M. Financial Risk: Modest Our assessment of Ericsson's financial risk continues to be supported by the company's solid balance sheet, with large cash and investment balances that materially exceed reported gross debt, and a prudent financial policy that limits debt. We believe the company will continue to maintain a large cash balance exceeding at least SEK20 billion in Furthermore, Ericsson considerably lowered its dividends in 2017 to SEK3.3 billion (compared with SEK12.3 billion in 2016) and we expect it will continue to adjust its dividend policy to its operating cash flow generation prospects. This is partly offset by our anticipation of negative DCF in Our Base-Case Cash Flow And Capital Structure Scenario Cash flow impact from the restructuring charges reported in 2017 to be equally split over 2017 and Cash outflows from the provisions reported in the first and second quarter of 2017 to be spread between 2017 and Significant cash inflows (between SEK10 billion and SEK20 billion) resulting from better working capital management and due to lower revenues in 2017 and to a lesser extent also in Annual dividend payment of SEK3.3 billion in 2017 and Some spending on small, bolt-on acquisition. Financial summary Table 2 Ericsson (Telefonaktiebolaget L.M.) -- Financial Summary Industry Sector: High Tech Equipment --Fiscal year ended Dec (Mil. SEK) Rating history BBB/Negative/A-2 BBB+/Stable/A-2 BBB+/Stable/A-2 BBB+/Negative/A-2 BBB+/Stable/A-2 SEPTEMBER 18,

8 Table 2 Ericsson (Telefonaktiebolaget L.M.) -- Financial Summary (cont.) Industry Sector: High Tech Equipment --Fiscal year ended Dec (Mil. SEK) Revenues 222, , , , ,779.0 EBITDA 13, , , , ,115.0 Funds from operations (FFO) 7, , , , ,524.7 Net income from continuing operations 1, , , , ,775.0 Cash flow from operations 10, , , , ,722.7 Capital expenditures 6, , , , ,429.0 Free operating cash flow 4, , , , ,293.7 Discretionary cash flow (7,860.9) (1,087.9) 3, , ,661.7 Cash and short-term investments 50, , , , ,708.0 Debt 11, Equity 141, , , , ,904.6 Adjusted ratios EBITDA margin (%) Return on capital (%) EBITDA interest coverage (x) FFO cash int. cov. (x) Debt/EBITDA (x) FFO/debt (%) 66.3 N.M. N.M. N.M. N.M. Cash flow from operations/debt (%) Free operating cash flow/debt (%) Discretionary cash flow/debt (%) SeK--Swedish Krona. N.M.--Not meaningful N.M. N.M. N.M. N.M N.M. N.M. N.M. N.M. (67.8) N.M. N.M. N.M. N.M. Liquidity: Exceptional The short-term rating is 'A-3'. We consider Ericsson's liquidity to be exceptional because we expect its sources of liquidity to amount to at least 2x uses in the two years from June 30, Furthermore, we think the company has good relationships with its banks and displays prudent financial risk management. SEPTEMBER 18,

9 Principal Liquidity Sources We anticipate the following primary liquidity sources over the 12 months started June 30, 2017: Consolidated cash and equivalents of SEK54 billion. An undrawn revolving credit facility (RCF) of $2.0 billion maturing in Annual FFO of about SEK1 billion-sek3 billion. Positive working capital effects, also in connection with noncash nonrecurring items, of SEK4 billion SEK7 billion. Moderate inflow from asset sales. Principal Liquidity Uses We anticipate the following primary liquidity uses over the same period: Annual capex of about SEK5 billion-sek7 billion. SEK3.3 billion annual dividend payments in Repayment of debt maturities and short-term debt of up to SEK3.2 billion. Debt maturities Debt maturities as of Dec. 31, 2016: 2017 SEK4.8 billion 2018 No maturity 2019 SEK0.9 billion 2020 SEK7.7 billion Thereafter SEK10 billion Other Credit Considerations Our rating on Ericsson also reflects currently weak industry conditions and very large restructuring costs, resulting in an adjusted EBITDA margin well below 10%, limited FOCF generation, as well as negative DCF generation in 2017 and Ratings Score Snapshot Corporate Credit Rating BB+/Stable/A-3 Business risk: Fair Country risk: Very low Industry risk: Moderately high Competitive position: Fair Financial risk: Modest Cash flow/leverage: Modest Anchor: bbb- SEPTEMBER 18,

