CHICAGO--(BUSINESS WIRE)--Fitch Ratings has removed from Rating Watch Negative and downgraded the Long-Term Issuer Default Rating (IDR) for Lexmark International Inc. (Lexmark) to 'BB' from 'BBB-'. Fitch has also assigned a 'BB+/RR1' rating to Lexmark's existing senior notes, which Fitch believes will become secured under the terms of the bond indenture. The Rating Outlook is Negative.
Fitch's actions affect $700 million of debt, excluding debt related to the acquisition. A full list of rating actions follows at the end of this release.
The consortium of investors, led by Apex Technology Co. Ltd. (Apex) and PAG Asia Capital (PAG), funded the $3.6 billion acquisition with $2.1 billion of new debt and $1.5 billion of equity contributions. The $2.1 billion of acquisition-related debt will be unconditionally guaranteed by Apex and secured by substantially all the assets of the company and assets of certain of its subsidiaries.
KEY RATING DRIVERS
Elevated Leverage: Fitch estimates total leverage will be 4x, pro forma for the acquisition close and use of net proceeds from the enterprise software (ESW) sale for debt reduction. Fitch expects leverage will decrease to below 3.5x and ultimately closer to 3x should revenue growth approach flat and the company achieves anticipated acquisition related run-rate cost synergies of approximately $190 million in three years.
Solid Annual FCF: Fitch expects annual FCF of $100 million to $200 million beyond 2017, driven by annuity revenue that represents approximately 70% of total revenue. The growth of annuity revenue provides a more predictable revenue stream that reduces volatility in an economic downturn. For 2017, Fitch expects FCF will be near break-even due to cash restructuring charges related to achieving acquisition related cost synergies, as well as the divestitures of the inkjet and ESW businesses.
Reliance on Printing Supplies: Printing supplies represented roughly 60% of Lexmark's revenue and an even greater percentage of operating profit, given the high profit margin on supplies. Reliance on printing volumes makes Lexmark vulnerable to long-term digitization, as print volumes are expected to decline in the low to mid-single digits during the rating horizon.
Limited Domestic Cash: Fitch expects Lexmark's domestic cash will remain limited, given the large percentage of cash flow generated outside the U.S. As a result, Lexmark may fund domestic cash shortfalls with incremental debt, likely delaying deleveraging, rather than potentially trigger tax liabilities by repatriating offshore cash. As of Sept. 30, 2016, $104.9 million of Lexmark's $117.7 million of cash and cash equivalents was located outside the U.S.
MPS Market Share: Lexmark has the second largest share of the large enterprise managed print services (MPS) market behind Xerox Corp., and growth continues to exceed the overall market, supported by and strong contract renewal rate.
ESW Sale: Fitch believes the ESW sale is a modest net credit negative, given reduced revenue diversification, as well as ESW's faster growth rates and higher profit margins. ESW is small at just over $600 million of run rate revenue (roughly 20% of total revenue) but growing by mid-single digits versus slightly negative for the remainder of the business, pro forma for the inkjet wind down. At the same time, non-GAAP operating income margin should continue expanding and already surpassed that of the ISS business. The sale unwinds Lexmark's 2015 acquisition of Kofax for $1 billion of total cash consideration and roughly doubled the company's enterprise software offerings, supporting potential debt reduction.
Competitive Industry: The print industry is intensely competitive, resulting in the commoditization of printing hardware, which drives consistent equipment pricing pressure.
Fitch's key assumptions within the rating case for Lexmark include:
--Modestly negative constant currency organic revenue growth over at least the near term, driven by large enterprise spending headwinds and the continued wind-down of inkjet revenues;
--Resumption of positive constant currency organic revenue growth in 2018 and beyond, driven by increased market penetration in China and Asia-Pacific;
--Lexmark achieves mid-teens operating EBITDA margins in 2017 but these expand to the high-teens despite a lower profit mix following the ESW sale, driven by the achievement of acquisition related cost synergies over the intermediate-term;
--Existing $400 million of senior notes due 2020 become pari passu with the acquisition related debt;
--ESW sales proceeds are sufficient to repay a portion of acquisition related debt in the near term;
--No other material debt repayments of dividends to the sponsors.
Positive rating actions could result from Fitch's expectations for:
--More than $100 million of annual FCF, driven by profitability expansion from the realization of transaction related cost synergies; and
--Total leverage sustained below 3.5x, driven by successful ESW sale and debt reduction.
Negative rating actions could result from Fitch's expectations for:
--Annual FCF near break-even from falling materially short on transaction related cost synergies and meaningfully lower than anticipated revenue growth; or
--Total leverage sustained near 4x, likely driven by lower than anticipated profitability, as well as less debt reduction from ESW sale proceeds.
Fitch believes liquidity is adequate and, as of Sept. 30, 2016, was supported by:
--$117.7 million of cash and cash equivalents, of which $104.9 million was located outside the U.S.;
--$200 million undrawn senior secured revolving credit facility expiring in three years;
Fitch's expectation for $100 million to $200 million of annual FCF beyond the near term also supports liquidity. In connection with the acquisition close, Lexmark terminated the $125 million secured trade receivables facility expiring Oct. 6, 2017 and $500 million revolver expiring 2019.
Pro forma for the transaction, Fitch estimates total debt will be $2.5 billion and consist of:
--$1.2 billion equivalent of RMB-denominated senior secured term loans maturing in seven years;
--$900 million term loan maturing in three years; and
--$400 million of 5.125% senior notes due March 15, 2020.
The indenture provides for make-whole redemptions and change of control puts for both tranches, as well as restrictions on the incurrence of secured debt up to 15% of consolidated net tangible assets. As a result, Lexmark redeemed the $300 million of 6.65% senior notes due June 1, 2018, and Fitch expects the remaining $400 million of 5.125% senior notes due March 15, 2020 will remain outstanding and be pari passu with transaction related senior secured debt.
Fitch's actions follow Lexmark's announcement of the successful completion of the acquisition by a consortium of investors for $40.50 per share in cash, equal to a total consideration of $3.6 billion. In connection with the acquisition's close, Lexmark announced it will separate and rebrand the Enterprise Software businesses as Kofax and then divest Kofax to focus on the imaging business, particularly in China and the Asia-Pacific region.
FULL LIST OF RATING ACTIONS
Fitch has taken the following rating actions:
Lexmark International Inc.
--Long-term IDR downgraded to 'BB' from 'BBB-';
--Senior secured notes assigned 'BB+/RR1' rating;
--Senior unsecured revolving credit facility 'BBB-' withdrawn;
--Senior unsecured notes 'BBB-' withdrawn.
The Rating Outlook is Negative.
Date of Relevant Rating Committee: Nov. 29, 2016
Summary of Financial Statement Adjustments - Fitch made no financial statement adjustments that depart materially from those contained in the published financial statements of Lexmark International Inc.
Additional information is available on www.fitchratings.com.
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 21 Nov 2016)
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