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China's 4G Rollout Boosts ZTE's Financial Profile

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Fitch Ratings says the rollout of China's 4G networks has provided ZTE an opportunity to repair its credit profile and deleverage, with encouraging signs evident in its 1H14 financial results.

Fitch said that it may consider an upgrade if ZTE's operating EBIT margin (including VAT refunds) rises to over 5%, funds flow from operations (FFO)-adjusted leverage falls below 5x, FFO-adjusted net leverage falls below 3x and it generates positive operating cash flow, all on a sustained basis.

Fitch continues to expect China to account for 60% or more of ZTE's network revenue in 2014-2015, driven by strong 4G capex. China Mobile has maintained its 2014 capex budget at CNY225bn and expects to keep a high capex budget for 2015 as the operator aims to speed up 4G rollout and customer acquisitions. The other two Chinese operators have also been permitted to roll out trial frequency division duplex long-term evolution (FDD LTE) networks in 16 cities, which will further fuel operators' 4G capex.

Robust China network revenue and profitability are likely to continue to support the recovery in ZTE's financial profile in the next 12-18 months, despite increased competitive pressure on the company's smartphone business. The robust growth in the higher-margin China network revenue offset the 16% yoy decline in low-margin terminal revenue in 1H14. Overall segment margin, before corporate overheads and unallocated expenses, rose to 18% in 1H14 from 14% in 1H13. Network segment margin improved to 24% in 1H14 (1H13: 21%), compared with terminal segment margin of below 2% during the same period.

A meaningful smartphone contribution looks unlikely in the next two years. Fitch believes rapid commoditisation of smartphones, saturation in developed markets, and increasing competition from other Chinese vendors will present a challenge to ZTE's smartphone ambitions.

Although the profitability of ZTE's smartphone business rebounded in 1H14 from 2H13 due to an end of inventory correction, ZTE's market position continued to slip. According to IDC, ZTE has not ranked among the top five smartphone vendors since 3Q13. In China, ZTE's smartphone market share fell to just 2.9% in 2Q14 (2Q13: 5.8%), according to Analysys International.

Fitch expects improving cash flow from operations to support deleveraging in 2H14 and 2015. ZTE's net cash flow from operating activities in 1H14 turned positive for the first time in the past decade and reached CNY1bn, against a net cash outflow from operating activities of CNY5.7bn in 1H13. Cash generation is typically stronger in the second half of the year. Net debt of CNY13bn at end-June 2014 was little changed from CNY12bn at end-2013. However, gross debt dropped to CNY29bn at end-June 2014 from CNY33bn at end-2013, including factored receivables of CNY5bn.

While China's 4G capex should bolster ZTE's financial profile, we believe the company may need to reduce its dependence on Chinese telecoms capex before the current cycle peaks to maintain a robust credit profile over the longer term. The global telecoms equipment market is characterised by cyclical demand and intense competition. In addition, ZTE's weaker position in Europe, its smaller 4G global market share, its dependence on China, and increasing competition in the smartphone industry continue to constrain its ratings.

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Tags: zte  fitch ratings  China