NEW YORK--(BUSINESS WIRE)--Fitch Ratings has upgraded Huntington Ingalls Industries, Inc.'s (HII) Issuer Default Rating (IDR) and senior unsecured debt ratings to 'BB+' from 'BB'. Fitch has also affirmed HII's senior secured facilities at 'BBB-'. The Rating Outlook is Stable. The ratings cover approximately $1.7 billion of outstanding debt. A full list of ratings follows at the end of this release.
KEY RATING DRIVERS
The upgrade is supported by HII's improved operating performance which resulted in higher than expected margins, stronger free cash flow generation (FCF - operating cash flows less CapEx and dividends), lower leverage (Debt to EBITDA) and lower FFO adjusted leverage. For the last twelve months (LTM) ending Sept. 30, 2014, the company had gross leverage of 1.7x, down from 2.3x and 3.2x at the end of 2013 and 2012, respectively. Fitch expects the company's leverage will decline further by the end of 2015 due to improving EBITDA margins and anticipated amortization of the senior secured term loan.
The ratings are also supported by Fitch's expectation of continued improvement of operating results driven by cost reduction initiatives and improved execution, solid liquidity, expected de-levering over the next two years and medium-sized acquisitions which are expected to diversify HII's revenues from nearly 100% exposure to the U.S. government's military spending. Additionally, the company has a significant role in the U.S. Navy's 30 year shipbuilding plan released in July 2014. HII is a sole source manufacturer of more than 70% of its revenues.
HII's credit metrics are solid for the new rating level. The company has the financial strength to withstand pressure on its revenues and profits, but Fitch believes a non-investment grade rating is still appropriate given concerns about low customer and product diversification of the company. Additionally, HII has a significant exposure to program execution risk as evidenced by the underperformance of its Ingalls segment within the past few years due to troubles with LPD and LHA ships.
Fitch's other rating concerns include large annual net working capital swings, increased dividends, and the company's exposure to risks to core defense spending after fiscal 2015. HII generates nearly all of its revenues from the U.S. government, exposing the company to changes in plans regarding the fleet needs of the Department of Defense (DoD) and the Department of Homeland Security. In addition, Fitch is concerned with future cash deployment actions as the company continues refining its cash deployment strategy.
The notching up of the senior secured credit facility by one rating level from the IDR of 'BB+' to 'BBB-' is supported by the coverage provided by HII's tangible assets and operating EBITDA compared to the fully drawn facility. The collateral for the facility includes substantially all of HII's assets with the exception of the Avondale shipyard and a few other exclusions.
HII's EBITDA margins have increased significantly and reached 14.3% during the first three quarters of 2014, up from 11.3% and 8.4% in 2013 and 2012, respectively. HII generated approximately $606 million of cash flow from operating activities during the last 12 months ended (LTM) Sept. 30, 2014, up significantly from $236 million at the end of 2013. HII's FCF totaled $421 million during the LTM ended Sept. 30, 2014, up from $72 million at the end of 2013 primarily due to better operating results and lower working capital requirements. Fitch expects HII will continue to generate more than $250 million FCF annually. HII focuses its cash deployment on bolt-on acquisitions, capital expenditures, dividends, share repurchases to offset dilutions and pension contributions.
As of Sept. 30, 2014, HII had liquidity of $1.4 billion, including $769 million in cash and $619 million availability under its $650 million domestic credit revolving facility, after giving effect to $31 million of outstanding letters of credit. Fitch expects HII's liquidity will likely decline as the company continues refining its cash deployment strategies.
At the end of 2013, HII's pension plans were underfunded by approximately $420 million (91% funded), a significant improvement over the $1.3 billion (74% funded) deficit at the end of 2012. The improvement is largely due to an increase in interest rates, positive asset returns, and contributions. The pension benefit obligation (PBO) was $4.3 billion at the end of 2013, while the other postretirement benefit obligation was $616 million. Fitch expects HII's funded status for year end 2014 to deteriorate slightly due to a decline in interest rates and new mortality tables, offset by a strong year of asset gains and $123 million in discretionary contributions.
The pension deficit and required contributions are mitigated by expected reimbursements from the U.S. government which treats a part of pension costs as allowable and reimbursable costs under some government contracts. Fitch expects HII's CAS reimbursements will fully offset its funding requirements over the next several years resulting in net cash inflows.
HII generates almost all of its revenues from the U.S. government, primarily the DoD. As a result, defense spending is a driver of HII's financial performance and credit quality. U.S. defense spending is stabilizing and Fitch expects it could increase modestly, though there are still risks to the downside from high federal debt levels, delays in passing defense budgets, or changes in overall defense strategy. On the other hand, the change in control of Congress and a rising global threat environment could be catalysts for increases in global defense budgets. The sequester remains incorporated into Fitch's defense forecasts, so changes in timing or amounts could affect the outlook in the positive direction.
Despite spending cuts and ambiguity in long-term defense spending, Fitch believes HII is in a better position than most contractors to withstand changes in defense spending. The length of HII's contracts offset much of the impact from potential budget cuts. Fitch believes that it is difficult to implement partial budget cuts to many, if not all, of HII's programs. HII's performance in 2012 and 2013 demonstrated its ability to withstand pressures from changes in U.S. government defense spending. HII is exposed to the changes of U.S. Navy's shipbuilding plans; however, such changes are long term in nature.
Fitch may consider a positive rating action if HII's overall credit metrics continue to strengthen, including if its leverage and FFO adjusted leverage decline and remain in the range of 1.25x - 1.5x and 2x - 2.5x, respectively. Fitch is not likely to take a positive rating action until U.S. defense spending trends stabilize; the company has a defined cash deployment strategy; and it completes the Avondale shipyard closure.
Given the company's low diversification and its exposure to project execution risks, Fitch expects HII would need to maintain stronger than average credit metrics and financial flexibility in order to obtain investment grade ratings.
A negative rating action is not likely in the near future; however, it would be considered should the company's leverage and FFO adjusted leverage increase and remain above 2.5x and 3.5x, respectively. Other metrics in addition to leverage would also be considered in determining negative rating actions.
Fitch has taken the following rating actions:
--IDR upgraded to 'BB+';
--Senior secured bank facilities affirmed at 'BBB-';
--Senior unsecured debt upgraded to 'BB+'.
The Rating Outlook is Stable.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage' (May 28, 2014).
Applicable Criteria and Related Research:
Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage