S&P Downgrades Long-, Short-Term Ratings on STMicroelectronics N.V. (STM) to 'BBB-/A-3'

Standard & Poor's Ratings Services said today that it had lowered its long- and short-term corporate credit ratings on Franco-Italian semiconductor manufacturer STMicroelectronics N.V. (NYSE: STM) (ST) to 'BBB-/A-3' from 'BBB/A-2'. The outlook is stable.

The downgrade reflects our anticipation that ST's operating performance will remain subdued over the next two years, partly due to weaker near-term industry demand, volatile revenue growth, and continued intense competition. In addition, we expect ST's adjusted EBITDA margin to remain lower than 20%, which is below the average profitability of many of its peer companies. This has led us to revise our assessment of the company's business risk profile to "fair" from "satisfactory."

We understand the company is targeting a 10% operating margin, which would only translate into a Standard & Poor's-adjusted EBITDA margin of about 20% (including restructuring costs). In our view, ST is unlikely to achieve this target until 2016 at the earliest. Still, we expect profitability to gradually increase because management is committed to reducing quarterly operating expenses to between $550 million and $600 million--including research and development (R&D) grants of about $30 million per quarter--and supporting its gross margin by improving manufacturing efficiencies. In addition, ST has recently announced additional restructuring at its Digital and Imaging segments to further reduce annual costs by $100 million from the third quarter of 2015. Furthermore, the recent weakening of the euro against the dollar will modestly support ST's profitability in 2015 because a large share of its costs is in euros, while the majority of its revenues are in U.S. dollars.

Our assessment of ST's business risk profile as "fair" reflects the company's relatively low and volatile profitability, despite public-sector funded R&D programs, which support profit margins. In our view, this is attributable to a relatively high proportion of fixed costs, with capacity utilization affecting margins. Other constraints include revenue volatility linked to global semiconductor demand, given the commoditization of many of ST's products; rapid technological changes; and intense competition that requires ST to incur sizable R&D expenses to stay competitive. These weaknesses are partly offset by the company's leading market positions for many customized high-performance analog, digital, and mixed-signal semiconductor applications and generally solid market positions in the industrial, consumer, automotive, and computer peripheral sectors. In addition, ST has broad product, end-market, and customer diversity, with no customer contributing more than 10% of its net
revenues.

We assess ST's financial risk profile as "modest," based on the group's strong balance sheet, with cash balances and short-term investments exceeding gross financial debt. In addition, we consider almost all the company's reported cash balances and short-term investments to be surplus cash, primarily because they are held at the parent company, thanks to a very efficient cash pooling system. These strengths are partly moderated by ST's potentially very volatile credit ratios during a major economic and semiconductor market downturn, owing to its relatively weak operating margins, high operating leverage with limited outsourcing, and our expectation of only moderate free operating cash flow (FOCF) in 2015-2016. We expect FOCF conversion to revenues of about 5% in 2014, increasing only moderately in 2015 and 2016. We also forecast limited discretionary cash flows after dividend payments. However, ST determines its dividends every six months, and we believe this could allow it to quickly adjust payouts in the event of a significant and unexpected industry downturn.

The stable outlook reflects our expectation of gradual profitability improvements, modest revenue growth, and positive discretionary cash flow for ST over the next 24 months.

We could raise the ratings if ST maintains a solid net cash position while successfully turning around its operating performance. Specifically, we could raise the rating if ST's revenues increased at least in line with the industry, with an adjusted EBITDA margin of at least 20% on a sustainable basis. We think this would translate into annual FOCF in the $700 million-$1 billion range.

Rating downside is remote over the next two years, given ST's strong balance sheet. However, we could lower the ratings if ST's operating performance deteriorated, for instance, due to continued revenue declines or materially lower revenue growth compared with the market average for a prolonged period. Although unlikely, we could also lower the ratings if ST's capital structure weakened as a result of aggressive debt-financed acquisitions.

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