Given our base-line assumption that cash dividends will stay at about EUR150 million-EUR200 million, including an interim dividend in 2012, we expect discretionary cash flows (FOCF less dividends) to be about EUR0.2 billion-EUR0.3 billion over our forecast horizon. Since we do not expect the company to undertake major acquisitions, we foresee gradual deleveraging.
Our view of Thales' ability to generate operating cash flows is supported by the group's order backlog of EUR26 billion as of June 30, 2012, which provides visibility for about two years. Thales' business activities are spread over numerous small contracts, which support stable cash generation. In its Defence & Security division, which represents about 56% of group sales, Thales is exposed to the risk of slowing defense budgets in the U.K. and France, which is somewhat offset, in our view, by the group's diverse defense activity programs. We believe that Thales' Aerospace & Transport division is likely to benefit from positive market developments in the global commercial aviation markets. In our base case for 2012, we expect Thales' revenues to stay unchanged year on year, with very minimal reductions of group sales in subsequent years.
In the first half of 2012, Thales' operating profits continued to improve. The reported EBIT margin, including restructuring costs, was 5.3% against 5.1% for the comparable period in 2011. This confirms our earlier expectation that Thales would continue the turnaround of profitability in 2012. The improvement was mainly the result of the company's five-year restructuring program "Probasis". We do not incorporate all expected cost savings from the program into our assessment of the group's credit profile, however. This is primarily because the group does not expect the full benefits to materialize until 2013 and 2014, and we see the potential for execution risks related to the program.
As of Dec. 31, 2011, fully-adjusted funds from operations (FFO) to debt stood at 48%, while fully-adjusted debt to EBITDA stood at 2.0x. In view of our base-line forecast for FOCF and dividends, we expect a gradual reduction of Thales' fully-adjusted debt, which totaled EUR2.2 billion on Dec. 31, 2011, and FFO to debt of 50%-55% for 2012, with moderate improvements to 55%-60% thereafter.
We view Thales' business risk at the higher end of our category "satisfactory", mainly owing to the group's solid position in the expanding defense electronics sector and diverse civil and military end markets. We consider these strengths to be partly offset by the group's modest operating margins, the highly competitive civil security market, slowing European defense markets, and possible program-execution risks.
Under our criteria for rating government-related entities, we continue to view Thales as having "limited importance" to its 27% owner, the Republic of France (unsolicited rating AA+/Negative/A-1+). We likewise view the link between Thales and the French government as "limited." As a result, we assess the likelihood of extraordinary government support as "low" and therefore don't add an uplift to our assessment of the group's stand-alone credit profile at 'bbb+'.
We consider Thales' liquidity to be exceptional under our criteria. Liquidity is supported by cash balances of about EUR1.9 billion as of Dec. 31, 2011, of which we view EUR400 million as needed for ongoing operations. For this reason, we do not deduct this cash amount in our calculation of Thales' credit ratios. We likewise don't view the proportionately consolidated cash of EUR179 million at subsidiary DCNS as being accessible to Thales.
Internal liquidity is supplemented by an undrawn committed revolving credit facility (RCF) of EUR1.5 billion from 20 banks, which matures in December 2015. Financial covenants in this facility, with accelerated payment, would only apply if the French government no longer held its golden share in Thales and, simultaneously, the ratio of consolidated net financial debt to EBITDA exceeded 3x. The EUR1.5 billion RCF has a step-up for rating deteriorations but no step-down for rating improvements.
For 2012, we expect Thales to generate a positive discretionary cash flow. Consequently, operating cash needs do not affect financial flexibility.
As of Dec. 31, 2011, Thales' short-term debt was EUR437 million. On the same day, maturities in 2013 were EUR674 million, including a EUR600 million bond due in April 2013. Cash generation at Thales is heavily skewed toward the second half of the year, as is the case for the majority of defense companies. In our view, Thales' financial flexibility is sufficient to cover these usual seasonal cash flow variations.
The positive outlook reflects the potential for an upgrade over the next 24 months, based on the group's operating prospects, which are supported by an order backlog of EUR26 billion. In addition, we believe that Thales will continue to report operating profits and positive FOCF in line with our base-line assumptions.
An upgrade depends on an improvement of credit metrics that would place Thales' financial risk profile more solidly in the "modest" category, such as FFO to adjusted debt of about 60% and debt to EBITDA of about 1.5x. Our base-case projections for Thales suggest that the company could be able to achieve these credit metrics within the next two years. Likewise, we would consider an upgrade only if Thales maintained a conservative financial policy, including refraining from potential larger acquisitions and shareholder remuneration.
We could revise the outlook to stable if Thales were to carry out very sizable acquisitions, unexpectedly engage in considerable shareholder remuneration, or generated lower FOCF than its cash dividend payout, making debt reduction less likely. We could also revise the outlook to stable if unexpected operational issues with projects were to lead to substantial cash-effective charges.
Related Criteria And Research
-- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Rating Government-Related Entities: Methodology And Assumptions, Dec. 9, 2010
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
-- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008
Ratings Affirmed; CreditWatch/Outlook Action
Corporate Credit Rating BBB+/Positive/A-2 BBB+/Stable/A-2
Senior Unsecured BBB+ BBB+
Commercial Paper A-2 A-2