S&P Affirms Ratings, Outlook on Nokia (NOK); Sees Alcatel Integration Progressing Smoothly

S&P Global Ratings said it has affirmed its 'BB+' long-term corporate credit rating on Finnish technology company Nokia Corp. (NYSE: NOK). We also affirmed our 'BB+' long-term corporate credit ratings on Nokia's core subsidiaries, Alcatel-Lucent S.A. and Alcatel-Lucent USA Inc. The outlook is positive.

At the same time, we affirmed the 'BB+' issue rating on Nokia's senior unsecured debt. We raised our recovery rating to '3' from '4', indicating our expectation of meaningful recovery in the higher half of the 50%-70% range in the event of a payment default.

We also affirmed our issue ratings on the debt issued by Alcatel-Lucent S.A. and Alcatel-Lucent USA Inc. at 'BB+'. The recovery rating on this debt remains unchanged at '3', indicating our expectation of meaningful recovery in the higher half of the 50%-70% range in the event of a payment default.

We also raised the short-term rating on Nokia Corp. and Alcatel-Lucent S.A. to 'A-3' from 'B'. This is to correct an error where we had previously incorrectly maintained our 'B' short-term ratings for both entities which should have been raised to 'A-3'.

The rating affirmation primarily reflects our view that Nokia is successfully integrating Alcatel-Lucent and is on track to achieve an adjusted EBITDA margin of 10% or more on a sustainable basis after the 2016 transition year. However, the conditions in the wireless infrastructure market have been more challenging than we expected a year ago and Nokia also faced some short-term hiccups in demand due to the integration and harmonization of product portfolios. We therefore lowered our revenue, EBITDA margin, and FOCF expectations for the combined group in 2016, but kept our assumption of a meaningful margin improvement in 2017 and 2018.

In our view, the acquisition of Alcatel-Lucent in January 2016 has strengthened our business risk assessment for Nokia. This is because Nokia's addressable market almost doubled and its product portfolio is now well diversified, including both mobile networks and fixed networks equipment and related software and services. In addition, inclusion of Alcatel-Lucent strengthened Nokia's position in the key U.S. market and we think the overall customer overlap, especially outside the U.S., is limited. Nokia is now No. 2 in the overall wireless telecommunications equipment market after Swedish Ericsson (Telefonaktiebolaget L.M.), No. 2 in the fixed broadband market after Chinese Huawei Technologies, and No. 2 in routers for service providers after U.S.-based Cisco Systems.

Nokia also benefits from market leading research and development (R&D) capabilities, further strengthened by Bell Labs, part of Alcatel-Lucent. The group currently employs more than 40,000 R&D staff and combined R&D expenses totaled €4.5 billion in 2015. Nokia Technologies (4% of the combined revenues in 2015 but with very high margins) manages the portfolio of approximately 30,000 individual patents and patent applications, and has more than 60 active licensees. In addition, Nokia Networks' and Alcatel-Lucent's portfolios include about 57,000 individual patents and patent applications in total.

Nokia has improved its margins during the past few years while Alcatel-Lucent successfully completed its Shift Plan restructuring program in 2015. Combined, the companies reported a non-International Financial Reporting Standards (IFRS) EBIT margin of 10.9% in 2015, but due to the current decline in revenues and the ongoing integration process, we assume materially lower profitability in 2016. However, we think that Nokia's profitability will already benefit from sizable cost synergies in 2017. The group has slightly increased its cost saving targets and now aims to achieve over €900 million annual cost savings in 2018 compared with previous expectations that it would reach about €900 million in 2019.

These strengths are partially mitigated by the volatile and severely price-pressured wireless equipment and services demand (59% of the combined revenues in 2015), as well as strong competition, primarily from Ericsson and Huawei. We expect the wireless infrastructure market to decline at least in 2016, based on the peak in fourth-generation (4G) wireless rollouts in 2015. Nokia's growth has also been subdued compared to Ericsson and Huawei in the past few years, partly as a result of lost market shares due to its focus on profitability. We also view Nokia's profitability as volatile, and note that there are still execution risks relating to the Alcatel-Lucent integration, particularly in case of a longer-than-expected industry downturn. We view Alcatel-Lucent's track record of cash generative operations as short.

