NEW YORK--(BUSINESS WIRE)--Fitch Ratings has taken various rating actions on Exelis Inc. (XLS) after the company's acquisition by Harris Corporation (HRS) on May 29, 2015. Fitch has removed from Rating Watch Negative and downgraded XLS' long-term Issuer Default Rating (IDR), senior unsecured facilities and senior unsecured notes to 'BBB-' from 'BBB+' and its short-term IDR to 'F3' from 'F2'. Simultaneously, Fitch has withdrawn the long- and short-term IDRs. A complete list of rating actions follows at the end of this release
HRS completed the acquisition of XLS in a cash and stock transaction valued at approximately $4.75 billion on May 29, 2015 with XLS continuing as the surviving entity and as a wholly owned subsidiary of the company. The rating action affects $650 million of XLS' senior unsecured indebtedness. HRS expects to guarantee XLS' notes and obtain XLS' guarantee of its notes within ten business days. A complete list of HRS' ratings is provided at the end of this release.
KEY RATING DRIVERS
The downgrade of XLS' senior unsecured notes equalizes the ratings with Fitch's senior unsecured credit ratings of HRS given the provision of upstream guarantees of HRS debt by XLS and the downstream guarantees provided HRS of XLS notes.
HRS' ratings are supported by the company's competitive position in the defense industry; technology capability; sizable international and commercial sales; good product diversification; adequate liquidity; and large backlog. The company has solid cash generation and strong operating margins and is expected to realize significant cost savings from the XLS acquisition. Additionally, HRS is a sole source provider for many of its products. The ratings are also supported by adequate financial flexibility and Fitch's expectations that HRS will improve its credit metrics over the next three years largely driven by voluntary and scheduled debt reductions.
Some of HRS' leverage metrics are weak for the ratings. Fitch estimates the company's leverage (debt to EBITDA) and adjusted leverage (adjusted debt / EBITDAR) are 3.1x and 3.3x, respectively, a significant deterioration compared to 1.5x and 1.7x at the end of fiscal 2014 (ended June 30, 2014). Fitch estimates HRS' credit metrics will improve over the next two years driven by modest revenue growth and voluntary debt repayment.
Despite HRS' elevated post-acquisition leverage, Fitch believes the company has an investment grade profile due to strong cash generation, solid financial flexibility, strong margins and technological advantages compared to some of its peers. HRS' management is committed to maintaining investment grade ratings and has publically stated its goal to de-lever rapidly. Many of the company's other credit metrics (profitability, diversity, backlog, etc.) are indicative of a strong investment grade company.
HRS has financial flexibility to reduce its debt rapidly. The recently announced $1.3 billion term loans will be repayable without penalties and HRS targets retiring approximately $1.8 billion in debt over the next three years to bring its net debt leverage to 1.5x (which Fitch estimates is equivalent to approximately 1.7x on a gross leverage basis) as communicated during the announcement of the XLS acquisition. Fitch expects HRS' leverage and adjusted leverage will decline to approximately 2.2x and 2.5x, respectively, by the end of fiscal 2017. Funds from operations (FFO) adjusted leverage is also expected to improve to approximately 3x during the same time frame.
Fitch's concerns include merger integration risks, uncertainty surrounding HRS' ability to realize identified synergies, XLS' large pension deficit which are assumed by the company (including a relatively high percentage of Level III assets), and corresponding future pension funding requirements. Additionally, Fitch is concerned about HRS' future cash deployment strategies but expects the company's share repurchases will be moderate.
There is also likely to be some strategic uncertainty given the possibility of future portfolio actions, but Fitch anticipates HRS will not make sizable acquisitions until it completes XLS' integration and reduces its leverage. HRS' ratings will also be exposed to shocks and downturns in U.S. military spending or shifts in spending mix, although Fitch believes there is a good chance that spending is now at or near a trough. Fitch also notes that despite the larger scale that will result from the acquisition, HRS will remain smaller than many of its key competitors.
HRS has assumed XLS' sizable pension deficit of $1.9 billion (70% funded) as of Dec. 31, 2014, up from $1.2 billion (78% funded) at the end of 2013. The deterioration in the funded status of the pension plans was primarily driven by a decrease in discount rates and new mortality/actuarial assumptions. The domestic pension benefit obligation was $6.8 billion at the end of 2014. Required cash contributions to XLS' plans were $133 million in 2014; however, the large pension deficit and required contributions are mitigated by the expected reimbursements from the U.S. government, which treats a part of pension costs as allowable, and reimbursable costs under some contracts.
Fitch's key assumptions within its rating case for the HRS include:
--Low single-digit revenue growth.
--EBITDA margins at approximately 21%, with modest increases in the following years, reflecting Fitch's conservative view of the realized merger synergies. Fitch excluded synergies in its modeling resulting in slower than possible revenue and margin improvements.
--Debt repayment will be accelerated and driven by the company's cash generation. HRS' leverage may be reduced faster if the company realizes planned synergies, allocates less cash to share repurchases and dividend increases, or divests assets.
--Dividend payout ratio will remain unchanged from HRS' pre-acquisition targets.
--Share repurchases will be suspended in fiscal 2016, but will resume in fiscal 2017. Fitch expects share repurchase amounts will depend on internal cash generation and may not resume in fiscal 2017 if the company's is not on target to achieving its 1.5x net leverage goal by the end of fiscal 2018.
--The company will contribute approximately $160 million towards its pension liabilities annually.
--Capital expenditures will fluctuate in the range of 2.25% to 2.75% of revenues.
--Cross guarantees between XLS and HRS will be put in place within next ten days.
Fitch does not expect to take positive rating actions until HRS reduces its leverage and makes progress on the merger integration.
Fitch may take a negative rating action if the HRS's post-acquisition leverage and adjusted leverage remain above 2.5x and 2.75x, respectively, for a prolonged and sustained period of time. Fitch may also consider a negative rating action if HRS's FCF margin declines and remains below 4%. Additionally, a negative rating action may be considered if the merger results in unforeseen operating challenges and HRS fails to achieve expected financial results, or engages in sizable share repurchases or acquisitions prior to reducing leverage.
Fitch expects HRS' liquidity will be in the range of $1.3 billion to $1.5 billion consisting of cash and nearly full availability under its $1 billion revolving credit facility. Fitch expects the company's liquidity will remain steady over the next several years as Fitch anticipates the cash balances will not increase due to rapid debt repayment. Additionally, Fitch expects HRS will generate approximately $600 million of annual free cash flow (FCF - Cash Flow from Operations less CapEx and Dividends).
FULL LIST OF RATING ACTIONS
Fitch has taken the following rating actions on Exelis Inc.:
--IDR downgraded to 'BBB-' from 'BBB+' and withdrawn;
--Senior unsecured notes downgraded to 'BBB-' from 'BBB+';
--Senior unsecured revolving credit facility downgraded to 'BBB-' from 'BBB+';
--Short-term IDR at downgraded to 'F3' from 'F2' and withdrawn;
--Commercial paper downgraded to 'F3' from 'F2' and withdrawn.
Fitch currently rates Harris Corporation as follows:
--Long-term IDR 'BBB-';
--Senior unsecured revolving credit facility 'BBB-';
--Senior unsecured term loans 'BBB-';
--Senior unsecured notes and debentures 'BBB-';
--Short-term IDR 'F3';
--Commercial paper 'F3'
The Rating Outlook is stable.
Additional information is available on www.fitchratings.com
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 28 May 2014)
Parent and Subsidiary Rating Linkage Fitch's Approach to Rating Entities within a Corporate Group Structure (pub. 05 Aug 2013)