NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed Northrop Grumman Corporation's (NOC) 'BBB+' Issuer Default Rating (IDR) and debt ratings with a Stable Rating Outlook. The ratings also apply to NOC's subsidiary Northrop Grumman Systems Corporation (NGSC). Approximately $3.9 billion of outstanding debt is covered by these ratings. See the full rating list at the end of this release.
Key Rating Drivers
The ratings reflect the company's competitive position within the defense industry, a balanced defense portfolio, financial flexibility, strong liquidity position, steady cash flow, solid metrics for the rating, margins levels, and relatively healthy pension position compared with many of its peers. These positive factors are somewhat offset by defense spending risks and uncertainties over the next several years.
NOC's cash deployment strategy is heavily weighted toward share repurchases and dividend payments. NOC's revenue growth opportunities could be limited in the next several years, and operating execution and cash deployment will drive credit quality. Fitch does not expect NOC to focus on reducing leverage going forward, and the main uses of cash are likely to be share repurchases, dividends, investments in its business, and targeted acquisitions.
Fitch is concerned with U.S. defense spending trends, the potential for continued large share repurchases, program terminations and restructurings in the Department of Defense's (DoD) fiscal 2012 budget and fiscal 2013 budget proposal, and low diversification by both business and geography. High defense spending levels support the ratings, but expected DoD budget declines beginning in 2013 will have a negative impact on the company's revenues and profitability. NOC's sizable pension liability is mitigated by low mandatory payment requirements and the relatively healthy funded status on a percentage basis.
The implementation of across the board sequestration-driven defense cuts is a concern; however, it is mitigated by NOC's large backlog, strong new awards in 2012 as the book to bill ratio exceeded 1.0x, flexible cost structure, strategic product positioning and the potential to grow international sales.
Liquidity at Dec. 31, 2012 was approximately $5.9 billion, consisting of $3.9 billion of cash and securities as well as full availability under two credit facilities totaling $2 billion ($1.5 billion expiring in September 2016 and $500 million expiring in September 2013). Approximately $580 million of NOC's cash was held overseas at the end of 2012. NOC's next significant bond maturity is $350 million in August 2014. Fitch expects NOC's liquidity to remain stable during 2013. It is Fitch's view that NOC's liquidity may decline with higher certainty of DoD's future spending plans and the sequestration's impact on the company's programs and performance.
NOC's debt-to-operating EBITDA ratio for the latest 12 months (LTM) ending Dec. 31, 2012, was 1.0x, unchanged from the prior year. EBITDA in 2012 declined slightly to $3.82 billion from $3.96 billion as of Dec. 31, 2011. The EBITDA margin remained relatively flat at approximately 15%. Fitch expects NOC's 2013 leverage will deteriorate slightly to the range of 1.1x to 1.3x as a result of lower revenues and margins.
Free cash flow (FCF; cash from operations less capital expenditures and dividends) was $1.8 billion in 2012, up from $1.1 billion in 2011, including the impact of $366 million and $1.1 billion of pre-tax pension contributions, respectively. Fitch conservatively expects FCF will be at least $1 billion in 2013.
Cash deployment will be a key credit driver over the next year given NOC's substantial liquidity, and Fitch believes NOC will make share repurchases the primary focus of the company's cash deployment strategy. NOC bought back approximately $1.3 billion worth of shares in 2012 and $2.3 billion in 2011. Fitch's ratings continue to incorporate expectations for more than $1 billion of annual share repurchases. Dividend increases and discretionary pension contributions are also incorporated in the ratings.