10 Modifiers Diversification/Portfolio effect: Neutral (no impact) Capital structure: Neutral (no impact) Financial policy: Neutral (no impact) Liquidity: Exceptional (no impact) Management and governance: Fair (no impact) Comparable rating analysis: Negative (-1 notch) Recovery Analysis Key Analytical Factors Our recovery rating on Ericsson's senior unsecured notes is '3' with recovery prospects at about 65%. Recovery prospects are supported by the moderate total amount of debt, but reduced by the company's unfunded pension deficit and certain amounts related to the sale of receivables, which we include as priority liabilities in our analysis. We assume the RCF would be drawn at 50% at default, given Ericsson's sizable cash balances. In our simulated default scenario, we assume severe macroeconomic and industry weakness affecting the group's activities, together with increased competition. We think that a continued decline in revenues and market share, combined with a sustained use of large cash balances for restructuring and investments in new technologies or products that do not improve operating performance, would lead to a hypothetical payment default in We anticipate that the group would most likely reorganize in a default scenario, given its geographic spread and established customer relationships, as well as its intellectual property portfolio. We therefore value Ericsson as a going concern. SEPTEMBER 18,

11 Simulated Default Assumptions Year of default: 2022 Minimum capex (% of sales): 1.5% Cyclicality adjustment factor: +10% (standard assumption for the hardware and semiconductors sub-segment of the technology sector) Operational adjustment: +25% (reflecting Ericsson's low leverage and our assumption that on a hypothetical path to default, Ericsson is likely to refinance or raise debt at higher interest rates than currently) Emergence EBITDA after recovery adjustments: about SEK6.4 billion Implied enterprise value multiple: 6.0x Jurisdiction: Sweden Simplified Waterfall Gross enterprise value (EV) at default: About SEK30.7 billion Administrative costs: 5% Tax-adjusted pension deficit adjustment to EV: about SEK8.6 billion Net value available to creditors: about SEK28.1 billion Priority claims: About SEK4.1 billion Unsecured debt claims [1]: About SEK38.6 billion Recovery expectation [2]: 50%-70% (rounded estimate: 65%) Recovery rating: 3 [1] All debt amounts include six months of prepetition interest. Unsecured RCF of $2 billion assumed 50% drawn on the path to default. [2] Rounded down to the nearest 5%. Reconciliation We adjust Ericsson's reported gross debt by adding the following key items: Present value of operating lease liabilities of about SEK12 billion. Net unfunded pension liabilities of about SEK19 billion. We deduct from Ericsson's debt the surplus cash, which we assume would be readily available for debt repayment. We consider cash and cash equivalents of about SEK47 billion as surplus cash. Table 3 Reconciliation Of Ericsson (Telefonaktiebolaget L.M.) Reported Amounts With S&P Global Ratings' Adjusted Amounts (Mil. SEK) Ericsson (Telefonaktiebolaget L.M.) reported amounts Debt Shareholders' equity EBITDA --Fiscal year ended Dec. 31, Operating income Interest expense EBITDA Cash flow from operations Capital expenditures Reported 26, ,817 15,418 6,299 1,355 15,418 14,010 10,612 S&P Global Ratings' adjustments Interest expense (reported) Interest income (reported) Current tax expense (reported) (1,355) (4,143) SEPTEMBER 18,

