Moody's cuts Solectron convertible ACES to B2, 0% convertibles to Ba3

Moody's lowered the ratings of Solectron Corp., including the new 7.25% convertible ACES due 2006 to B2 from Ba2 and the two 0% convertibles to Ba3 from Ba1. The outlook is stable.

The downgrade, Moody's said, is based on the continued erosion in operating performance, high debt to cash flow ratio and continued uncertainty over the strength and trajectory of a recovery in its customers' end markets.

Risks are heightened by Solectron's customer base, which is heavily skewed to computing, data networking and telecommunications, which could impede the company's return to profitability if manufacturing volumes from existing and new product platforms do not pick up.

These risks are mitigated, however, by Solectron's March 1 cash position of $3.25 billion, $2.6 billion of which was unrestricted. Also helping are a significant number of awards from new and existing OEM customers that are set to ramp-up as early as fiscal third quarter and the company's ongoing restructuring activities, Moody's said.

The stable outlook takes into account Solectron's sizable scale of business, cost savings from restructuring activities, and its advanced technological capabilities.

The ratings could be lowered further if new customer platforms are delayed or develop more slowly than is currently expected, operating losses are not reversed or if meeting prospective working capital increases while arranging to repay the $1.6 billion convertible due November 2020 that is putable in May 2004 poses any funding challenges.

A surge in customer orders, marked improvement in both inventory and fixed asset turnover and improved returns on assets and invested capital would lead us to consider a ratings upgrade.

Having attained annual revenues in its global manufacturing unit of $17.2 billion in fiscal 2001, Solectron has been unable to substitute new product platforms on a scale commensurate with production volume declines that began in fiscal second quarter 2001.

Furthermore, Solectron must contend with a set of problems confronting its customers, not the least of which have been the poor visibility afforded by their own service provider and corporate end use customers and in some instances declining credit ratings, Moody's said.

While Solectron still has the wherewithal to win prominent OEM divestitures such as the recently announced $125 million acquisition of Lucent's Merrimack Valley optical telecom business, the $2 billion guaranteed volume over the initial three-year contract may not be realized if current trends in optical wireline equipment purchases are not reversed.

Moreover, the incremental OEM product platforms that Solectron has recently arranged do not appear to achieve the diversification of end use markets that might offset the volatility in its revenues. Fiscal first half of 2002 revenues were derived 57% from data networking and communications equipment, including mobile telecom equipment, and 33% from computers and peripherals.

Solectron has differentiated itself, to some degree, through a strategy of providing comprehensive product life cycle solutions. The continued evolution of Solectron's engineering infrastructure has provided a capacity for advanced technological services that may far exceed demand for such expertise under the current telecom and information technology investment environment, encumbering its business with higher fixed operating costs that could continue to inhibit returns.

Solectron's quarterly revenues have continued to decline sequentially and manufacturing inefficiencies stemming from lower capacity utilization and acceleration of the transition to Asian locations have cut into margins. Debt to last 12 months EBITDA, adjusted for restructuring charges and taking into account the $1.05 billion convertibles ACES, was a substantial 8.5 times, while free cash flow would not have covered interest expense. Although debt to capitalization would be about 33%, if the substantial goodwill accruing from recent acquisitions was taken into consideration, on a consolidated tangible net worth basis the ratio would be a significantly higher 49%.

There are benefits, however, from these acquisitions that for Solectron would have exceeded the book valuation of the underlying assets.

Solectron's cash horde is the consequence of its conscientious effort to work out excess inventory with its OEM customers. In effect, there was less working capital requirements corresponding to the 29.7% decline in revenues in the last 12 months from the year earlier period.

The current cash and investments position, supplemented by additional cash from lower accounts receivable and inventory funding over the next several quarters, should be sufficient to enable the company to repay the $1.5 billion 0% convertible due May 2020 that is putable in May 2003.

About 69% of the company's cash, cash equivalents and short-term investments is situated in the U.S., although funds located in foreign operations could be repatriated quickly, if necessary. Restricted funds are comprised of accounts tied to synthetic leases, interest requirements on the convertible ACES and moneys pledged as collateral for certain loans originated in Malaysia.

Ratings on the recently arranged $500 million guaranteed senior secured credit facilities, cut to Ba2 from Ba1, recognize the guaranty by all of Solectron's domestic subsidiaries and the collateral pledge of 100% of the stock of the domestic subsidiaries. The valuation of long-lived assets held in the U.S. exceeds the principal amounts that may be borrowed under the facilities.

Solectron is currently in compliance with the financial covenants under the facilities, including minimum consolidated tangible net worth and cash interest coverage tests and a 50% maximum consolidated debt to capitalization ratio.

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