NOC's pensions were 82.8% funded ($4.78 billion underfunded) on a GAAP basis at the end of 2012. Excluding non-qualified plans and European plans, the pensions were 86% funded on a GAAP basis, and they were over 100% funded on an ERISA basis. The pension benefit obligations totaled $27.7 billion, and assets were $23 billion as of Dec. 31, 2012. Required contributions in 2012 were approximately $67 million and the company projects $66 million of required funding in 2013. Discretionary pension contributions are an important part of NOC's cash deployment strategy, totaling $300 million in 2012, $1 billion in 2011, $830 million in 2010, and $800 million in 2009. The company plans on making $500 million of discretionary contributions in 2013. The company lowered its discount rate to 4.1% from 5.0% in 2012.
NOC generated approximately 90% of its 2012 revenues from the U.S. government, primarily the Department of Defense. As a result, defense spending is a key driver of NOC's financial performance and credit quality. Fitch expects 2013 to be a challenging year for U.S. defense contractors. The full implementation of sequestration's defense spending reductions will increase pressure on revenues, but Fitch believes it will not necessarily have a significant effect on credit ratings in the U.S. aerospace and defense sector if companies take actions to offset the impact.
The spending environment will likely continue to be uncertain through 2013. A challenge defense contractors will face is determining how to adapt given the uncertain execution of the sequestration and the overall fiscal pressures in the federal government.
Because of the lag between budget authority and outlays, Fitch expects the bulk of sequestration's impact could be shifted into fiscal 2014, providing some additional time for companies to adapt. Most of the spending cuts are from projected budget growth and come off the existing high spending levels. Fitch expects inflation adjusted spending will likely decline, albeit modestly, over 10 years. As an example, Fitch estimates the implemented budget cuts would only reduce base budgets back to the levels seen in fiscal years 2007 or 2008. A key risk in the sector remains cash deployment to offset the impact on earnings from lower revenues.
Fitch believes that the implementation of sequestration's cuts would not lead to negative rating actions given NOC's diversified portfolio, long lead times for program execution and solid backlog. Sequestration is expected to impact new awards and Fitch believes NOC will be able to adjust its cost structure to maintain profitability. The exposure to DoD spending is mitigated by strong margins, solid FCF, increasing international sales and NOC's good liquidity.
Approximately 60% of the company's consolidated debt is issued by the holding company (NOC), with the rest issued by NGSC. The holding company's bonds are structurally subordinated to NGSC's debt because there are no upstream guarantees from NGSC, the company's remaining operating subsidiary after the Huntington Ingalls Industries (HII) spin off. For this reason, the holding company notes sit in a weaker credit position than NGSC's debt, but Fitch does not consider the difference to be great enough for the holdco's ratings to be lower than the operating subsidiary's ratings, for two reasons: the credit strength of the consolidated enterprise, and the holding company's 100% ownership and strong management control of the subsidiary. Unlike NOC's bonds, the bank facilities, which are located at NOC, benefit from upstream guarantees from NGSC.
Rating Sensitivities
Negative rating actions could result from large, debt-funded acquisitions; significant performance issues on large contracts; or material changes in U.S. defense spending trends. Given NOC's solid credit metrics for its existing ratings, more than one of the preceding would probably have to occur for the company's credit quality to decline. Fitch does not anticipate positive ratings actions in the near term given the uncertainty of DoD spending and the company's cash deployment strategies; however, positive ratings actions may be considered if the company adopts a more conservative financial strategy, coupled with continued strong execution in its core businesses.
Fitch affirms Northrop Grumman Corporation's ratings as follows:
--Issuer Default Rating (IDR) at 'BBB+';
--Senior unsecured debt at 'BBB+';
--Bank facilities at 'BBB+'.
Fitch affirms Northrop Grumman Systems Corporation's ratings as follows:
--IDR at 'BBB+';
--Senior unsecured debt at 'BBB+'.
The Rating Outlook is Stable.
Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.
Applicable criteria and related research
--'Corporate Rating Methodology', Aug. 8, 2012;
--'2013 Outlook: Global Aerospace and Defense', Dec. 21, 2012.
Applicable Criteria and Related Research
Corporate Rating Methodology
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=684460
2013 Outlook: Global Aerospace and Defense
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=697071
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