Gemalto : Update on the credit after the massive profit warning in October and the pending acquisition of 3M’s Identity Management business

We upgrade our credit opinion to Positive (vs. Stable). Despite the weakness of the Mobile SIM segment and near-term headwinds for Payment solutions, Gemalto should report flattish revenues in 2016 thanks to the growing diversification of its business portfolio. We estimate a net leverage of 1.4x in 2016 pro-forma the announced acquisition of 3M’s Identity Management unit last month (vs. 0.6x in 2015), but we are confident that the group will improve its credit metrics in 2017, barring further external growth. The improvement will be supported by higher margins, material FCF generation, and modest shareholder distributions. - We reiterate our Neutral recommendation on the 2021 notes. They offer an attractive spread pick-up of 48 bps compared with the average Asw-spread of BBB rated bonds (reflecting the absence of credit rating) and they should benefit from the improvement of Gemalto’s pro-forma credit metrics this year. However, Their Asw-spread is relatively expensive compared with other non-rated bonds with similar maturities and estimated ratings. - >Support factors - • Leadership positions in its markets. Gemalto ranks ahead #2 player Oberthur in terms of revenues (€ 3.1bn in 2015 vs. € 2.8bn for Oberthur including Morpho).• Growing diversification of Gemalto’s business portfolio. The revenue contribution of the struggling SIM business has reduced to 18% of total sales in 9M16 (vs. 33% in 2014) while the contribution of the M2M, Enterprise and Government businesses has increased to 44% of total sales (vs. 25% in 2014). The revenue share of the Payment business (the largest revenue contributor) remained stable at 31%.• Management anticipates an increase in adjusted EBIT to € 500-520m in 2017 (+21% compared with € 423m in 2015) on the back of higher gross margin, despite modest revenue growth and sustained investments. Our EBIT estimate (excl. M&A) for 2017 is € 500m.• Sound FCF generation. We forecast a material increase in FCF to € 282m in 2016 (vs. € 161m in 2015) and we believe that the 2016 level is sustainable.• Conservative financial policy, with a net debt/EBITDA ratio <1.0x historically (1.4x in 2016e pro-forma the announced acquisition of 3M‘s Identity Management business) and moderate dividend payments. Points to watch - • Management cut its 2017 adjusted EBIT target to € 500-520m (vs. >€ 660m previously) as a result of 1/ a sluggish SIM market, 2/ delays in the adoption of mobile payment solutions, 3/ lack of near-term momentum in the payment segment and 4/ overinvestments.• Technology risks: new technologies are looking attractive for the industry at large, but they may result in market share changes (e.g. the eSIM technology).• Fierce competition for low-end solutions (commoditization).• Potential reputation risk if a security breach in Gemalto’s products would occur.• M&A risk. Gemalto was eyeing Morpho (sold to Oberthur/Advent for € 2.43bn) and finally agreed to acquire 3M’s unit for € 797m. Gemalto continues to keep an eye on M&A on an opportunistic basis. In the short term, though, we think that Gemalto will likely focus on the integration of 3M’s unit.