NEW YORK--()--Fitch Ratings has affirmed TransDigm Group Inc.'s (NYSE: TDG) and its indirect subsidiary TransDigm, Inc.'s (TDI) Issuer Default Ratings at 'B' with a Stable Outlook. In addition, Fitch also affirmed the 'BB/RR1' ratings for TDI's term A loan and senior secured credit facility and the 'B-/RR5' rating for TDI's senior subordinated notes. Approximately $4.3 billion of outstanding debt is covered by these ratings.
TDG's ratings are supported by the company's strong free cash flow (FCF; cash from operations less capital expenditures and dividends), good liquidity, and financial flexibility which includes a favorable debt maturity schedule.
TDG benefits from high profit margins and low capital expenditures, diversification of its portfolio of products which support a variety of commercial and military platforms/programs, a large percentage of sales from a relatively stable aftermarket business, its role as a sole source provider for the majority of its sales, and management's history of successful acquisitions and subsequent integration. Fitch also notes that TDG does not have material pension liabilities and has no other post-employment benefit (OPEB) obligations.
Fitch's concerns include the company's high leverage, its long-term cash deployment strategy which focuses on acquisitions, and weak collateral support for the secured bank facility in terms of asset coverage. Additionally, Fitch is concerned with the risks to core defense spending; however, this risk is mitigated by TDG's relatively low exposure to the defense budget and by a highly diversified and program-agnostic product portfolio.
Fitch notes that TDG is exposed to the cyclicality of the aerospace industry, as it reported several quarters of organic sales declines during fiscal 2009 and 2010 driven by lower demand for aftermarket parts and by production cuts by commercial original equipment manufacturers (OEMs). While market cyclicality is somewhat mitigated by growth from acquisitions, high margins and sales diversification to the defense sector, the expected decline in defense spending coupled with a possible downturn may result in lower FCF.
The Recovery Ratings and notching in the debt structure reflect Fitch's recovery expectations under a scenario in which distressed enterprise value is allocated to the various debt classes. The expected recovery for bank-debt holders remains 'RR1', indicating recovery of 91% - 100%. The senior subordinated notes are 'RR5' which reflects an expectation of recovery in the 11% - 30% range.
At November 2012, Fitch estimates TDG's leverage to be approximately 5.4 times (x) up from approximately 4.6x as of Sept. 30, 2012. The increased leverage is in line with the company's historic leverage which typically fluctuates between approximately 4.5x and 6.0x, occasionally reaching higher than 7.0x. At the end of fiscal 2012, TDG's leverage was approximately 4.6x, down from 5.6x at the end of fiscal 2011. TDG's leverage decreased significantly once the results of McKechnie Aerospace Holdings Inc. (MAH) were included in consolidated financials, however, at the beginning of fiscal 2011, leverage reached above 7.0x immediately after the MAH acquisition. As of Oct. 16, 2012, TDG had pro forma debt of $4.3 billion, up from $3.6 billion at Sept. 30, 2012. TDG's leverage is somewhat high for the rating; however, it is mitigated by strong margins and positive FCF generation. Fitch projects TDG's leverage to fluctuate between the historical range of 4.5x to 6.0x.
At Sept. 30, 2012, TDG's liquidity consisted of $440 million in cash and $303 million available under its revolver ($310 million less $7.1 million in letters of credit), partially offset by $20.5 million in current amortization payments under the $2 billion term loan. Year-over-year TDG's liquidity increased by $64 million, mostly due to an increase in cash from several acquisitions closed during fiscal 2012 and 2011. TDG does not have major maturities until 2017. Fitch expects TDG to maintain a solid liquidity position in fiscal 2013 and 2014.
In the fiscal year ended Sept. 30, 2012, TDG generated approximately $385 million FCF, and Fitch expects FCF to decline to approximately negative $250 million in 2013 driven by a special dividend of $660 million. Excluding special dividends paid in fiscal 2010 and early fiscal 2013, TDG generates solid positive FCF, aided by typically low capital spending and high margins. Capital expenditures tend to be less than 2% of sales per year. In fiscal 2011, FCF totaled $239 million, up from negative $220 million in fiscal 2010.
In 2011, TDG generated approximately $272 million in cash by divesting two businesses. Fitch does not expect significant cash generation via divestitures going forward. Fitch expects TDG to generate more than $350 million of FCF in fiscal 2013 (excluding special dividend). Projected cash flows should be sufficient to fund day-to-day operations while allowing the company the flexibility to pursue modest future acquisitions.
