S&P: Japan's Sharp Corp. Upgraded To 'B-' From 'CCC+', Ratings Removed From CreditWatch Positive, Outlook Positive
The upgrades follow the completion of new share issuance through third-party allocations to Taiwan-based Hon Hai Precision Industry Co. Ltd. (A-/Stable/--) on Aug. 12, 2016. The capital increase improved Sharp's capital base significantly, but we believe the company will take time to recover its business competitiveness and cash flow generation within Hon Hai group. Nevertheless, Sharp is important to Hon Hai's medium - to long-term business strategy, under which Hon Hai aims to change its business model from its current one as an electronics manufacturing service provider. As a result, we believe Hon Hai is likely to give Sharp reasonable support in the event it is financially weakened. Accordingly, we incorporate one notch of uplift into our corporate credit rating on Sharp from its stand-alone credit profile (SACP), which excludes the likelihood of extraordinary support from the parent group, to reflect potential support from Hon Hai, whose creditworthiness is materially higher than Sharp's.
On May 17, 2016, we raised our long-term corporate credit rating on Sharp one notch to 'CCC+' to reflect clearer confirmation that the company's creditor banks intended to maintain their supportive stance toward the company, as borne out by updates to agreements on Sharp's existing syndicated loans. At the same time, we continued to place our ratings on Sharp on CreditWatch with positive implications, where we had placed them from negative on March 31, 2016, to reflect the agreement between Sharp and Hon Hai for the share allocation.
In our opinion, Sharp is likely to mitigate volatility in the earnings of its LCD business to some degree thanks to a higher capacity utilization ratio as a result of active use of Hon Hai's wider customer base on a global basis and reduced procurement costs through Hon Hai's supply chain. Moreover, we expect the company to further reduce costs under the new management, somewhat improving its profitability. Nonetheless, Sharp's business environment will remain difficult, in our view, mainly in the area of its LCD business. The market for small and midsize LCD panels used mainly in smartphones, a focus for Sharp, is facing markedly slowing growth. In addition, declining prices for large LCD panels have made that business unprofitable. Furthermore, organic light emitting diode (OLED) displays have rapidly expanded their share of the market for high-definition and high value-added displays, in which Sharp has had strengths. Accordingly, Sharp will not find it easy to maintain its market position and competitiveness in the display market, in our view. Given the shift in demand to OLEDs, our rating analysis considers as a positive factor the company's ability to use the boost in capital that Hon Hai has provided to invest in OLED displays. However, this positive factor will be offset by challenges in mass-production and expected fierce competition. Overall, we assess the company's business risk profile as vulnerable.
The injection of capital from Hon Hai has helped Sharp exit negative net worth, and we believe the company recovered its capital base materially. Even if Sharp somewhat improves its production utilization rate and its profitability under Hon Hai's management, we expect the company's cash flow generation to remain weak for some time. Moreover, the possibility of additional impairment losses cannot be ruled out, in our view, if demand for LCD panels for TVs and smartphones falls. Considering these factors, we assess the company's financial risk profile as highly leveraged.
We assess Sharp's liquidity as less than adequate. A material decrease in short-term debt following updates to agreements on syndicated loans and a capital increase from Hon Hai have improved Sharp's liquidity, in our view. As a result, we estimate Sharp's liquidity sources over the next 12 months will be over 1.5x annual uses. However, the company's liquidity will continue to come under pressure, in our view, because its funding remains vulnerable to the attitudes of banks supporting the company. These factors constrain our assessment of the company's liquidity as less than adequate.
We assume the following under our base-case scenario:The LCD business will continue operating losses in fiscal 2016 (ending March 31, 2017), due to the maturing market for small LCD panels for smartphones as well as continued fierce competition and price declines; Sound profitability will continue in copiers and home electric appliances in non-LCD segments;Utilization of Hon Hai's supply chain, together with cost reductions, will boost operating profit; andIncreased capital will enable ?90 billion to ?100 billion in capital investments annually, including for OLED displays. We assume Sharp will have the following financial measurements for fiscal 2016 under our base-case scenario:Operating profit of about ?20 billion and an EBITDA margin in the 4.5%-4.9% range; and Debt to EBITDA of about 10.0x (excluding surplus cash adjustments), and EBITDA interest coverage of mid-4x. Our assessments of Sharp's business risk and financial risk profiles produce an SACP for the company of 'ccc+'. Although Hon Hai's ongoing support may bear fruit in the future, Sharp's stand-alone creditworthiness will remain vulnerable to changes in external environment. Meanwhile, our corporate credit rating on Sharp incorporates one notch of uplift for support from Hon Hai, which has higher creditworthiness than Sharp. We believe Sharp is important to Hon Hai's medium - to long-term strategy, under which Hon Hai aims to change its business model from its current one as an electronics manufacturing service provider. Hon Hai is also likely to provide support to Sharp in the event it is financially weakened, because it has invested a record amount in Sharp and leads its management restructuring.
We equalize our rating on Sharp's senior unsecured debt with the long-term corporate credit rating. We lower the senior unsecured debt rating on Sharp two notches from the long-term corporate credit rating on the basis of our estimate that priority liabilities, including secured debt, account for about 40% of Sharp's total assets. We also incorporate two notches of uplift in the senior unsecured debt rating, reflecting support from banks. We expect banks to continue to support the company, partly depending on Hon Hai's strong creditworthiness. If Sharp's creditworthiness deteriorates again and the company defaults on any of its debt, there is a possibility the company will conduct a debt-to-equity swap (or loan waiver), as it did in March 2015. In such a case, the company is more likely to fulfill its obligations to bondholders than to lender banks.
The positive outlook reflects our view that Sharp is likely to somewhat mitigate the high volatility in its earnings from its LCD business with the use of Hon Hai's customer base and supply chain. It also incorporates our view that the company is likely to recover its profitability with a further reduction in cost. We may consider an upgrade if support from Hon Hai and cost reductions restore Sharp to a sustainable operating profit or help it recover EBITDA materially and stabilize its earnings base and if we believe Sharp can sustain its capital base in the longer term. Conversely, we may revise our outlook on Sharp downward to stable if its fiscal 2016 operating performance remains weak and mutual benefits with Hon Hai do not materialize quickly.