12 Table 3 Reconciliation Of Ericsson (Telefonaktiebolaget L.M.) Reported Amounts With S&P Global Ratings' Adjusted Amounts (Mil. SEK) (cont.) Operating leases 12, , ,226 2, Postretirement benefit obligations/deferred compensation 19, (94) (94) 275 (24) (1,221) -- Surplus cash (46,919) Capitalized development costs Dividends received from equity investments Non-operating income (expense) Non-controlling Interest/Minority interest Debt - Accrued interest not included in reported debt Debt - Fair value adjustments EBITDA - Income (expense) of unconsolidated companies EBITDA - Gain/(Loss) on disposals of PP&E D&A - Impairment charges/(reversals) EBIT - Income (expense) of unconsolidated companies (4,483) (2,668) -- (4,483) (4,483) (4,483) (120) (31) (31) -- (31) (37) (37) -- (37) Total adjustments (15,099) 1,481 (1,489) (1,371) 1,122 (7,732) (3,479) (4,483) S&P Global Ratings' adjusted amounts Debt Equity EBITDA EBIT Interest expense Funds from operations Cash flow from operations Capital expenditures Adjusted 11, ,298 13,930 4,928 2,477 7,686 10,531 6,129 Related Criteria General Criteria: Methodology For Linking Long-Term And Short-Term Ratings, April 7, 2017 Criteria - Corporates - General: Recovery Rating Criteria For Speculative-Grade Corporate Issuers, Dec. 7, 2016 General Criteria: S&P Global Ratings' National And Regional Scale Mapping Tables, June 1, 2016 Criteria - Corporates - Recovery: Methodology: Jurisdiction Ranking Assessments, Jan. 20, 2016 Criteria - Corporates - General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Dec. 16, 2014 General Criteria: Methodology: Industry Risk, Nov. 19, 2013 General Criteria: Group Rating Methodology, Nov. 19, SEPTEMBER 18,

13 Criteria - Corporates - Industrials: Key Credit Factors For The Technology Hardware And Semiconductors Industry, Nov. 19, 2013 Criteria - Corporates - General: Corporate Methodology: Ratios And Adjustments, Nov. 19, 2013 Criteria - Corporates - General: Corporate Methodology, Nov. 19, 2013 General Criteria: Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013 General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities And Insurers, Nov. 13, 2012 General Criteria: Use Of CreditWatch And Outlooks, Sept. 14, 2009 Related Research Swedish Telecom Supplier Ericsson Downgraded To 'BB+' On Weaker Revenue And Margin Prospects; Outlook Stable. July 24, 2017 Business And Financial Risk Matrix Business Risk Profile Financial Risk Profile Minimal Modest Intermediate Significant Aggressive Highly leveraged Excellent aaa/aa+ aa a+/a a- bbb bbb-/bb+ Strong aa/aa- a+/a a-/bbb+ bbb bb+ bb Satisfactory a/a- bbb+ bbb/bbb- bbb-/bb+ bb b+ Fair bbb/bbb- bbb- bb+ bb bb- b Weak bb+ bb+ bb bb- b+ b/b- Vulnerable bb- bb- bb-/b+ b+ b b- Ratings Detail (As Of September 18, 2017) Ericsson (Telefonaktiebolaget L.M.) Corporate Credit Rating Nordic Regional Scale Senior Unsecured Corporate Credit Ratings History 24-Jul Mar Oct Jul Aug Jan-2013 BB+/Stable/A-3 --/--/K-4 BB+ BB+/Stable/A-3 BBB-/Negative/A-3 BBB/Negative/A-2 BBB+/Negative/A-2 BBB+/Stable/A-2 24-Jul-2017 Nordic Regional Scale --/--/K-4 31-Mar Oct-2016 BBB+/Negative/A-2 --/--/K-3 --/--/K-2 *Unless otherwise noted, all ratings in this report are global scale ratings. S&P Global Ratings credit ratings on the global scale are comparable across countries. S&P Global Ratings credit ratings on a national scale are relative to obligors or obligations within that specific country. Issue and debt ratings could include debt guaranteed by another entity, and rated debt that an entity guarantees. SEPTEMBER 18,

14 Additional Contact: Industrial Ratings Europe; SEPTEMBER 18,

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