Ericsson Profit Margins Under Pressure - But Better Prospects Than Rivals

Fitch has affirmed the debt ratings for Ericsson as stable and the Issuer Default rating (IDR) and senior unsecured rating of 'BBB+.' Fitch said that the affirmation of Ericsson's ratings reflect the company's leading industry position in mobile network equipment, a growing Professional Services business, which should provide some earnings protection in light of the coming industry downturn, healthy liquidity and strong balance sheet.

Fitch also noted that operating margins, which have shown good progress in 2008, following the October 2007 profit warning, are likely to face renewed pressure. However, as the industry leader (in mobile) Ericsson should preserve margins better than a number of its competitors, most of whom already exhibit much lower margins.

While infrastructure markets face the prospect of a downturn in 2009, with Fitch currently anticipating an overall industry decline in the mid-to-high single digit range, Ericsson's strength in mobile communications and in particular its position in the growth markets of China and India, should provide some revenue and earnings support.

While demand remains for key fixed line technologies, Ericsson's strength in mobile (where it is the market leader with an estimated 35% of the GSM/ WCDMA market) has seen it perform more strongly than Alcatel-Lucent (traditionally much stronger in fixed technologies) and Nokia-Siemens ('NSN'; the market no. 2 in mobile networks). Operating margin (before restructuring) at Ericsson in its networks business (for 3Q08) was 11% (vs. 5.1% at NSN).

The outlook for network investment, while generally expecting revenue declines in 2009, is in Fitch's view more visible than for handsets at present, where volume declines of more than 5% are generally expected but where the absolute extent of the downturn remains uncertain. In networks Ericsson has strong market positions in India, China and Latin America which will continue to exhibit healthy growth - albeit network sales in China and India are intensely competitive and therefore lower margin by nature. Fitch does expect margin pressure in 2009 for Ericsson, given the need to maintain market share in these markets. The consolidation that has taken place in the industry over the past 2-3 years (eg. Alcatel-Lucent and NSN) and an apparent easing in the pricing environment in early 2008, offer some pricing and margin support. In China the company is the market leader in GSM and where WCDMA is expected to play a meaningful position in 3G role-outs.

While conditions in the handset industry are a concern for Ericsson, given its 50% stake in Sony-Ericsson, the latter results do not directly impact Fitch's measure of EBITDA or cash flow (beyond the fact that dividends which had started to become quite meaningful are now unlikely, at least through 2009). Weakness at Sony-Ericsson could drive further restructuring and associated provisions while operating losses, should they materialise, will need to be funded. That being said, Sony-Ericsson had close to €1.5bn of cash (€1.4bn of net cash) at 3Q08, and is therefore likely to be able to weather weak conditions / results for some time without any kind of parent support.

Liquidity at Ericsson remains strong, with net cash of SEK30.2bn (€2.8bn) at 3Q08. While this value will reduce once Ericsson completes its investment in the ST wireless chipset JV (cash cost of US$1.1bn) the company will remain well capitalised and with healthy liquidity. Cash conversion has also improved since the company's profit warning in 3Q07, with Ericsson's target measure of CFO/FFO of better than 70%, currently being comfortably achieved (with an LTM ratio above 100%). Additional liquidity is provided by an undrawn USD2.0bn backup facility maturing 2014. Along with Nokia, Ericsson have made clear public statements about not getting back into the vendor finance business, with Nokia's resistance to this type of exposure removing a potential competitive pressure.

Fitch notes that working capital flows can be material in the networks business. A flat to negative growth environment would traditionally point to positive working capital flows. However the ongoing strength of anticipated network rollout in emerging markets (which is more capital intensive) could upset this pattern. Operating margin performance in Networks in the mid-high single digits combined with the maintenance of a healthy net cash position are considered important in the context of maintaining current ratings through the industry downturn.

Posted to the site on 19th December 2008