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Fitch Revises Ericsson's Outlook to Negative

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Fitch Ratings has revised the Outlook on Sweden based Ericsson's debt ratings to Negative from Stable and affirmed the IDR and senior unsecured rating at 'BBB .'

­The revision of the Outlook reflects concerns over an increasingly competitive telecoms equipment supply industry, as well maturing telecoms service markets. These adverse market conditions are weighing on Ericsson's operating and free cash flow margins, which began to weaken in 2011 and remained so in 2012. The company had been clear that the margin profile would weaken through 2011 and 2012.

The Negative Outlook has been prompted by the lack of visibility around when and how margins will recover.

Ericsson has been guiding to and delivering lower networks margins since early 2011. Fitch remains concerned about how this profile is likely to change. Management are targeting a return to double digit operating margins in this division but declined to give any timeframe for this happen, at its recent Investor Day in November. It also did not provide guidance as how it expects its overall gross margin structure to change, with the agency's concern reflecting the fact the company has lost over 8 percentage points of gross margin in the past six quarters.

Margin pressure has been a function of the nature of network revenues, primarily reflecting a grab for market share by Ericsson in 2010 when bidding on network modernisation contracts in Europe. This involves a labour-intensive swap-out of old 2G and 3G base stations for new multi-standard base stations, which should inevitably lead to higher margin upgrade and expansion work in the future. The mix of network coverage revenues along with the increasing share of services revenue in the overall mix, has also contributed to this pressure.

In addition to the networks division (accounting for 49% of Q312 revenues and posting a Q312 operating margin of 5%) the group comprises Global Services (45% of revenues; operating margin 8%) and Support Solutions (6% of revenues; operating margin 14%); together generating a combined margin excluding JVs of 7% in 3Q12. Global Services is an inherently lower gross margin but growing and less volatile margin business. Support Services, which provides software solutions for things like over the top content and data monitoring and management is a far more nascent business. While margins are currently strong, positive margins are a relatively recent development and it remains to be seen what sustainable margin levels are in the segment.

Fitch accepts that Ericsson's qualitative and quantitative factors map well against its network equipment peer group. The limiting factor in this benchmarking is that the peer group almost without exception, exhibits a weak credit profile.

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