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Fitch Ratings has downgraded the ratings for Flextronics International Ltd. (Flextronics) as follows: <?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />
-- Issuer Default Rating (IDR) to 'BB+' from 'BBB-';
-- Senior Unsecured credit facility to 'BB+' from 'BBB-';
-- Senior subordinated notes to 'BB' from 'BB+';
The Rating Outlook is Stable. Fitch's action affects approximately $1.7 billion of total debt.
The ratings downgrade reflects Fitch's expectations that Flextronics will continue to operate near historically low margin levels versus Fitch's prior expectations for material margin expansion for the core EMS business, and will experience negative free-cash flow likely through FY08 (March 2008) while investing heavily in expanded manufacturing capacity and working capital to support a significant expected increase in revenue. These factors are somewhat mitigated by Fitch's belief that Flextronics is at an inflection point as the company is beginning to benefit from its original design manufacturer (ODM) and vertical integration strategy after several years of disappointing results which negatively impacted profitability. The ramp in ODM and vertical integration business has contributed to a turnaround in overall revenue growth and, longer-term, could drive increases in operating profitability. In addition, despite the lack of improvement in operating margin, return on invested capital (ROIC), which is a primary focus of the company, has improved considerably over the past several years from 6.1% in F2Q04 to 11% in F2Q07. However, Fitch expects that upside to Flextronics' operating model over the next several quarters will be limited by high costs associated with ramping new program wins, adding significant operating and program specific risk to expectations that already include negative free cash flow. In addition, Fitch believes that the electronics manufacturing services (<?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />EMS) industry in general continues to suffer from excess capacity which will likely continue to negatively impact pricing for all competitors and represents further risk to Flextronics' margins and free cash flow outlook.
The Ratings and Stable Outlook reflect:
-- low operating EBIT margins consistent with the EMS industry in general;
-- increasing investment in vertical integration through R&D and acquisitions resulting in higher fixed costs;
-- inconsistent free cash flow that has been negative for the past three quarters due to rising capital expenditures and increased working capital, the latter a function of higher revenue as well as increasing cash conversion cycle (CCC) days, a trend which has been driven by lower inventory turns as OEM customers such as Nortel require Flextronics to hold increasing levels of inventory; and
-- the risk associated with ramping and integrating new program wins as well as on going program specific risk which has negatively impacted the company and others EMS providers historically.
Flextronics' ratings strengths center on the company's:
-- top-tier EMS industry position with leading scale and low-cost manufacturing operations;
-- relatively stable operating performance with industry leading cash conversion cycle (CCC) days that are, however, expected to continue to moderately increase from a low of 8 days in F3Q06 (December 2005) to a historically normal range of 16 to 18 days as Flextronics absorbs increasing inventory levels for OEM customers;
-- broad end market diversification with significant exposure to more stable and non-traditional end markets such as mobile handsets and consumer electronics; and
-- continued strong growth of its small but higher margin ODM business in high growth markets such as handsets, possibly enabling the ODM business to turn profitable in FY07 (March 2007).
In addition, Fitch expects the long-term trend of OEMs increasingly outsourcing manufacturing and design services to continue across most end markets.
Liquidity as of Sept. 30, 2006 was solid and consisted of:
-- $1 billion in cash and cash equivalents;
-- a $1.35 billion revolving credit facility expiring May 2010 which was undrawn and fully available; and
-- an accounts receivable securitization program expiring September 2007, which is off-balance sheet and allows Flextronics to sell an interest of up to $700 million in receivables providing a maximum of $500 million in total liquidity, of which approximately $245 million was available as of June 30, 2006.
Free cash flow has been inconsistent over the past several quarters due to higher working capital associated with the significant ramp in new program wins as well as an increase in capital expenditures. Fitch believes free cash flow will remain inconsistent as Flextronics' revenue grows approximately 20% year-over-year for the remainder of FY07. However, Fitch expects the company will produce consistent positive free cash flow once annual revenue growth subsides to more normalized levels of 10% or less and CCC days stabilize closer to historical levels of approximately 16 to 18 days from the current level of 13 days as days payable outstanding (DPOs) decreases as well as Fitch's expectation that the company will continue to face inventory pressure from OEM customers.
Total debt as of Sept. 30, 2006 was $1.7 billion and consisted of:
-- $250 million in short-term debt including credit facilities and the current portion of capital leases;
-- $195 million in zero coupon convertible junior subordinated notes due 2009;
-- $500 million in 1% convertible subordinated notes due 2010;
-- $400 million in 6.5% senior subordinated notes due 2013;
-- $386 million in 6.25% senior subordinated notes due 2014; and
-- $9 million in other long-term debt.
Flextronics recently completed the divestiture of several non-strategic business units including the sale of its software group in September 2006 which generated roughly $600 million in cash proceeds, part of which was utilized to reduce debt by approximately $70 million in F3Q07 (September 2006).