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ZTE's Debt Ratings Outlook Revised to Positive Despite Weak Smartphone Prospects

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Fitch Ratings has revised China based ZTE's outlook to Positive from Stable, and affirmed its long term debt rating at 'B '.

At end-June 2013, ZTE had gross debt of CNY35.5 billion (USD5.8 billion).

­The revision in the Outlook reflects Fitch's expectation of a reversal of the decline in ZTE's credit profile, driven by China's 4G network rollout and the company's strategic refocus and cost reductions.

However, the ratings are constrained by high financial leverage, the highly competitive global telecoms equipment market, which is characterised by cyclical demand, ZTE's weaker position in Europe, its smaller 4G market share in developed markets, its over-dependence on China, and increasing competition in the smartphone industry.

China's 4G rollout is expected to provide ZTE an opportunity to repair its credit profile and deleverage. Fitch expects China to account for over 60% of ZTE's network revenue in the next two years. The Chinese government awarded the 4G licences to all three Chinese telecoms operators in December 2013, which Fitch expects to drive a modest growth in Chinese telecoms capex in 2014. The ratings agency added that it expects licensing of FD based LTE technology in next 12 months to fuel operators' capex in 2015.

Network Division Driving Margins

Fitch expects further margin improvement within the network division in the next 12-18 months, driven by more China contracts and the completion of low-margin European modernisation contracts.

Network gross margin rebounded to 32.4% in 1H13, from 26.5% in 2012. However, Fitch does not expect ZTE's margins to recover to historical highs as the smartphone division will weigh on overall margins. They believe ZTE may need to reduce its over-dependence on Chinese telecoms capex before the current cycle peaks to maintain the recovery in its margins.

Smartphone Challenges

Fitch believes that rapid commoditisation of smartphones, saturation in developed markets and Lenovo's new access to North and Latin American markets through its Motorola acquisition will present a significant challenge to ZTE's smartphone ambitions in those markets.

Also ZTE's smartphones are struggling domestically - market share contracted to 5.4% in 3Q13 from 9.7% in 3Q12, according to iiMedia Research. Gross profit of ZTE's terminal segment fell 19% yoy in 1H13.

Meaningful smartphone contribution looks unlikely in next two years.

Adequate Liquidity

ZTE's liquidity remains satisfactory. Unrestricted cash of CNY16bn at end-June 2013 exceeds the CNY13bn of short-term loans and the current portion of long-term debt. The company is well supported by Chinese banks. Unused banking facilities totalled CNY48bn at end-June 2013. In addition, we expect positive free cash flow in 2H13 and 2014.

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