Fitch Affirms L-3 Communications at 'BBB-'; Outlook Stable

Thu Sep 26, 2013 5:44pm EDT

(The following statement was released by the rating agency) NEW YORK, September 26 (Fitch) Fitch Ratings has affirmed the 'BBB-' Issuer Default Rating (IDR) and debt ratings for L-3 Communications Holdings, Inc. (L-3) and L-3 Communications Corporation. Fitch also affirms the 'BB+' rating for L-3's convertible contingent debt securities, which are rated one notch below the IDR and senior unsecured debt due to the subordination of the security's guarantees. The Rating Outlook is Stable. Approximately $3.6 billion of outstanding debt is covered by these ratings. A full rating list follows at the end of this release. Key Rating Drivers Key factors that support the ratings include L-3's adequate credit metrics; strong liquidity position; and Fitch's expectation of solid margins and substantial free cash flow (FCF; cash from operations less capital expenditures and dividends). Other positive factors include L-3's diverse portfolio of products and services, and increasing international and commercial sales which accounted for 24% (11% international) of sales in 2012, up from 18% (8% international)in 2011. L-3 expects international and commercial sales to grow to 27% in 2013, a level which L-3 achieved in the second quarter. The higher percentage of in international and commercial sales is driven by organic sales growth and by the spin-off of Engility Holdings, Inc. (Engility), which reduced L-3's exposure to the U.S. government spending. Fitch's rating concerns include: --L-3's declining revenues and lower margins, which are expected to remain under pressure due to the impact of sequestration and the continued withdrawal of the U.S. troops from Afghanistan; --The company's cash deployment strategy, which includes a focus on dividends and share repurchases, though this is mitigated by L-3's commitment to retaining investment grade ratings and the $500 million of debt reduction completed in 2012; and --L-3's exposure to declines in core U.S. defense spending, and uncertainty surrounding the fiscal 2014 Department of Defense (DoD) budget, although Fitch believes that modest defense spending declines (which are incorporated into Fitch's projections) will not have a material impact on the company's credit metrics. Fitch's is also concerned with L-3's underfunded pension plans, with a deficit totaling $1.2 billion (63% funded status) as of Dec. 31, 2012. This concern is mitigated the company's strong cash generation as the required minimum contribution represents less than 10% of L-3's FCF. Additionally, the pension deficit is expected to decline in 2013 due to increasing interest rates. On July 17, 2012, L-3 completed the spin-off of Engility, receiving a one-time $335 million dividend. On July26, 2012, L-3 used some of the dividend proceeds to redeemed $250 million of 6.375% senior subordinated notes due 2015 to decrease its leverage heightened by the spin-off of Engility which accounted for approximately 8%-10% of L-3's combined EBITDA and FCF in 2012. On Oct. 15, 2012, L-3 redeemed the remaining $250 million of the 6.375% senior subordinated notes. The repayment of the notes completed the company's shift away from senior subordinated debt in its capital structure. L-3's credit metrics have remained relatively stable over the past five years with leverage in the range of 2.0x-2.2x and FFO interest coverage typically above 6.5x, and recently above 7.0x. The company's leverage was 2.2x as of Dec. 31, 2012. Fitch expects L-3's leverage to deteriorate by the end of 2013 driven by declining sales and lower operating margins. Leverage may increase further in 2014 and 2015 driven by deterioration of sales and operating results due to significant unexpected U.S. defense budget cuts; however Fitch believes L-3 will limit the leverage deterioration to maintain financial metrics adequate for investment grade ratings. The company's liquidity as of June 28, 2013 was $1.3 billion, consisting of availability of substantially all of its $1 billion credit facility (expiring in February 2017) and $328 million in cash and short-term investments. Fitch expects L-3 to maintain cash balances of approximately $600-$700 million and liquidity in the $1.6-1.7 billion range over the next several years. Additionally, L-3 has no debt maturities through 2015 with the next material debt maturity in 2016 when $500 million of 3.95% senior unsecured notes are due. The company generated $185 million of FCF in the first half of 2013, compared to $175 million for the same period in 2012 (excluding Engility results). In the last 12 months (LTM) ending June 28, 2013, the company generated approximately $852 million of FCF. L-3 reported approximately $850 million FCF in 2012 and $900 million in both 2011 and 2010. L-3's FCF benefits from low capital expenditures as a percentage of sales; it has averaged 1.3% of sales between 2009 and 2012. L-3's cash generation is seasonal as the company collects the majority of its cash during the second half of the year. Despite seasonality of the cash flows, L-3 generates positive FCF every quarter. Fitch estimates that L-3 will generate approximately $800 million of annual FCF (after dividends). Fitch's ratings and Outlook for L-3 incorporate expectations of meaningful cash deployment toward shareholders. In the first six months of 2013, L-3 deployed $248 million towards share repurchases and $101 million towards dividend payments. L-3 has increased dividends per share by double digits annually over the past three years (10%, 11% and 12.5% in 2013, 2012 and 