CHICAGO--(BUSINESS WIRE)--Fitch Ratings has affirmed the Issuer Default Rating (IDR) and long-term debt ratings at 'A-' for Tyco International Ltd. (Tyco; NYSE: TYC) and Tyco International Finance S.A. (TIFSA). The Rating Outlook is Stable. A full list of ratings follows at the end of this release.
Key Rating Drivers:
The rating affirmation reflects Tyco's strong market positions in its fire and security markets, broad geographic presence, low leverage, and Fitch's expectation for improving operating performance following the company's separation from its ADT and Flow businesses at the end of fiscal 2012. Tyco's low leverage and its financial flexibility are important in the near term while it restructures and integrates its fire and security operations as a standalone business and funds separation-related and other special charges.
Debt/EBITDA at June 28, 2013 was 1.0x which is solid for the rating level. However, Fitch estimates free cash flow (FCF) after dividends and special items in 2013 could be near the $150 million to $175 million range, which is lower than Fitch's original estimate of $400 million. The reduction reflects nearly $100 million of environmental charges recognized in 2013 as well as additional separation and restructuring costs. The reduced FCF estimate is low but represents an improvement compared to 2012 which included the impact of corporate and interest expenses associated with the separated ADT and Flow businesses. FCF in 2013 also reflects lower dividends following the separation and benefits from restructuring. FCF could remain low through fiscal 2014 while Tyco funds expenditures for restructuring, environmental and asbestos liabilities, separation costs, and contingent tax liabilities.
Concerns about low FCF are mitigated by debt/EBITDA near 1.0x, adequate liquidity, and a conservative debt structure that includes limited debt maturities totalling approximately $325 million through calendar 2018. The negative impact on FCF from higher environmental and separation charges is incorporated in the ratings, but it leaves little room for further deterioration in Tyco's operating and financial performance or credit metrics compared to Fitch's expectations.
When excluding special items, Fitch estimates adjusted FCF would be near $500 million in 2013 and could increase modestly in subsequent years as operating results gradually improve. Fitch estimates operating margins could potentially increase by 150-200 bps or more over several years, but realizing the improvement will depend on the effectiveness of ongoing restructuring and integration, steady or improving activity in non-residential construction markets, and favorable economic conditions in emerging regions where much of the company's growth is expected to be located.
In addition to cash payments for special charges, rating concerns include potential tax liabilities related to Tyco's separation transactions in 2012 and 2007. In June 2013, Tyco was notified by the IRS that the company owes income taxes of $1,037 million for the 1997-2000 tax years. The amount includes penalties but not interest which could be substantial. The IRS claim relates to intercompany debt on which the IRS has disallowed $2.86 billion of interest and related deductions. If its claim is upheld, the IRS could potentially demand additional income tax payments for similar deductions totalling $6.6 billion in subsequent periods. Tyco intends to contest the IRS's proposed adjustments.
A resolution of the dispute could take several years which would defer the cash impact, and the final amount of any settlement or payment is highly uncertain. Any payments that might eventually be required would be shared with the other companies involved in both of Tyco's separations in 2012 and 2007. If the IRS makes claims on all $9.5 billion of deductions and ultimately prevails, Fitch estimates Tyco's share of the income tax liabilities could total approximately $600 million, not including interest. The amount would be in addition to a separately identified $175 million tax liability.
Other rating concerns include protracted weakness in non-residential construction and discretionary cash deployment for share repurchases and acquisitions. Fitch believes Tyco has adequate liquidity and financial capacity to fund a modest amount of discretionary spending, including $300 million of share repurchases which Fitch expects will be largely directed in the future toward offsetting dilution. Acquisitions have totaled approximately $225 million in 2013, a level which Fitch expects will continue as acquisitions are a key source of growth in the company's fragmented markets. Asbestos liabilities are another concern but should be manageable. Net asbestos liabilities amounted to $176 million at June 28, 2013, the majority of which is related to Tyco's Yarway subsidiary which filed bankruptcy in April 2013. Tyco expects to pay $100 million to Yarway to settle an intercompany liability but estimates the impact of the matter on Tyco's financial condition will not be material.
At Sept. 28, 2012 pension plans were underfunded by $546 million (U.S. $308 million; foreign $238 million). Tyco estimates it will contribute at least the required $61 million to its pension plans in 2013. U.S. plans were 67% funded and non-U.S. plans were 81% funded. More than half (57%) of Tyco's gross pension obligations are outside the U.S.
Tyco's liquidity is sufficient to support its operations and financial obligations and includes approximately $455 million of cash and a $1 billion bank credit facility that matures in 2017. There are no material debt maturities scheduled until October 2015. Holders of 8.5% notes due in 2019 ($364 million outstanding) have the right to require Tyco to repurchase the notes in July 2014, but the notes currently carry a high premium, so early redemption seems unlikely. There is room for a modest increase in debt without increasing leverage materially or negatively affecting the ratings, assuming the company realizes expected operating improvements. Fitch assumes debt/EBITDA would remain below 1.25x and would be closer to 1.0x until FCF metrics improve.
Tyco is the largest provider in many of its global markets. Nearly 30% of revenue comes from recurring services which are relatively stable and help to offset cyclicality in the installation business. The company is focused on expanding in emerging markets, growing the attractive services business, and improving project selectivity in its security business to support higher margins. The near-term negative impact on financial results from project selectivity can be expected to reverse as older projects are completed. Margins should also improve over the long term due to a higher mix of service business and productivity associated with restructuring. Margins are currently pressured by environmental and separation-related costs, weak conditions in commercial construction, and incremental costs in the security business following the separation from ADT.
A positive rating action is unlikely in the near term while Tyco uses much of its excess cash to fund special charges.
Fitch could take a negative rating action if cash deployment for special charges fails to decline after fiscal 2014; a material improvement in FCF is delayed beyond mid-fiscal 2015; liquidity is impaired by an adverse tax decision or by share repurchases or acquisitions; the company is unable to realize expected margin improvements; or fire and security markets weaken materially and lead to a decline in operating and financial results.
Fitch has affirmed the following ratings:
Tyco International Ltd.
--IDR at 'A-';
--Senior unsecured notes at 'A-';
--Short-term IDR at 'F2'.
Tyco International Finance S.A.
--IDR at 'A-'
--Senior unsecured revolving credit facilities at 'A-';
--Senior unsecured notes at 'A-';
--Short-term IDR at 'F2';
--Commercial paper at 'F2'.
The Rating Outlook is Stable.
Additional information is available at www.fitchratings.com.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology', Aug. 8, 2012;
--'Parent and Subsidiary Rating Linkage, Aug. 8, 2012.
Applicable Criteria and Related Research:
Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage
Parent and Subsidiary Rating Linkage