OREANDA-NEWS. Fitch Ratings has upgraded Finland-based Nokia Corporation's (Nokia) Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'BB+' from 'BB'. The Outlook on the IDR is Positive.

The upgrade reflects Nokia's improved operating profile following its acquisition of Alcatel-Lucent, steady operational progress in the company's core network and technologies division and sustained 2015 financial performance at Alcatel-Lucent despite the lengthy acquisition process. While integration risks remain, Fitch believes these are manageable. Nokia has a strong balance sheet position with a net cash position of EUR7.78bn (end-2015) that provides the company with flexibility for managing cyclicality, sector risks and investments. We expect Nokia to reduce debt by EUR3bn in line with its capital structure optimisation programme announced in October 2015.

The Positive Outlook reflects our view that the potential extraction of acquisition synergies, further operational improvements and a strengthening market position, combined with greater visibility on cash generation, is likely to allow Nokia to achieve a low investment grade rating in the medium-term.

KEY RATING DRIVERS
Improved Operating Profile
The acquisition of Alcatel-Lucent has improved Nokia's medium- to long-term operating and business risk profile as a result of greater scale, expanded customer reach, R&D cost amortisation, greater innovation scope, a broader product portfolio and potentially stronger margins through cost reduction. Fitch believes that the combined entity will be better- positioned to compete in a highly competitive, rapidly changing industry where scale, innovation and customer reach are key to profitably, as well as growing and maintaining market share.

The greater scale and broader product portfolio improve Nokia's diversification and alleviate risks to its original strategy, which was to focus on wireless infrastructure and services only. A slowdown in the sale of 4G equipment as mobile operators complete their LTE roll-out, greater convergence in fixed and mobile networks and IP and cloud services could have otherwise seen Nokia struggle in the long run.

Cost Reduction Potential
Nokia envisages that the Alcatel-Lucent acquisition will yield annual operational cost savings of EUR900m by 2018, a year earlier than originally envisaged, with associated one-off integration and restructuring costs of EUR900m. Nokia estimates that on a pro-forma basis, the reduced costs would improve the 2014 margins of the combined entity to 12% from 8.7%. The main areas of synergies include product and service overlap, sales force optimisation, supply chain and procurement and overhead costs.

Sustained Execution and Integration
At end-2015 both Nokia and Alcatel-Lucent showed continued improvements in operating margins and operating cash flows on the back of restructuring and focus on more profitable segments and geographies where both entities have capabilities to sustainably compete.

However, a lack of pro-forma consolidated financial information, potential integration risks and a track record of operating as a combined entity, create a lack of visibility in cash flows at this stage that result in a more cautious rating approach. Our scenario analysis indicates that a combination of sustained operational performance and extraction of integration synergies, assuming no major cyclical downturns and changes in the sector risk profile, is likely to see sustainable improvements in the company's cash generation. Greater visibility on these elements will be key to Nokia achieving an investment-grade rating.

Conservative Financial Policy
At end-2015, Nokia had a strong net cash position of EUR7.78bn. Included within this are disposal proceeds of EUR2.56bn from the sale of its mapping business HERE. Nokia has announced a capital structure optimisation programme, which includes EUR3bn reduction of debt and debt-like items (of which EUR1.87bn was completed at end-February 2016), a planned EUR 0.6bn special dividend in 2016 with minimum EUR 0.9bn dividends payable in 2016 and 2017 (assuming approximately 6 billion shares outstanding) and a planned two-year EUR 1.5bn share repurchase programme.

Fitch expects that Nokia will continue to maintain a significant net cash position given sector risks relating to technology cycles and macro-cyclicality and a strong balance sheet requirement for its contract tendering process.

Sector Backdrop
We expect the size of the market in which Nokia competes to remain broadly flat in the medium-term. This reflects declines in wireless equipment sales as a result of a slowdown in geographic 4G network equipment build, offset by equipment sales growth in 4G capacity improvements, software and manged services, core networking and fixed access.

The evolution of 5G services may provide a basis for growth in the sector; however, the exact form of these services are not visible as yet and they are likely to take at least three to five years to materialise, as technology standards develop and mobile operators aim to gain some return from 4G investments before making scale investments in 5G.

The lack of growth in the sector over the medium-term will keep competition intense, which is likely to exert pressure on prices and margins, particularly for equipment sales. This makes maintaining a strong R&D focus and growing the software and services part of their portfolio key for telecoms equipment manufacturers. This in turn raises the sector's risk profile with R&D making a demand on cash flows while growing the software and services portfolio will mean competing with well-established global software service providers.

The sector is, however, key to the entire communications ecosystem with market shares becoming increasingly concentrated among few large players such as Huawei, Ericsson, Cisco and Nokia. Some of these players such as Nokia and Ericsson also hold significant intellectual property portfolios. Both Nokia and Alcatel-Lucent have strong positions in the US where Chinese vendors are not present. Further, telecoms operators will always aim to procure from at least two telecoms vendors to minimise supplier concentration risk. These elements support Nokia's rating within the context of a competitive sector backdrop.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Flat to low single-digit revenue growth over the next four years.
- Initial margin dilution following the integration of Alcatel-Lucent followed by expansion to around 13% as EUR900m of synergies are realised with a full run-rate to be achieved 2019 (company target 2018).
- Integration costs of EUR900m to be incurred over the next three years, with the majority of outflow in 2017.
- Capex to remain at around 3% of revenues.
- Declining but strong net cash position as the company returns excess cash to shareholders.

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to an upgrade to include:
- Sustained operational performance and market position within core operating divisions including acquired divisions of Alcatel-Lucent.
- Evidence that the integration programme with Alcatel-Lucent is on track, along with no slippage in cost-saving targets.
- Sustained group EBIT margins in the high single-digit range, with healthy revenue and cash flow visibility.
- Sustained pre-dividend free cash flow (FCF) margins trending consistently at 3% to 5% (2015: 1.5%).
- A conservative financial policy with a sustained net cash position that would enable the company to manage integration costs, fund R&D and investments through cyclical or macro-economic downturns and provide confidence for end-customer tendering processes.

Future developments that may, individually or collectively, lead to the Outlook being changed to Stable include:
- Deterioration in operating performance in Nokia's core operating divisions
- Sustained delays to or increase in the cost of Nokia's integration programme with Alcatel-Lucent.
- Sustained mid-single digit group EBIT margins
- A lack of progress in pre-dividend FCF generation.
- Sharp weakening of net cash position because of a sharp deterioration in the operating environment or increased shareholder remuneration.