OREANDA-NEWS. Fitch Ratings has affirmed Netherlands-based STMicroelectronics N.V.'s (STM) Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB-'. The Outlook on the IDR is Stable.

STM's rating is supported by the company's strong position within a number of key growth segments in the semiconductor market and the maintenance of a conservative financial policy. The restructuring and potential exit of unprofitable and declining business lines are affecting the company's financial performance which Fitch expects may continue over the next 18 to 24 months. STM is set to announce its decision for the underperforming elements of the company's Digital Product Group (DPG) in early 2016.

STM has some financial flexibility within its rating to manage a restructuring of the DPG assuming there is no significant macro-economic downturn and it maintains its market share within its core profitable segments. If a solution for DPG can be found, it could lead to a strengthened credit profile based on a more focussed set of well-positioned product lines with improved margins exposed to growing segments of the semiconductor market.

KEY RATING DRIVERS

Mixed Portfolio
STM has a diversified customer base and product portfolio servicing a number of industry sectors and applications, which account for approximately 40% of a global USD360bn market for semiconductors. In many of these segments, such as Automotive, Analogue and Industrial, STM has a leading position with a market share in the top three. This is offset by challenges the company faces primarily within its Digital (part of DPG) and Microsystems units (accounting for approximately 25% of FY14 revenues) which are either declining and / or materially unprofitable and subject to potential restructuring.

Post Restructuring Focus
STM's current group operating margin of 2% to 3% is low compared with many of its peers with margins typically between 12% and 20% and sector leaders such as Intel (A+/Stable) and Texas Instruments (A+/Stable) with operating margins between 25% and 30%. Fitch estimates that STM could raise its group operating margins to between 8% and 12% in the medium term, if management achieve its announced segment targets for Embedded Processing Solutions and Sense & Power and Automotive Products.

We believe the chances of STM achieving the lower end of its target are reasonably good. The company is set to detail its solution for the underperforming elements of DPG in early 2016, which could lead to the restructuring of the unit. Greater efficiencies in manufacturing, improved capacity utilisation, cost reduction, maintaining or improving market share within profitable segments and revenue growth will be key to the improvement and also in determining the extent to which the lower end of targets are exceeded.

Fitch expects that any solution to addressing the underperformance within DPG is likely to continue to impact STM's financial performance over the next 18 to 24 months. There is some uncertainty around what will happen to DPG. We expect the company to give more detail in 1Q16. However, pre-dividend free cash flow is likely to improve over the next two years assuming no major cyclical downturns and will provide the company some flexibility to absorb one-off restructuring charges that might be incurred during the process. Once a solution is found it could lead to a strengthened credit profile based on a more focussed set of well positioned product lines with improved margins.

Conservative Financial Policy
At the end of 3Q15, STM had a net cash position of USD459m. Fitch forecasts funds from operations (FFO) adjusted leverage is likely to peak in FY15 at around 3.0x from 2.8x in FY14. In our rating case scenario, we expect FFO adjusted leverage to gradually decline to 2.2x by FY18 driven by revenue growth and margin improvement. The maintenance of a minimum net cash position around current levels is key to the company's rating given operational and sector risks.

Scale and Focus Increasingly important
Although STM has a leading position within its core product areas, the semiconductor market remains highly fragmented. While the sector is expected to continue to grow strongly over the next five years, the pace of growth is likely to slow as the market approaches an early stage of maturity. Within this context, we believe scale, segment focus and specialisation are likely to play an increasingly important role in driving the economics and competitive capability within the sector. This reflects the importance of R&D and innovation in the sector to drive both growth and maintain market share.

STM is well positioned for many of the growth areas in the sector such as Internet of Things (IoT), Automotive and Industrial. Its broad product and applications portfolio will also be beneficial for the IoT sector. However, the company's manufacturing facilities are running at a utilisation level of around 80%. This provides some scope for operational leverage.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
- Revenue decline of 8% YoY in FY2015 and 3% growth per year between 2016 and 2018.
- A gradual reduction in Sales, General and Administrative (SG&A) expenditure equating to a two percentage point improvement in SG&A as percentage of sales between FY15 and FY18.
- R&D expenditure of USD1.4 to USD1.5bn per year.
- An improvement in operating margin from 2.3% in FY14 to 6% in 2018 driven by improvement in gross margin and reducing SGA.
- Stable capex at USD500m to USD550m per year.
- Stable dividends at USD350m per year.

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- Consolidated operating margins trending consistently in the mid-single digit range.
- Low-single digit free cash flow margin (post-dividend cash flow to sales).
- Stable operating environment and competitive market position.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Failure to generate anything more than zero to low-single digit operating margins on a consolidated basis.
- Ongoing losses within the DPG without a successful resolution within the next two years.- Failure to generate positive free cash flow on a sustainable basis, which would likely lead to a downgrade in the absence of management action (ie. capex and or dividend cuts).
- Failure to maintain a sustainable net cash position, in the event that FCF visibility and or margins do not improve.