Our assessment of Nokia's financial risk reflects the group's very strong balance sheet, including significant cash balances well in excess of reported gross debt. Nokia reported a net cash position of €8.2 billion as of March 31, 2016. This is partly offset by the group's volatile cash flow generation during the industry cycle. In addition, we expect negative discretionary cash flow (DCF) for Nokia in 2016 and 2017 due to high restructuring expenses and significant dividend distributions. In October 2015, Nokia announced a two-year €7 billion capital structure optimization program consisting of €4 billion in shareholder distributions and a €3 billion reduction in the combined company's interest-bearing liabilities and debt-like items. The €3 billion deleveraging was completed at the end March 2016, and we expect the remaining Alcatel-Lucent convertible notes to be redeemed during 2016. As a result, all the remaining debt is senior unsecured and has no financial
covenants.

We adjust Nokia's reported gross debt by adding the following key items:

• About €2 billion receivables factoring outstanding;
• Present value of operating lease liabilities of about €0.8 billion; and
• Net unfunded pension liabilities of about €2 billion.

We also deduct from the debt the surplus cash, which, in our assumption, would be readily available for debt repayment. We think about €1.5 billion–€2.0 billion of Nokia's cash balances and short-term investments do not qualify as surplus cash currently.

Our base case assumes:

• Total revenues declining by 5%-7% in 2016, compared with proforma revenues in 2015, primarily reflecting our expectation of a mid-single-digit decline in the wireless infrastructure market in 2016. In addition, we assume a significant revenue decline in the Nokia Technologies segment--which previously benefitted from nonrecurring items in 2015--primarily due to the arbitration award related to the licensing agreement with Samsung. Nokia's revenues could also suffer from the integration and harmonization of product portfolios.
• Relatively stable revenues in 2017, primarily supported by improving demand trends for Nokia's Ultra Broadband segment and modestly growing revenues at the IP Networks and Applications segment (25% of the combined revenues in 2015). In addition, we expect higher revenues at Nokia Technologies, supported by increased R&D capabilities and investments in some growth businesses.
• Company reported non-IFRS EBIT of about 7% in 2016 and above 10% in 2017.
• Our assumption of restructuring costs of €0.7 billion-€1.0 billion in 2016 and less than €0.5 billion in 2017. We include these costs in our EBITDA calculation. We also assume that the majority of cash outflows will occur in 2017.
• Annual capital expenditures (capex) of €600 million-€800 million.
• Modest acquisitions, including the €170 million acquisition of Withings S.A. in 2016, but no material divestments.
• Ordinary dividend payment of €960 million in 2016, modestly increasing thereafter.
• Special dividend of €600 million in 2016 and the purchase of shares of about €1.5 billion in 2016–2017.

Based on these assumptions, we arrive at the following adjusted credit
measures in 2016–2018:

• Adjusted EBITDA margin of 8%-10% in 2016 and 13%-15% in 2017.
• Negative reported FOCF between €1.7 billion and €1.2 billion in 2016. In addition to restructuring cash outflows, this reflects the €1.6 billion nonrecurring items booked in the first quarter, consisting of a €1 billion reduction in the sale of receivables, €350 million related to the harmonization of working capital processes and practices, and €280 million paid to Qualcomm due to the termination of Alcatel-Lucent's license agreement. We expect positive FOCF between €0.5 billion and €1.0 billion in 2017.
• Funds from operations (FFO) to debt well above 60%.
• Adjusted debt to EBITDA between 0.5x and 1.0x.

The positive outlook reflects the potential for a one-notch upgrade in about 6–12 months if Nokia continues to successfully integrate Alcatel-Lucent and execute its cost cutting plans, industry conditions improve, and Nokia maintains a very conservative balance sheet.

We could raise the ratings if Nokia's revenues are likely to stabilize and, at the same time, the group demonstrates revenue performance at least in line with the industry. An upgrade would also hinge on Nokia being able to sustainably improve its adjusted EBITDA margin to about 10% or more, coupled with prospects of at least break-even DCF generation after the 2016 transition year. In addition, an upgrade would be supported by an adjusted debt-to-EBITDA ratio of below 1x and FFO to debt above 65%.

We could revise the outlook to stable if we think Nokia could report adjusted EBITDA margins sustainably below 10% due to strong price competition, market share losses, or higher-than-expected restructuring costs. In addition, significant negative DCF generation or a meaningful deterioration of the group's reported net cash position below €3 billion could lead us to revise the outlook to stable.

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