Sept 23 (The following statement was released by the rating agency)
Fitch Ratings has assigned a 'BBB-' rating to The ADT Corporation's (NYSE: ADT) proposed offering of about $1 billion of senior unsecured notes due 2021. The new issue will be equal in right of payment with all other senior unsecured debt. Net proceeds from the notes issuance will be used for general corporate purposes, which will include the repayment of borrowings under the revolving credit facility and share repurchases. The Rating Outlook is Stable. A complete list of ratings follows at the end of this release.
KEY RATING DRIVERS
ADT's ratings and Outlook reflect the company's strong brand recognition, its national footprint and leading market position, recurring revenue base, sustainable free cash flow (FCF) generation and solid liquidity. Concerns include emerging competition from non-traditional security service providers, risk associated with operating as an independent public company, and contingent liabilities, particularly tax liabilities, related to its spin-off from Tyco International, Ltd. (Tyco).
The ratings also reflect management's willingness to undertake a more aggressive financial strategy soon after becoming an independent company, as well as management's evolving financial strategy.
EVOLVING FINANCIAL STRATEGY
The company has revised its financial strategy twice since its spin-off from Tyco in September 2012. Following its spin-off, management was committed to a strong investment grade rating and put in place a capital structure that reflected this profile.
In November 2012, ADT initiated a $2 billion share repurchase program over a three-year period that will be funded by debt and FCF. As part of this strategy, the company increased its leverage target to 2x and reiterated its commitment to an investment grade rating. Through the first nine months of fiscal 2013, ADT had repurchased $1.06 billion of stock.
In July 2013, the company once again changed its financial strategy and increased its leverage target to 3x. ADT expects to use proceeds from the incremental leverage to invest in growing its core business, increase operating efficiency, and pursue accretive acquisitions to complement its organic growth, as well as return excess cash to shareholders in the form of dividends and share buybacks.
These shifts in strategy create some uncertainty regarding the stability of management's financial policies beyond the near term.
SOLID LIQUIDITY POSITION
ADT has a solid liquidity position with cash of $272 million at June 28, 2013 and no borrowings under its $750 million revolving credit facility that matures in June 2017. Fitch expects the company will maintain liquidity of approximately $800 million-$900 million, consisting of cash and availability under its revolving credit facility. ADT does not have any debt maturities until 2017, when $750 million of senior notes become due.
The ratings incorporate ADT's strong competitive position as the largest residential security provider in the U.S. ADT currently has over six million customers and a roughly 25% market share based on company estimates.
Fitch believes that ADT's competitive position will remain strong in the near-to-intermediate term. However, ADT faces competition from non-traditional security service providers. Several cable and telecom companies have introduced interactive security services that compete with ADT. While the security service customer base of these companies is substantially smaller than ADT at the current time, this emerging trend could provide significant competition for ADT going forward.
RESILIENT BUSINESS MODEL
ADT's subscriber-based business requires significant upfront costs to generate new customers. Capital expenditures, including dealer-generated accounts and bulk purchases and subscriber systems, totaled $1.09 billion and $902 million in 2012 and 2011, respectively. Capital expenditures for 2012 represent approximately 33% of annual revenues. Fitch expects capital expenditures to approximate 35%-40% of annual revenues in the next few years. Fitch estimates that new customers yield an average cash payback of three years.
Approximately 90% of ADT's annual sales are recurring in nature, resulting in steady income and cash flow. ADT generated $378 million of FCF for the latest 12 months (LTM) period ending June 28, 2013, compared with $406 million and $537 million of FCF during 2012 and 2011, respectively. (Note: ADT did not pay dividends in 2011 and 2012 and paid $86 million of dividends for the June 28, 2013 LTM period.) Fitch expects ADT will generate annual FCF (cash flow from operations less capital expenditures and dividends) of roughly $200 million-$350 million during the next few years.
As part of the separation, ADT has entered into separation and distribution and other agreements with Tyco and Pentair Ltd. (formerly Flow Control). ADT also entered into a Tax Sharing Agreement with Tyco and Pentair, which governs the rights, responsibilities and obligations of the three post-separation companies regarding certain tax matters.
The IRS recently issued Notices of Deficiency to Tyco based on audits of the 1997 through 2000 tax years. The IRS has disallowed interest and related deductions for certain intercompany debt totaling $2.86 billion and indicated that Tyco's former U.S. subsidiaries, including ADT, collectively owe $883.3 million of additional taxes plus penalties of $154 million. If the IRS is successful in asserting its claim, it would have an adverse impact on interest deductions related to the same intercompany debt in subsequent periods (2001-2007) totaling $6.6 billion.
Tyco strongly disagrees with the IRS position and is contesting these proposed adjustments. Should the IRS successfully assert its position, the amount assessed would have to be in excess of $1.85 billion before ADT would be required to pay any of the amounts assessed based on the existing tax-sharing agreements. No payments with respect to these matters would be required until the dispute is definitively resolved.
Future ratings and Outlooks will be influenced by broad economic trends, as well as company-specific activity, particularly FCF trends and uses, debt levels and liquidity position.
Positive rating actions are unlikely in the near-to-intermediate term, as Fitch monitors ADT's performance and management's financial strategy as a stand-alone company.
On the other hand, Fitch may consider taking a negative rating action if there is meaningful deterioration in ADT's financial results or management again undertakes a more aggressive financial policy, leading to diminished liquidity and higher debt levels. In particular, negative rating actions could occur if ADT's leverage is materially above its 3x target on a consistent basis.
Fitch currently rates ADT as follows:
--Issuer Default Rating (IDR) 'BBB-';
--Revolving bank credit facility 'BBB-';
--Senior unsecured debt 'BBB-';
--Short term IDR 'F3';
--Commercial Paper 'F3'.