Acquisitions are the main focus of TDG's cash deployment strategy. In fiscal 2012, TDG made three acquisitions totaling $868 million compared $1.7 billion spent on acquisitions in 2011. TDG announced an additional acquisition in the first fiscal quarter of 2013 totaling approximately $236 million. Historically, TDG had not paid regular annual dividends to its shareholders and had not engaged in significant share repurchases, though TDG's board authorized a $100 million share repurchase program on Aug. 22, 2011. As mentioned above, in November 2012, after the end of the company's fiscal year, TDG completed a special dividend (including dividend equivalent payment) of approximately $700 million funded by two new debt issuances totaling $700 million. Fitch expects TDG will continue to focus its cash deployment on acquisitions, or special dividends if the company does not find suitable acquisition targets.
TDG is exposed to three business sectors: commercial airplane original equipment (OE), commercial aftermarket and defense (both original equipment and aftermarket). TDG's sales growth rates during the latest economic downturn were primarily driven by the acquisitions and the stability of defense spending which significantly moderated year over year organic sales declines in commercial OE and aftermarket sales.
Fitch considers the conditions within the industry to be supportive of the rating. Commercial aerospace markets have grown over the past year with increased production by major OE manufacturer's and solid aftermarket activity. The industry's long-term health is supported by a growing global demand for air travel, and increasing demand for fuel efficient and lighter weight modern planes. TDG's has a niche position in the market due to the proprietary nature of many of the company's products and as a result, its ability to maintain high margins.
Approximately 23% of TDG's revenues are derived from the defense industry.
U.S. defense spending has been on an upward trend for more than a decade, but the fiscal 2012 and fiscal 2013 budgets represent a turning point, with spending beginning to turn down in fiscal 2013, even excluding war spending, albeit from very high levels. The fiscal 2012 Department of Defense (DoD) base budget is up less than 1% compared to fiscal 2011, and the requested base budget for fiscal 2013 is down 1% to $525 billion. Fiscal 2013 Modernization Spending (procurement plus research and development [R&D]), the most relevant part of the budget for defense contractors, is down 4%, the third consecutive annual decline by Fitch's calculations.
The overhang of potential automatic cuts beginning in early 2013 related to the 'sequestration' situation adds to the uncertainty faced by defense contractors in the current environment. The U.S. defense outlook will be uncertain and volatile over the next one to two years, and program details will be needed to evaluate the full effect on TDG's credit profile.
On Sept. 14, 2012, the Office of Management and Budget issued a Sequestration Transparency Act report detailing the potential impact of sequestration on funding reductions for both defense and nondefense budget accounts. The report assessed that unless the sequestration law is changed, the DoD budget will be cut by approximately $52 billion in fiscal year (FY) 2013. Budget cuts to Modernization Spending would be expected to account for approximately $23 billion or nearly 44% of the cuts despite comprising only 29% of the total DoD budget. The majority of the remaining cuts will be in the Operations and Maintenance account. Should sequestration occur, the cuts in Modernization Spending could be partly mitigated by low outlay rates during the first year for the majority of Procurement and R&D programs.
TDG's exposure to DoD spending is mitigated by a highly diversified portfolio of products and by high aftermarket content which could actually be a positive factor if DoD determines to prolong lives of existing equipment to cope with cuts in procurement.
What Could Trigger A Rating Action:
Fitch may consider a positive rating action if the company maintains its leverage level within the range of 4.5x to 5.6x along with its strong revenue growth and high cash generation. A positive rating action will be contingent upon clarity in DoD spending going forward and the corresponding impact on the company's revenues. A negative rating action may be considered should the company significantly increase its current leverage due to aggressive acquisition(s); if the global economy weakens; or defense spending cuts have a more significant impact on the company's earning and FCF than currently anticipated.
Fitch has affirmed the following ratings:
--Long-term IDR at 'B'.
--IDR at 'B';
--Senior secured revolving credit facility at 'BB/RR1';
--Senior secured term loan at 'BB/RR1';
--Senior subordinated notes at 'B-/RR5'.
The Rating Outlook is Stable.
Additional information is available at 'www.fitchratings.com'. The ratings above were unsolicited and have been provided by Fitch as a service to investors.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology', Aug. 8, 2012;
--'Rating Aerospace and Defense Companies: Sector Credit Factors', Aug. 9, 2012.
Applicable Criteria and Related Research:
Corporate Rating Methodology
Rating Aerospace and Defence Companies