Debt ratings agency, Fitch has warned that the outlook for the global telecom equipment sector in 2009 is negative based on expectations of declining markets in both handsets and infrastructure. Ratings across Fitch's rated telecom equipment portfolio are exhibiting lower rating headroom, although the agency does not at present envisage a major re-rating of these companies given healthy liquidity, some margin protection and limited refinancing risk.

Nevertheless, concerns remain for the sector more generally given the relative performance weakness at vendors such as Alcatel-Lucent and Nortel Networks, where earnings and cash flow remain weak and further major restructuring is now taking place. In the case of Nortel there are questions over its long-term sustainability given the degree to which it has become marginalised in an increasingly global industry.

"While credit conditions are not conducive for large-scale M&A, further industry consolidation could be seen, with the failure or disposal of some parts of these businesses providing scope for the market leaders to increase market position and/or acquire assets at marked down prices," says Stuart Reid, Senior Director at Fitch's European TMT team. Fitch anticipates margin pressure across the sector, with a lack of visibility, particularly in the handset market, reducing rating headroom at those vendors with significant exposure to mobile devices.

While visibility is limited across the industry, Fitch believes it is possible that the handset industry could experience a more significant decline than was seen in the last down-cycle in 2001. This is attributed to current global macroeconomic conditions, and the degree to which handsets have become commoditised and in some markets reliant on carrier subsidies (which are likely to be reduced in the current environment). These conditions are likely to extend the handset upgrade cycle, which is an important driver for an industry where upgrades represent more than 50% of unit sales.

The degree to which sales have slowed in the latter part of 2008 and the pace at which the macroeconomic climate has deteriorated make clear guidance on volume declines in 2009 particularly difficult to forecast. However, Fitch - like key industry players - believes that declines are likely to be more than mid-single digit. This uncertainty and the broad margin guidance recently issued by industry leader, Nokia, for its devices & services division, suggest that significant earnings volatility and margin compression is a risk across the sector. Despite this, the strength of margin performance at Nokia until now, along with its scale and cost structure, suggests it will survive the downturn with stronger margins than most of the mass market handset vendors, and potentially with a stronger market position given the more vulnerable position of some of its smaller competitors.

While infrastructure markets are, likewise, expected to decline in 2009, Fitch expects the downturn to be less severe than that seen in 2001. With key industry players guiding to mid-to-high single digit revenue declines for the industry, Fitch considers some revenue support will be provided by growth in emerging markets such as China, India and Latin America. Furthermore, in developed markets, telecom carriers generally remain in good financial shape and have yet to signal a major retrenchment in capital spending in the face of more limited revenue growth.

A trend that should provide some medium term revenue and margin support is the increasing use of vendors' outsourcing capabilities to run operator networks. Each of the top three vendors, Ericsson, Nokia-Siemens Networks and Alcatel-Lucent, have been developing these services, which provide vendors with a stable and recurring revenue streams with relatively good operating margins (eg. mid-teens at Ericsson) and potential to lock-in customers to multi-year contracts, while generating operating expense savings and synergies for the carriers.

While two Fitch-rated issuers, Motorola and Nokia, currently have Negative Outlooks, it is fair to say that rating headroom will be lower across the agency's telecom equipment portfolio throughout 2009. This view reflects the prospect of margin pressure in both handset and infrastructure markets and weaker visibility regarding operating cash flow trends (which could experience working capital pressures as customers and / or suppliers demand more attractive trade terms). Solid net cash positions at major European vendors, at least, provide some protection as does scale and industry leadership, which are both important in the context of margin protection and an ability to influence pricing.

The full report (pdf file, 9 pages) is available on the Fitch website - free registration required.

Posted to the site on 6th January 2009

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