2011, respectively). Fitch expects L-3 to maintain its shareholder friendly cash deployment strategies and to continue increasing its dividend yield. Fitch expects L-3 to deploy approximately $900 million to $1 billion toward shareholders annually, but the cash deployment may be limited to the $600 million to $700 million range in 2013. L-3 has a pension deficit of $1.2 billion up from $1 billion at the end of 2011 (63% funded). L-3's pension benefit obligation (PBO) was $3.2 billion at the end of 2012. The large pension deficit is mitigated by the expected reimbursements from the U.S. government which treats a part of pension costs of defense contracts as allowable and reimbursable costs. Additionally, the underfunded status of the plans is mitigated by the company's strong cash generation as the required minimum contribution represents less than 10% of FCF. L-3 contributed the $173 million and $176 million minimum required amount to its pension plans in 2012 and 2011, respectively. The company expects to contribute approximately $165 million ($95 million discretionary) to its pension plans in 2013 and has already contributed $43 million during the first half ended June 28, 2013. Fitch expects L-3 to make above $100 million annual contributions over the next several years. Additionally, the pension plan deficit is expected to decline significantly in 2013 due to increasing interest rates. L-3 generated approximately 71% of its 2012 revenues from the U.S. government, primarily the DoD. As a result, defense spending is a key driver of L-3's financial performance and credit quality. The DoD budget environment is highly uncertain during fiscal 2014 because of the large, automatic spending cuts which went into effect on March 1, 2013. The full implementation of sequestration-driven defense spending reductions beginning with fiscal 2014 will increase pressure on revenues for most U.S. contractors. However, Fitch believes it will not necessarily have a significant effect on credit ratings in the U.S. aerospace and defense sector if companies take actions to offset the impact of the sequester. The fiscal 2014 budget request submitted by President Obama in April 2013 attempted to avert sequestration cuts for the DoD and stabilize defense spending at the fiscal 2013 budget request level. The fiscal 2014 DoD budget will be significantly reduced from fiscal 2013 levels if the proposal does not pass or if another compromise is not reached by October 2013. Fitch believes that there is a high likelihood that the budget proposal will not be approved by the start of FY2014, and Congress will either enact a continuing resolution at fiscal 2013 DoD spending levels or will let sequestration play out as the law is written currently. Either scenario will result in lower military spending in fiscal 2014. Such uncertainty creates a significant challenge for defense contractors because it impairs their ability to plan appropriate cost cutting measures to counter the potential DoD spending cuts. Most of the expected spending cuts are from projected budget growth and come off the existing high spending levels. Fitch expects inflation adjusted spending will likely decline, albeit modestly, over 10 years. As an example, Fitch estimates the implemented budget cuts would only reduce base budgets back to the levels seen in fiscal years 2007 or 2008. Sequestration is incorporated into Fitch's ratings for L-3, and Fitch believes that the implementation of sequestration cuts in fiscal 2014 would not lead to negative rating actions given L-3's diversified portfolio, long lead times for program execution and solid backlog. Sequestration is expected to impact new awards and Fitch believes L-3 will be able to adjust its cost structure to maintain profitability. L-3's sales are not tied to any major program as the company does not have a contract which represents more than 3% of its revenues. A higher percentage of sales to foreign and commercial customers also mitigates the budget cut risks. Rating Sensitivities: Fitch may consider a positive rating action should L-3 improve its credit profile by decreasing leverage and moderating its shareholder friendly cash deployment strategies. A negative rating action may be considered if L-3 completes a large debt-funded acquisition which weakens L-3's credit profile or if there are dramatic changes in U.S. defense spending policies, but an action would depend on L-3's efforts to reduce costs in line with lower revenues. Fitch affirms L-3's ratings as follows: L-3 Communications Holdings, Inc. --IDR at 'BBB-'; --Convertible contingent debt securities at 'BB+'. L-3 Communications Corporation --IDR at 'BBB-'; --Senior unsecured notes at 'BBB-'; --Senior unsecured revolving credit facility at 'BBB-'. The Rating Outlook is Stable. Contact: Primary Analyst David Petu, CFA Director +1-212-908-0280 Fitch Ratings, Inc. One State Street Plaza, New York, NY 10004 Secondary Analyst Craig Fraser Managing Director +1-212-908-0310 Committee Chairperson Jason Paraschac Senior Director +1-212-908-0746 Media Relations: Brian Bertsch, New York, Tel: +1 212-908-0549, Email: brian.bertsch@fitchratings.com. 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', Aug. 5, 2013; --'Treatment and Notching of Hybrids in Corporates and REIT Credit Analysis', Dec. 13, 2012. Applicable Criteria and Related Research: Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage here Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis here Additional Disclosure Solicitation Status here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. 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