TEXT-S&P raises Harman International rating to 'BBB-'
Overview -- We have revised the business risk profile on Harman International Industries Inc. to satisfactory from fair because we believe the company will be able to retain its competitive position, especially in the automotive audio and infotainment segments. -- We assume the company will maintain or improve margins in most segments and that management will pursue a conservative financial policy. -- We have raised the corporate credit rating on Stamford, Conn.-based auto supplier Harman International Industries Inc. to 'BBB-' from 'BB+'. -- The stable outlook reflects our view that the company's improved operating performance will enable it to remain profitable and cash flow positive despite weak demand in Europe. Rating Action On Sept. 6, 2012, Standard & Poor's Ratings Services raised its corporate credit rating on Harman International Industries Inc. to 'BBB-' from 'BB+'. The outlook is stable. At the same time, we also raised our rating on the senior unsecured debt to 'BB+' from 'BB'. Rationale The upgrade reflects our revision of Harman's business risk profile to "satisfactory" from "fair," based on our assumption that the company will be able to sustain profitability at or above double-digit EBITDA margins, expand its global manufacturing presence along with the automakers it supplies, and continue to successfully innovate its software- and hardware-based product lines. We believe this is feasible, given the track record of recent years and our expectation of mixed but overall slow recovery in auto sales and vehicle production globally. We assume growth in the emerging markets will exceed that for most mature markets in the year ahead. We expect new-vehicle demand to improve in North America at about 11% year over year in 2012, but sales will likely fall in Europe for the fifth year in a row in 2012. We believe Harman's products, which are largely software based, can withstand the risk of commoditization, as well as potential inroads from other competitors that may have greater financial resources. In our opinion, the company has the technological capabilities to continue a leadership position in innovating product for the connectivity-infotainment segment of the auto industry, where vehicle performance safety and satisfaction of consumer's desire for information intersect. Harman's recently developed scalable infotainment products have the potential to expand its vehicle exposure beyond premium brands to more price sensitive volume brands. The ratings also reflect Harman's "intermediate" financial profile, including our expectation that the company can generate positive free cash flow after capital spending of at least $150 million per year in the next two years, lease-adjusted leverage will remain below 2.5x (it was 1.4x for fiscal year end June 30, 2012), and funds from operations (FFO) to total debt will remain above 30% (it was 65.4% as of June 30). We believe that, given the company's sizable backlog of new automotive business to be launched in the next several years, the company will be able to generate double-digit margins and free cash flow next year despite significant economic uncertainty. Less profitable auto business has been running off and should be minimal by 2016 at worst. Through its multiyear restructuring program and relocation to low-cost countries, Harman, in our opinion, has achieved an operational break-even point that better fits expected intermediate-term global auto production levels. Also, the company continues to win new business awards from major global automakers that should boost revenues beginning in 2013, when this new business is scheduled to launch. The automotive order backlog totaled $16.1 billion at fiscal year-end June 30, 2012. New auto order in fiscal 2012 totaled $4 billion for infotainment and $1.2 billion for branded car audio. We believe the company's profit potential and competitive standing in its markets depend on operational efficiencies and ongoing technological innovation, which is why the company targets research and development (R&D) spending at 8% of sales. We believe that management's financial policies will remain conservative. Still, we expect the company will pursue periodic acquisitions of technology, although most should not lead to higher leverage, depending on the size of the investment. Also, the board has recently authorized a $200 million share repurchase authorization and initiated dividend payments to shareholders. We believe the company's free cash flow will support these shareholder friendly actions rather than debt. The upgrade incorporates the assumption that the company will be able to comfortably manage its $400 million October 2012 debt maturity with cash on hand or alternative borrowing. Kohlberg Kravis Roberts & Co. L.P. (KKR; not rated), holds Harman's $400 million 1.25% convertible notes and controls one seat on Harman's board of directors. We do not expect KKR to make a renewed leveraged buyout attempt, given a standstill agreement, and we have no reason to believe KKR's presence in the corporate capital and governance structures has hurt Harman's financial and business strategies. In addition to KKR, an activist shareholder--Relational Investors LLC (not rated; Ralph Whitworth and David Batchelder)--has held shares in Harman since 2009. We acknowledge the potential for more aggressive shareholder friendly actions typically associated with such investors. But our rating on Harman incorporates the assumption that it will remain an independent, publicly traded company with a conservative financial policy based upon the track record developed under current management and while Relational has been a shareholder. The company reports three business segments: -- Infotainment, which provides 56% of sales and EBITDA margin of 10.2% in fiscal 2012; -- Lifestyle (auto and consumer audio products), with 30% of revenues and 13.1% EBITDA margin; and -- Professional audio, with 14% of revenues and 16.7% EBITDA margin. Harman's satisfactory automotive business position benefits from its expertise in audio technology, which is evident from its strong position in the professional audio market, and from brand awareness garnered in the consumer audio market. The company has well-recognized brand names in audio products, such as Harman/Kardon, JBL, and Infinity, and a leading market position in