UPDATE: S&P Upgrades Alcatel-Lucent (ALU) to 'B'; Sustainability Program On-Track for Op. Margin Improvement

(Updated - August 18, 2014 9:45 AM EDT)

Standard & Poor's Ratings Services raised its long-term corporate credit ratings on French-American telecommunications equipment supplier Alcatel-Lucent (NYSE: ALU) and its subsidiary Alcatel-Lucent USA Inc. to 'B' from 'B-'. The outlook is stable. We also affirmed the 'B' short-term rating on Alcatel-Lucent.

At the same time, we raised our issue rating on the senior secured term facilities issued by Alcatel-Lucent USA to 'BB-' from 'B+'. The recovery rating on these facilities is '1', indicating our expectation of very high (90%-100%) recovery for debtholders in the event of a payment default. We expect to withdraw the issue rating later this week, once we get confirmation that the facilities have been redeemed in full.

We raised our issue ratings on Alcatel-Lucent's recently issued €688 million and €460 million convertible bonds to 'B' from 'B-'. The recovery rating on the bonds is '4', indicating our view of average (30%-50%) recovery prospects in the event of a payment default.

We also raised our issue ratings on the group's remaining senior unsecured debt instruments to 'B' from 'CCC+' and removed them from CreditWatch with positive implications. The recovery rating on these debt instruments is '4', reflecting our expectation of average (30%-50%) recovery for debtholders in the event of a payment default.

The upgrade primarily reflects our expectation that Alcatel-Lucent is on track with its restructuring program to sustainably improve its operating margins in 2014 and 2015. In addition, the group has sharply reduced its interest costs and improved its liquidity by refinancing expensive debt instruments with cheaper long-term debt. As a result, we now expect a marked improvement in the group's interest cover ratios in the next 12 months, as well as almost break-even free operating cash flow (FOCF) in 2015, compared with negative FOCF of about €0.7 billion in 2014.

Nevertheless, we continue to assess the group's financial risk profile as "highly leveraged," which primarily reflects our expectation of still-high Standard & Poor's-adjusted gross leverage ratios, including debt to EBITDA and funds from operations (FFO) to debt well above 5x and below 10%, respectively, in 2014 and 2015. Our projections of volatile credit measures through the industry cycle also underpin our assessment.

We continue to assess the group's business risk profile as "weak," which primarily reflects the group's still relatively low profitability relative to many of its peers, partly due to continued significant restructuring needs. The group reported a 4.8 percentage point year-on-year improvement in operating margins (before restructuring costs) in the first-half of 2014 to 2.7%. However, reported operating margins after restructuring costs were still a negative 3.4% in the first half of 2014.

In addition, the group faces fierce competition, volatile demand, and has substantial operating leverage due to a highly fixed-cost base. This is partly mitigated by Alcatel-Lucent's solid diversification in terms of technologies and products, as well as its leading positions in fixed-line access, internet protocol (IP) and fiber optics transmission, and core network technologies.

Under our base case, we assume:

• Flat- to low-single-digit organic revenue growth in 2014, based on our expectation of roughly flat revenues in its Core Networking segment, and modestly growing Wireless Access revenues. This excludes revenues from the Managed Services subsegment, which we expect to decline by more than 50% in 2014.
  
• Revenue growth of 4%-6% in 2015, primarily due to solid revenue growth in the group's subsegments IP Routing, IP Transport and Fixed Access, partly offsetting lower wireless equipment revenues.
  
• An operating margin improvement (as adjusted by Alcatel-Lucent) toward about 5% in 2014 and 6%-7% in 2015, up from 2.0% in 2013, primarily on the back of the group's continued cost cutting, higher gross margins due to a better product mix and higher revenues, and the exiting from unprofitable managed services contracts and geographies.
  
• Continued high cash outflows from restructuring of about €0.50 billion to €0.55 billion in 2014, and about €0.45 billion to €0.50 billion in 2015, compared with €0.52 billion in 2013.
  
• Moderately negative working capital requirements of about €0.2 billion to €0.3 billion in 2014 and 2015.
  
• €550 million to €600 million in capital expenditures in 2014 and 2015, up from €528 million in 2013.
  
• Disposal proceeds of up to €0.4 billion from the divestment of subsidiaries LGS Innovations LLC and Alcatel-Lucent Enterprise, to be received in part in 2015.

Based on these assumptions, we arrive at the following credit measures for Alcatel-Lucent:

• Standard & Poor's-adjusted gross debt to EBITDA of more than 10x and FFO to debt of about 2.0% at year-end 2014, improving to about 7.0x and 8.0% by year-end 2015, compared with 20.5x and negative 2.8% at year-end 2013.
  
• EBITDA interest coverage ratios, as adjusted by Standard & Poor's, of about 1.5x at year-end 2014 and about 3x at year-end 2015, up from 0.6x in 2013.
  
• Close to break-even FOCF in 2015, compared with FOCF of approximately negative €0.7 billion in 2014 and negative €663 million in 2013.

We assess Alcatel-Lucent USA as a core subsidiary for its 100%-owner Alcatel-Lucent. We view Alcatel-Lucent USA's as integral to the group's operations, identity, and future strategy. In addition, we understand that Alcatel-Lucent USA generates most of the group's profits. Our long-term corporate credit rating on Alcatel-Lucent USA is therefore the same as that on Alcatel-Lucent.

The stable outlook primarily reflects our expectation that the group will demonstrate further improvement in its operating margin (Alcatel-Lucent-adjusted) toward about 5% for the full year 2014 and 6%-7% in 2015, coupled with prospects of achieving close to break-even FOCF generation (excluding potential asset disposal proceeds) in 2015.

We could raise the ratings if Alcatel-Lucent achieved stronger operating margin improvement and better FOCF generation than we currently expect for 2015 as a result of higher-than-expected revenue growth or higher-than-expected gross margins. In particular, an operating margin (Alcatel-Lucent-adjusted) of about 8%-9% and sustainable positive FOCF could support a one-notch upgrade.

We could lower the ratings if Alcatel-Lucent's FOCF generation does not materially improve compared with the expected cash burn of €0.6 billion to €0.7 billion in 2014 or if the group's operating margins (Alcatel-Lucent-adjusted) remain in the low-single digits in 2014 and 2015 as a result of stronger-than-expected competitive pressure on revenues and gross margins or insufficient cost-cutting measures. This could also lead us to revise down our business risk assessment on Alcatel-Lucent to "vulnerable" from "weak."

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