CHICAGO--(BUSINESS WIRE)--Fitch Ratings has assigned a 'BBB-' rating to The ADT Corporation's (NYSE:ADT) proposed offering of $500 million senior unsecured notes due 2019. This issue will be equal in right of payment with all other senior unsecured debt. Net proceeds from the notes issuance will be used to repay borrowings under the revolving credit facility, share repurchases, and for general corporate purposes.
The Rating Outlook is Stable. A complete list of ratings follows at the end of this release.
KEY RATING DRIVERS
ADT's ratings and Outlook reflect the company's strong brand recognition, its national footprint and leading market position, recurring revenue base, sustainable free cash flow (FCF) generation and solid liquidity. Concerns include emerging competition from non-traditional security service providers, risk associated with operating as an independent public company, and contingent liabilities, particularly tax liabilities, related to its spin-off from Tyco International, Ltd. (Tyco).
The ratings also reflect management's willingness to undertake a more aggressive financial strategy soon after becoming an independent company, as well as management's evolving financial strategy.
EVOLVING FINANCIAL STRATEGY
The company has revised its financial strategy twice since its spin-off from Tyco in September 2012. Following its spin-off, management was committed to a strong investment grade rating and put in place a capital structure that reflected this profile.
In November 2012, ADT initiated a $2 billion share repurchase program over a three-year period that will be funded by debt and FCF. As part of this strategy, the company increased its leverage target to 2x and reiterated its commitment to an investment grade rating.
In July 2013, the company once again changed its financial strategy and increased its leverage target to 3x. ADT expects to use proceeds from the incremental leverage to invest in growing its core business, increase operating efficiency, and pursue accretive acquisitions to complement its organic growth, as well as return excess cash to shareholders in the form of dividends and share buybacks.
In November 2013, the board increased the company's $2 billion share repurchase program by an additional $1 billion, expiring on Nov. 27, 2015. ADT repurchased $1.24 billion of stock during fiscal 2013 (ending Sept. 27, 2013). During the 1Q'14 (ending Dec. 27, 2013), ADT repurchased $1.18 billion of stock, including $451 million for the repurchase of 10.2 million shares as part of a Share Repurchase Agreement with Corvex Management LP. As of Dec. 27, 2013, the company had $581 million remaining under its authorization programs.
In November 2013, ADT's board also approved a 60% increase in the company's quarterly dividend to $0.20 per share from $0.125 per share starting in January 2014.
These shifts in strategy create some uncertainty regarding the stability of management's financial policies beyond the near term.
Debt to EBITDA was 2.6x for the latest twelve month (LTM) period ending Dec. 27, 2013 compared with 2x at fiscal year-end 2013 (ending Sept. 27, 2013) and 1.6x at the end of fiscal 2012. On a pro forma basis assuming that part of the proceeds from the notes issuance will be used to pay down revolver borrowings, debt to EBITDA will be about 2.8x. Interest coverage was 8.8x for the LTM period ending Dec. 27, 2013 compared with 13.6x in fiscal 2013 and 17.3x in fiscal 2012. Fitch expects these credit metrics will remain relatively stable during fiscal 2014.
SOLID LIQUIDITY POSITION
ADT has a solid liquidity position with cash of $80 million at Dec. 27, 2013 and $525 million of borrowing availability under its $750 million revolving credit facility that matures in June 2017. Fitch expects the company will maintain liquidity of approximately $600 million - $800 million, consisting of cash and availability under its revolver. ADT does not have any debt maturities until 2017, when $750 million of senior notes mature.
The ratings incorporate ADT's strong competitive position as the largest residential security provider in the U.S. ADT currently has over six million customers and a roughly 25% market share based on company estimates.
Fitch believes that ADT's competitive position will remain strong in the near-to-intermediate term. However, ADT faces competition from non-traditional security service providers. Several cable and telecom companies have introduced interactive security services that compete with ADT. While the security service customer base of these companies is substantially smaller than ADT at the current time, this emerging trend could provide significant competition for ADT going forward.
RESILIENT BUSINESS MODEL
ADT's subscriber-based business requires significant upfront costs to generate new customers. Capital expenditures, including dealer-generated accounts and bulk purchases and subscriber systems, totaled $1.22 billion for the LTM period ending Dec. 27, 2013. Total capital expenditures were $1.20 billion, $1.09 billion and $902 million in fiscal years 2013, 2012 and 2011, respectively. Capital expenditures for the Dec. 27, 2013 LTM period represent approximately 36.7% of LTM revenues. Fitch expects capital expenditures will approximate 35% - 40% of annual revenues in the next few years. Fitch estimates that new customers yield an average cash payback of three years.
Approximately 90% of ADT's annual sales are recurring in nature, resulting in steady income and cash flow. ADT generated $259 million of FCF for the LTM period ending Dec. 27, 2013, compared with $348 million, $406 million and $537 million of FCF during fiscal years 2013, 2012 and 2011, respectively. (Note: ADT did not pay dividends in fiscal 2011 and fiscal 2012 and paid $112 million of dividends in fiscal 2013 and $108 million for the Dec. 27, 2013 LTM period.) Fitch expects ADT will generate annual FCF (cash flow from operations less capital expenditures and dividends) of roughly $200 million-$300 million during the next few years.
As part of the separation, ADT has entered into separation and distribution and other agreements with Tyco and Pentair Ltd. (formerly Tyco's Flow Control segment). ADT also entered into a Tax Sharing Agreement with Tyco and Pentair, which governs the rights, responsibilities and obligations of the three post-separation companies regarding certain tax matters.
In July 2013, the IRS issued Notices of Deficiency to Tyco based on audits of the 1997 through 2000 tax years. The IRS has disallowed interest and related deductions for certain intercompany debt totaling $2.9 billion and indicated that Tyco's former U.S. subsidiaries, including ADT, collectively owe $883 million of additional taxes plus penalties of $154 million. If the IRS is successful in asserting its claim, it would have an adverse impact on interest deductions related to the same intercompany debt in subsequent periods (2001 - 2007) totaling $6.6 billion.
Tyco has advised ADT that it strongly disagrees with the IRS position and is contesting these proposed adjustments in the U.S. Tax Court. Should the IRS successfully assert its position, the amount assessed would have to be in excess of $1.85 billion before ADT would be required to pay any of the amounts assessed based on the existing tax-sharing agreements. No payments with respect to these matters would be required until the dispute is definitively resolved.
Future ratings and Outlooks will be influenced by broad economic trends, as well as company-specific activity, particularly FCF trends and uses, debt levels and liquidity position.
Positive rating actions are unlikely in the near-to-intermediate term, as Fitch monitors ADT's performance and management's financial strategy as a stand-alone company.
On the other hand, Fitch may consider taking a negative rating action if there is meaningful deterioration in ADT's financial results or management again undertakes a more aggressive financial policy, leading to diminished liquidity and higher debt levels. In particular, negative rating actions could occur if ADT's leverage is materially above its 3x target on a consistent basis.
Fitch currently rates ADT as follows:
-- Issuer Default Rating (IDR) 'BBB-';
-- Revolving bank credit facility 'BBB-';
-- Senior unsecured debt 'BBB-';
-- Short-term IDR 'F3';
-- Commercial Paper 'F3'.
Additional information is available at www.fitchratings.com.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (Aug. 5, 2013).
Applicable Criteria and Related Research:
Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage