Fitch Revises Caterpillar's Rating Outlook to Negative; Affirms IDR at 'A'

CHICAGO--()--Fitch Ratings has affirmed the Issuer Default Ratings (IDR) at 'A' and revised the Rating Outlook to Negative from Stable for Caterpillar Inc. (CAT), Caterpillar Financial Services Corporation (CFSC), and certain of CFSC's subsidiaries. A full list of rating actions follows at the end of this release.

NEGATIVE OUTLOOK

The revision to Negative reflects the impact of the extended downturn in CAT's machinery markets and an increased risk that the company could face challenges to rebuild its operating and financial performance to levels that support the current ratings. Fitch continues to view CAT's operating profile as fundamentally sound including its ability to weather cycles inherent in its markets and a strong competitive position.

A key rating consideration is the strength of an eventual demand recovery and CAT's future margins and free cash flow (FCF). A slow recovery could impede CAT's return to stronger credit metrics, and even in a stronger recovery, working capital requirements could constrain FCF if the company does not realize expected operating improvements from restructuring.

These concerns are mitigated by CAT's comprehensive actions to reduce its cost structure, which should enable it to generate solid financial results when end-market demand improves. Fitch anticipates that EBITDA margins, calculated excluding restructuring, could stabilize in 2017 near 12% compared to a peak level of more than 16% in 2012.

A $2 billion three-year restructuring program was implemented in 2015 which reduced costs by $880 million during the first nine months of 2016. CAT estimated total cost reductions related to the three-year restructuring program would be $1.5 billion annually, not including additional restructuring and other actions taken in 2016, which should also bring down costs and support future margins.

Fitch expects credit metrics may not improve until after 2017, one year later than originally expected, before a possible demand recovery emerges. Fitch estimates FCF will decline toward break-even in 2016 due to lower revenue and margins, lower benefits from inventory reductions, higher pension contributions, higher cash costs for restructuring, and a reduction in dividends from CFSC. CAT plans to make pension and OPEB contributions of $350 million in 2016 and $550 million in 2017 compared to $350 million in 2015. FCF as calculated by Fitch includes recurring dividends from CFSC and is adjusted to exclude the impact of changes in receivables sold to CFSC.

If CAT's end markets decline further in 2017, Fitch estimates FCF could be near break-even or slightly negative. However, CAT has strengthened its working capital management which, when combined with restructuring, could support stronger FCF than currently estimated. In the event of even a modest recovery, CAT could begin to rebuild credit metrics which could support a return to a Stable Outlook.

The ratings could be downgraded in the event that CAT's machinery markets do not show signs of material improvement within 12-18 months, together with a clear path to improved FCF and stronger credit metrics.

KEY RATING DRIVERS

The long-term ratings for CAT incorporate a high degree of cyclicality in the company's construction, mining, energy and transportation markets. Manufacturing revenue has declined by more than 40% since 2012 due to sharply lower capital spending by mining companies, the negative impact of low oil prices on demand for engines and construction equipment, and weak global economic growth. Any initial increase in demand typically would be driven by maintenance and replacement spending, and it is unlikely that the next upcycle would reach the previous peak, particularly in the mining sector.

Rating strengths include CAT's liquidity, operating flexibility, global presence, broad product lines, diverse customer base, and an established and well-capitalized independent dealer network. The dealer network is a core part of CAT's strategy as it supports the company's market share for both original equipment and aftermarket business. Continued R&D spending of approximately $2 billion annually through the past few years of the downturn should help protect CAT's competitive position when end-market demand recovers.

Rating concerns include support that could be required for CFSC in the event that credit quality in CFSC's receivables portfolio deteriorates materially or if CFSC has diminished access to funding sources. Fitch views CFSC's credit profile as strong and believes support from CAT is unlikely to be needed in the near term. However, if delinquencies and asset write-downs increase CFSC could experience lower liquidity, and dividends from CFSC to CAT could be reduced or eliminated. These concerns are mitigated by CFSC's focus on its captive portfolio and CFSC's effective management of its residual risk exposure.

Fitch estimates debt/EBITDA will be in the low 2x range into 2018 (low 3x range when including adjustments related to Financial Products described in the next paragraph) compared with 1.3x or lower prior to 2015, assuming CAT uses available cash to repay scheduled debt maturities.

Under Fitch's criteria for rating non-financial corporates, Fitch calculates an appropriate debt/equity ratio of 3x at Financial Products based on asset quality as well as liquidity and funding that incorporate support from CAT in the form of funding agreements. The calculated ratio assumes lower external funding than is typically reported by Financial Products, with the difference funded by CAT as an equity injection. Fitch assumes CAT would fund its equity injection through the use of excess cash or new debt which we include in debt at the manufacturing business. This Fitch-calculated debt amount is higher than actual debt outstanding. Actual debt/equity at Financial Products as measured by Fitch, including intangible assets, was 6.8x as of Sept. 30, 2016. As a result, Fitch calculates a pro forma equity injection of approximately $4.1 billion would be needed to reduce debt/equity to 3x at Financial Products.

CAT is involved in litigation with the IRS which has proposed taxes and penalties totaling approximately $1 billion for the 2007-2009 period related to profits at a CAT subsidiary in Switzerland. The amount of an eventual resolution is uncertain and the process could be lengthy, which would allow CAT to generate additional cash flow to help fund any payments if they are required.

There are also investigations into conduct at CAT's Progress Rail business regarding business practices and potential violations of environmental laws that could result in penalties or fines.

CATERPILLAR FINANCIAL SERVICES CORPORATION (CFSC)

CFSC's ratings and Outlook are equalized with CAT's, reflecting Fitch's view of CFSC as a core subsidiary of CAT based on the 100% ownership, shared brand name, importance of CFSC to achieving CAT's strategic objectives and the Support Agreement between the two entities. The Support Agreement requires CAT to maintain 100% ownership of CFSC, maintain CFSC's net worth at no less than $20 million, and maintain CFSC's fixed-charge coverage at not less than 1.15x or higher on an annual basis.

Beyond these support-driven considerations, Fitch also considers CFSC's consistent operating performance and solid asset quality performance, which are counterbalanced by elevated leverage levels relative to stand-alone finance and leasing companies, but consistent with similarly rated captive finance peers, as well as its reliance on wholesale funding sources. Today's rating actions are based solely on support-driven factors that drive CFSC's ratings rather than a change in Fitch's view of the captive finance company's overall credit profile.

Asset quality metrics have remained solid in 3Q16. At the end of the quarter, past dues were 2.77% compared to 2.68% in 3Q15. Write-offs, net of recoveries, were $29 million, or 0.48% of average receivables as calculated by Fitch, compared to $69 million or 1.15% one-year prior. The decrease in net write-offs was due to the absence of large write-offs that occurred in 3Q15 in the mining and marine portfolios. While overall asset quality metrics will remain solid in the near-term, Fitch expects mean reversion in delinquency and write-off performance over the medium- to longer-term. As of Sep. 30, 2016, the allowance for credit losses amounted to $346 million, or 1.28% of net finance receivables, compared to $348 million, or 1.26% of net finance receivables. Given strong historical asset quality performance and direct CAT support, Fitch views CFSC's loss reserves to be sufficient to cover potential losses on its receivables.

Operating performance was modestly weaker in third quarter 2016 (3Q16) relative to last year, but remained consistent when compared to recent years after hitting lows in 2009 when weak economic conditions contributed to higher credit costs and lower origination volumes. Revenues in 3Q16 were $2 million lower compared to 3Q15 due to lower values on returned or repossessed equipment and lower average earning assets, offset by higher average financing rates. Pre-tax income was $7 million lower in 3Q16 compared to last year due to an increase in provisions for credit losses, offset by a decline in general, operating and administrative expenses. This translated to pre-tax returns on average assets of 1.72% in 3Q16 as calculated by Fitch compared to 1.78% one-year earlier. Fitch expects overall operating performance to remain relatively stable over the near- to medium-term, but metrics are expected to be comparatively weaker in 2016 relative to 2015 due to a decline in origination volume, modestly lower equipment values, and higher credit costs.

Leverage, which is calculated by Fitch as gross debt to tangible equity, was 8.79x, as of Sept. 30, 2016. However, covenant leverage, defined under CFSC's credit facilities as consolidated debt to consolidated net worth (including preferred stock but excluding accumulated comprehensive income and non-controlling interests), was 7.56x, as of Sept. 30, 2016, and consistent with the historical average of 7x-8x. Fitch expects CFSC to manage leverage with sufficient cushion relative to the maximum leverage level permitted by its covenant of less than 10x (measured as of year-end and monthly over a rolling six-month basis). Further, it is important to note that leverage, although high, remains consistent with other captive finance peers but higher than many stand-alone finance companies. Fitch does not anticipate any significant changes in CFSC's capital structure over the Outlook horizon. Should funding requirements increase, Fitch believes that CAT would inject additional capital into the captive finance company, as necessary to manage CFSC's overall leverage profile.

As of Sept. 30, 2016, CFSC had approximately $1 billion of unrestricted balance sheet cash and generated annualized operating cash flow of $1.4 billion. The company also had availability under its various borrowing facilities for contingent liquidity. Funding is 100% unsecured, which is viewed favorably compared to peers, but remains reliant on confidence-sensitive, wholesale sources. The company relies on the global debt capital markets and bank funding programs to provide liquidity for its operations, as well as support from its parent. CFSC's ability to consistently access the global capital markets demonstrates the strength of CAT's brand and franchise. Fitch believes the company's comprehensive funding platform, in combination with the financial strength of its parent, is consistent with other captive finance companies.