branded automotive audio products, as well as in general audio equipment for professional use. Harman's business risk profile reflects its material exposure to the highly competitive global auto market--which accounts for about 70% of the company's revenues--and concentration of sales with certain automakers. Harman holds a significant position (a reported 22% market share) in infotainment technology for the auto market. Harman has fair geographic diversity with its $4.4 billion of fiscal 2012 revenues derived 30% in Europe (74% from Germany, and the remainder from U.K., France, Italy, and Spain), 40% in North America, 12% in the BRIC countries (Brazil, Russia, India, and China), and 18% in the rest of the world. Harman's auto products are concentrated among premium branded vehicles--BMW AG constituted 19% of automotive sales in fiscal 2012, Audi/Volkswagen AG 14%, followed by Toyota, Fiat Chrysler, and Daimler AG. Liquidity We consider Harman's liquidity as "strong" under our criteria. We believe Harman can more than cover its needs for the next two years, even if EBITDA were to decline 30% from our assumed level. As of June 30, 2012, the company had $617 million in cash and $203 million in short-term investments. Also, the company had $541.3 million of available borrowing capacity, net of letters of credit, on its undrawn $550 million multicurrency revolving credit facility that expires in December 2015. Under the revolving facility, covenants include the requirement that the interest coverage ratio must be more than 3.25 to 1.00, total leverage must be less than 4.00 to 1.00, and senior leverage must be less than 3.00 to 1.00 at the end of each quarter, on a trailing-12-month basis. The covenants do not tighten over time. We believe that Harman will have adequate EBITDA cushion in meeting these requirements. Harman's only debt maturity is its $400 million, 1.25% convertible note issue due October 2012. We believe the company will fund payment of this obligation when it's due with available cash, but a refinancing of this maturity would not affect the rating since leverage is currently well under 2x. The company generated $156 million in free cash flow for the fiscal year-end 2012, and we believe it will generate free cash flow, after capital spending, in fiscal 2013 and 2014 of at least $200 million, given reduced cash restructuring costs versus prior years. But potentially higher working capital requirements for product launches could offset this. During fiscal 2013 and 2014, we expect the company to use cash for midsize acquisitions, share repurchases, and dividend payments. In October 2011, the board authorized share buybacks up to $200 million and a modest dividend was reinstated in fiscal 2011. The company repurchased $124 million of its common stock in fiscal 2012. We expect capital spending to remain at about 3% or less of revenues in fiscal 2013 and 2014, and R&D expenditures to average 8% of revenues in the future. Harman's unfunded pension obligation is not significant. Outlook Our stable rating outlook on Harman reflects our view that its improved operating performance, resulting from attention to cost, efficiency, and engineering initiatives, and currently strong financial metrics will enable it to remain profitable and cash flow positive despite weak demand in Europe in the year ahead. The company occupies a growth segment within the auto market-driver-oriented electronic information devices that are safely interconnected with vehicle operations. Our base case assumes that the company will remain committed to balancing investments, dividends, and acquisitions in line with an investment-grade financial profile. At the current rating, we believe the company has sufficient free cash flow to accommodate some acquisitions and modest share buybacks. We could raise the rating in the next two years if Harman continues to win business with good margins, demonstrates its ability to innovate to maintain its leadership position in Western markets for auto audio and infotainment, further diversifies its customer base, and generates EBITDA margins that remain in the top quartile of the auto supplier sector. For an upgrade, we would also expect the company's credit metrics and cash flow after capital spending to remain somewhat improved from those reported as of June 30, 2012. This will be challenging because of the company's exposure to cyclical and highly competitive end-markets with potential swings in profitability and our view that there will be some expansion through acquisitions that may add some debt from time to time. Over the longer term, it is less likely that the business profile could improve, given our view that the auto industry is evolving into a global marketplace and, as a result, competition and cyclicality will continue to be a major consideration in the years ahead. We could lower our ratings if we see an increased likelihood of a combination of adverse market conditions, large acquisitions, or share buybacks that would weaken the company's credit measures to below what we see as commensurate for the 'BBB-' rating. We could lower the ratings if free operating cash flow turns negative for multiple quarters, or if FFO to total debt were to decline below 30%. We believe this would not occur unless another very substantial downturn in auto production caused Harman's revenues to decline 25% or more. Related Criteria And Research -- August U.S. Auto Sales Rise Above Standard & Poor's 2012 Full-Year Expectation, Sept. 5, 2012 -- Issuer Ranking: Global Auto Suppliers, Strongest To Weakest, June 8, 2012 -- The Credit Overhang: Implications For The Global Automotive Sector Of A Hard Landing In China, May 29, 2012 -- Credit FAQ: Top 10 Investor Questions: What Are The Issues To Consider In Credit Analysis Of The U.S. Auto Sector In 2012?, May 15, 2012 -- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- Key Credit Factors: Business And Financial Risks In The Auto Component Suppliers Industry, Jan. 28, 2009 -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008 Ratings List Upgraded; Outlook Action To From Harman International Industries Inc. Corporate Credit Rating BBB-/Stable/-- BB+/Positive/-- Upgraded To From Harman International Industries Inc. Senior Unsecured BB+ BB Recovery Rating NR 5 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.
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