Nokia Hit by Another Ratings Downgrade from Moodys
Moody's Investors Service has today downgraded Nokia's long-term senior unsecured debt and the probability of default rating (PDR) to Ba3 from Ba1. The short-term senior unsecured ratings of Not-Prime were affirmed. The outlook on all ratings remains negative.
"Today's rating action reflects our view that Nokia's transition in the smartphone business will cause deeper operating losses and consequently cash consumption in the coming quarters than we had previously assumed," says Wolfgang Draack, a Moody's Senior Vice President and lead analyst for Nokia. "A return to profitability in the Devices & Services (D&S) segment on the back of smartphones with the Windows Phone 8 mobile operating systems is by no means assured," Mr Draack continues.
Nokia reported a 9.1% negative non-IFRS operating margin for the Devices & Services (D&S) segment in Q2, which was far worse than the -5.0% with an improving trend in H2 that Moody's had factored into the Ba1 rating.
The Q2 operating margin includes inventory-related write-offs of about 550 b.p., but according to management the margin may not materially improve in Q3. Moody's thinks this may not even be the weakest period of the product transition and estimates that discounts and inventory-related obsolescence even for the relatively new Lumia range of devices led to an operating loss of more than EUR500 million in the Smart Devices segment. At around 16% gross profit margin, the new Lumia devices are loss-making at operating level at this time.
In view of a very price competitive and fast moving smartphone industry, Moody's expects that the next, Windows Phone 8-based smartphone generation will find it challenging to achieve a level of differentiation and market penetration to become a meaningful income generator in the first few quarters after launch. If the devices are launched and first units shipped in Q4 2012 and find immediate traction, it might still take until mid-2013, before volumes and margins reach a level of sustainable profitability. Given further rather modest profitability in the Mobile Phone business and at Nokia Siemens Networks, Moody's now expect a return to profitability only in the second half 2013.
Such a long period of operating losses, though backed by strong liquidity and the expectation of an eventual turnaround is more commensurate with a Ba3 rating.
The Nokia group has achieved a positive cash flow before dividends in the second quarter, but that was boosted by EUR400 million prepayments on intellectual property and EUR120 million contribution from Nokia Siemens Networks, whose cash flow, however, is likely to be negative in H2, 2012 due to restructuring costs. Moody's estimates that funds from operations in the core business have not materially improved in Q2 and will deteriorate further due to aggressive pricing, cash cost of restructuring and launch cost for the new devices. In Q2, Nokia has been able to compensate cash consumption in operations by cash inflows from monetization of intellectual property and platform payments from Microsoft. Moody's expects management to keep up these efforts but with diminishing proceeds, so that Nokia's strong balance of net cash will gradually erode.
Moody's notes that Nokia has maintained a strong liquidity position and capital structure. At the end of June 2012, Nokia, including 100% of the Nokia Siemens Networks (NSN) communications equipment partnership with Siemens, had approximately EUR9.4 billion of cash and marketable securities, more than twice its reported financial debt. Nokia ended the second quarter of 2012 with EUR4.2 billion of net cash, down from EUR4.9 billion three months before, after paying EUR0.7 billion of dividends to shareholders. For its liquidity needs, Nokia also has a reliable EUR1.5 billion revolving credit facility due in 2016, which does not contain financial covenants.
Yet, in Moody's view a very strong cash position cannot offset operating challenges and losses in the core business for an extended period of time.
The negative outlook on Nokia's Ba3 ratings reflect the low visibility with regard to (i) the trend for Nokia's market share in smartphones and whether the Windows-based devices can attain a solid market share with positive income contribution to Nokia; (ii) demand and margin potential for the group's feature phones in emerging markets; and (iii) Nokia's future net cash flows, which are adversely affected by pricing pressure, marketing incentives and restructuring expenditures, although this is partially mitigated by royalty collections, platform payments from Microsoft and potential disposal proceeds.
Given that the rating outlook is negative, there is currently limited potential for an upgrade of Nokia's ratings. However, Moody's could upgrade the rating if (i) Windows devices make meaningful gains in the smartphone market and achieve a positive margin; (ii) Nokia's revenues start to grow again and it achieves a clear positive non-IFRS operating margin as reported by Nokia (-4.0% for the first half 2012, as adjusted by Moody's); and (iii) the group maintains a comfortable adjusted net cash position (approximately EUR1.8 billion as per the end of June 2012, as adjusted by Moody's).
Moody's would stabilise Nokia's outlook if (i) the Lumia family of devices gains meaningful market share and the Smart Devices segment returns to non-IFRS operating profit; (ii) the margin contribution of the Mobile Phones segment advances to the high single digits in percentage terms (4.5% in H1/2012); and (iii) the group's cash consumption falls to marginal levels.
Moody's would consider downgrading Nokia's rating further if there is evidence that the Lumia product family is failing to gain a robust market share or is not trending towards profitability; or if Nokia's cash consumption accumulates over the coming quarters such that the group's reported level of net cash approaches EUR1.5 billion (EUR4.2 billion at end of June 2012). The rating anticipates a very weak Q3 in terms of profitability, but general improvement thereafter.