KEY RATING DRIVERS - Caterpillar Financial Australia Limited (CFAL), Caterpillar International Finance (CIF) and Caterpillar Finance Corporation (CFC)

CFAL, CIF and CFC are wholly-owned subsidiaries of CFSC. The ratings of the subsidiaries reflect the unconditional and irrevocable guarantee provided by CFSC for full repayment of obligations under the subsidiaries' various borrowing facilities. The guarantee is viewed as the strongest form of parental support, which in Fitch's view, enhances the rating linkages between CFSC and is subsidiaries. As a result, the IDRs and debt ratings of the subsidiaries are linked to those of CFSC.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for CAT's manufacturing business include:

--The cyclical downturn continues into 2017 in CAT's mining, energy, and international construction equipment markets with some stabilization possible by the end of the year;

--EBITDA margins decline into 2017 due to lower revenue and an unfavorable sales mix, partly offset by restructuring benefits. EBITDA strengthens over the long term due to a lower cost structure and operating improvements;

--Ongoing restructuring actions contribute to annual cost savings of at least $1.5 billion by 2018 related to a $2 billion program announced in 2015 and additional savings from more modest restructuring actions implemented in 2016;

--FCF declines in 2016 but remains positive. Thereafter, we believe FCF could continue to be constrained if end markets do not stabilize. FCF could improve if end markets stabilize and CAT realizes planned restructuring benefits and manages working capital effectively;

--Future cash deployment for share repurchases will be minimal until CAT's performance improves although some repurchases are possible to offset dilution from stock compensation;

--Debt maturities are repaid as scheduled.

--CAT maintains market share.

RATING SENSITIVITIES

Caterpillar Manufacturing Business

Future developments that could lead to a Stable Outlook include:

--Stronger FCF after 2016 that would support debt reduction and return to mid-cycle leverage within 18 months;

--A recovery in demand which would be expected to lead to favorable incremental EBITDA margins;

--Meaningful market share growth in emerging markets;

--Effective product development;

--An increase in the company's geographic and product diversification or in the proportion of relatively stable parts and services revenue.

Future developments that may, individually or collectively, lead to a downgrade include:

--FCF is insufficient to repay scheduled debt maturities and reduce leverage toward mid-cycle levels as CAT's end markets eventually recover. When including Fitch's adjustment to CAT's debt related leverage at Financial Products, Fitch expects mid-cycle FFO adjusted leverage will be near 3x or below (2x or below when excluding the adjustment), and debt/EBITDA including Fitch's adjustment for Financial Products will be near 2.3x or below (1.3x or below when excluding the adjustment);

--Margins remain permanently lower after end-market demand improves;

--CAT experiences poor execution on its operating strategies including restructuring and inventory and supply chain management;

--Market share declines materially in key product lines or geographic regions;

--CFSC requires support from CAT due to asset write-offs or difficulty accessing debt markets.

CFSC and Designated Subsidiaries

Positive rating momentum would be limited by Fitch's view of CAT's credit profile, as CFSC's ratings and Outlook are linked to that of its parent. Fitch cannot envision a scenario where the captive would be rated higher than its parent.

Conversely, negative rating actions for CFSC could be driven by a change in the perceived relationship between CAT and CFSC. For example, if Fitch believed that CFSC had become less core to CAT's strategic operations and/or adequate support was not provided to the captive finance company in a time of need. In addition, consistent operating losses, a material change in tangible balance sheet leverage, and/or deterioration in the company's liquidity profile, any of which alters CFSC's perceived risk profile and/or requires the injection of regular financial support from CAT, could also drive negative rating actions.

The ratings of CFAL, CIF, and CFC are linked to those of CFSC, and therefore, are sensitive to changes in CFSC's ratings.

LIQUIDITY

CAT's liquidity (excluding CFSC) at Sept. 30, 2016, as calculated by Fitch, totaled $5.6 billion, including manufacturing cash of $5.3 billion and credit facility availability of approximately $2.5 billion, offset by $553 million of current maturities of long-term debt, $263 million of short-term debt, and $1 billion of short-term borrowings from CAT affiliates. Slightly more than 80% of CAT's $6.1 billion of consolidated cash was held overseas. CAT estimates a portion of its overseas cash would be subject to U.S. taxes if repatriated.

Long-term debt is well-distributed, with annual maturities over the next five years consisting of $500 million due in 2017, $900 million due in 2018 and $1.4 billion due in 2021. Other cash requirements include pension contributions that CAT estimates at $350 million in 2016 and $550 million in 2017. At the end of 2015, pension plans were underfunded by $4.8 billion (76% funded).

Credit facility availability of $2.75 billion as of Sept. 30, 2016 is the internal allocation of CAT's consolidated $10.5 billion of facilities to the equipment business. CAT can revise the allocation of these facilities between CFSC and its equipment businesses at any time. The facilities were amended in September 2016 and consist of a $3.15 billion 364-day facility that expires in September 2017, a $2.73 billion facility that expires in September 2019, and a $4.62 billion facility that expires in September 2021.

Under intercompany variable and term lending agreements and other notes, as of Sept. 30, 2016 CAT may borrow up to $2.29 billion from CFSC ($1.5 billion outstanding) and CFSC may borrow up to $3.3 billion from CAT ($1.8 billion outstanding) on a short-term basis. In addition, CFSC provides a $2 billion committed credit facility to CAT which expires in 2019.

CFSC also purchases, at discount, dealer and customer receivables from CAT. Outstanding receivables balances purchased by CFSC totaled $2.2 billion at Sept. 30, 2016. Fitch classifies changes in these amounts as financing cash flows at CAT's manufacturing business.

FULL LIST OF RATING ACTIONS

Fitch has affirmed the following ratings:

Caterpillar Inc. (CAT)

--Long-Term IDR at 'A';

--Senior unsecured bank credit facilities at 'A';

--Senior unsecured notes at 'A';

--Short-Term IDR at 'F1';

--Commercial paper (CP) at 'F1'.

Caterpillar Financial Services Corporation

--Long-Term IDR at 'A';

--Short-Term IDR at 'F1';

--Senior unsecured notes at 'A';

--Senior unsecured bank facilities at 'A';

--CP at 'F1'.

Caterpillar Financial Australia Limited

--Short-Term IDR at 'F1';

--CP at 'F1'.

Caterpillar International Finance Limited

--Long-Term IDR at 'A';

--Senior unsecured notes at 'A';

--Senior unsecured credit facilities at 'A'.

Caterpillar Finance Corporation

--Long-Term IDR at 'A';

--Senior unsecured notes at 'A';

--Senior unsecured credit facilities at 'A'.

The Rating Outlook is revised to Negative from Stable.

The ratings cover approximately $10.3 billion of debt at CAT as of Sept. 30, 2016 and nearly $28 billion of unsecured debt at CFSC, before considering intercompany loans.

Summary of Financial Statement Adjustments:

--CAT's operating cash flow has been adjusted to exclude the impact of changes in sales of receivables to Cat Financial which Fitch considers to be a financing cash flow.

--Leverage at CAT is adjusted to include new debt under Fitch's calculated equity injection to Financial Products.

Additional information is available on www.fitchratings.com

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

Global Non-Bank Financial Institutions Rating Criteria (pub. 15 Jul 2016)

https://www.fitchratings.com/site/re/884128

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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1016164

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Contacts

Fitch Ratings
Primary Analyst
Eric Ause, +1-312-606-2302
Senior Director
Fitch Ratings, Inc.
70 W. Madison Street
Chicago, IL 60602
or
Secondary Analyst
Craig Fraser, +1-212-908-0310
Managing Director
or
Committee Chairperson
Philip Zahn, +1-312-606-2336
Senior Director
or
Primary Analyst (Caterpillar Financial Services Corporation and designated subsidiaries)
Johann Juan, +1-312-368-3339
Director
Fitch Ratings, Inc.
70 West Madison St
Chicago, IL 60602
or
Secondary Analyst
Sean Pattap, +1-212-908-0642
Senior Director
or
Committee Chairperson
Doriana Gamboa, +1-212-908-0865
Senior Director
or
Media Relations
Alyssa Castelli, +1-212-908-0540 (New York)
alyssa.castelli@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Eric Ause, +1-312-606-2302
Senior Director
Fitch Ratings, Inc.
70 W. Madison Street
Chicago, IL 60602
or
Secondary Analyst
Craig Fraser, +1-212-908-0310
Managing Director
or
Committee Chairperson
Philip Zahn, +1-312-606-2336
Senior Director
or
Primary Analyst (Caterpillar Financial Services Corporation and designated subsidiaries)
Johann Juan, +1-312-368-3339
Director
Fitch Ratings, Inc.
70 West Madison St
Chicago, IL 60602
or
Secondary Analyst
Sean Pattap, +1-212-908-0642
Senior Director
or
Committee Chairperson
Doriana Gamboa, +1-212-908-0865
Senior Director
or
Media Relations
Alyssa Castelli, +1-212-908-0540 (New York)
alyssa.castelli@fitchratings.com