-- U.S.-based defense contractor Exelis' credit ratios have been
below our expectations since the spin-off from ITT last year, mostly because of
a higher-than-expected pension liability.
-- We do not believe they will improve to levels that support the former
rating in the next two years.
-- We are lowering our corporate credit rating on Exelis to 'BBB-/A-3'
-- The stable outlook reflects our belief that although revenues and
earnings will be at best flat the next few years, cash generation should
remain solid, enabling the company to continue to fund its large post
retirement obligations, which should result in modestly improving credit
On Sept. 28, 2012, Standard & Poor's Ratings Services lowered its long-term
corporate credit rating on Exelis Inc. to 'BBB-' from 'BBB' and the short-term
corporate credit and commercial paper (CP) rating to 'A-3' from 'A-2'. The
outlook is stable. We also lowered the unsecured debt rating to 'BBB-' from
The downgrade reflects our belief that credit ratios will not improve to
levels that support the previous rating in the next two years, even factoring
in recovery of some of these costs under government contracts. Leverage and
cash flow protection measures have been worse than our expectations since the
spin-off of Exelis from ITT Corp. (BBB-/Stable/A-3) last year because post
retirement liabilities were higher than we originally thought. We also expect
that revenues and earnings will be flat to declining the next few years
because of lower U.S. defense spending and the withdrawal of U.S. combat
troops from Afghanistan, although cash generation should remain solid.
Exelis has significant post-retirement obligations, including those of the
employees of its former parent (which are no longer accruing benefits) that
were much higher at the time of the spin-off than we had originally expected,
resulting in weaker-than-expected credit ratios. We now expect debt to EBITDA
to be above 3x in 2012 and funds from operations (FFO) to debt about 20%,
compared with our original expectations of 2x-2.5x and 35%, respectively.
However, postretirement obligations are allowable costs under defense
contracts, so Exelis should be able to recover some of these costs over time.
If adjusted for about 50% recovery, expected 2012 debt to EBITDA would be
about 2.3x and FFO to debt about 30%, levels more appropriate for the rating.
We also expect that credit protection measures will be flat in 2013, as large
contributions ($275 million so far in 2012) reduce the pension obligation, but
Our ratings on the contractor reflect the company's good program and customer
diversity, leading positions in certain areas of defense electronics, and
moderate balance-sheet debt. Offsetting these factors are challenges replacing
previously high demand for products related to the wars in Iraq and
Afghanistan, significant uncertainty about future levels of U.S. defense
spending, and significant required pension contributions. We categorize the
company's business risk profile as "satisfactory" and financial risk profile
as "intermediate" under our criteria.
Exelis became an independent company on Oct. 31, 2011, after a spin-off from
ITT Corp. Before the spin-off, the company issued $890 million of debt, of
which it used $775 million to pay a dividend to ITT, and had repaid $240
million by the end of 2011. Exelis' EBITDA margins are in line with most large
defense contractors' at 12%-13%. However, margins are likely to deteriorate
somewhat over time because of a shift to lower-margin service sales and the
loss of the fairly high-margin war-related products.
We expect sales to be down about 5% in 2012 and at best flat in 2013, with
sales of war-related products and services declining, which new service
contracts and growth in non-military products somewhat offset. Orders from the
Department of Defense (DoD) in the remainder of 2012 may be delayed or reduced
because of uncertainty about future levels of defense spending and the
possibility of sequestration ($500 billion of additional across-the-board cuts
to defense spending over the next 10 years) starting on Jan. 2, 2013. We do
not believe that sequestration will be fully implemented, but defense spending
over the next 10 years may be cut more than the $487 billion already planned.
Although Congress has not yet signed the fiscal 2013 (starting Oct. 1, 2012)
defense budget into law, it recently passed a continuing resolution that will
fund the DoD and other government agencies at 2012 levels until March 2013.
Exelis provides a range of products and services in electronic warfare,
sensing and surveillance, air traffic management, positioning and navigation,
information and cybersecurity, networked communications, composite
aerostructures, and logistics. Sales are fairly evenly split between products
and services, down from about 60% products a few years ago. Approximately 70%
of revenues come from the U.S. military and intelligence agencies, 9% from
foreign militaries, and the rest from other U.S. government agencies, such as
NASA and the Federal Aviation Administration, as well as commercial customers.
Although program diversity is good, with the largest program representing
about 8% of revenues, approximately 10% of sales in 2011 were for products and
services funded out of supplemental appropriations related to Iraq and
Afghanistan. In recent years, demand for night-vision systems, SINCGARS
radios, and improvised explosive device (IED) jammers was significant, but
these sales have been declining as troops are being withdrawn from the region.
Although the company may have trouble replacing the lost sales given the
likely declines in overall defense spending, Exelis has good positions in
priority areas for the U.S. military that should still receive funding, as
well as opportunities in nonmilitary and international markets such as air
traffic management, commercial aerostructures, and commercial imagery
We assess Exelis' liquidity as strong. We expect sources of liquidity will
exceed uses by at least 1.5x in the next 12 months and by at least 1x in the
next 12-24 months, the minimum required by our criteria for a "strong"
designation. We also expect sources will exceed uses even if EBITDA were to
decline by 30%.
As of June 30, 2012, the company had $166 million of cash and an undrawn $600
million revolving credit facility, which matures in 2015. However, the
revolver supports a CP program that had $257 million issued at that date. We
expect Exelis to pay off most of the outstanding CP by year end. The company
has also started paying a modest dividend, which costs about $80 million a
year, but we don't expect it to repurchase shares in the next few quarters.
Except for any CP that may be outstanding, no material debt maturities are
upcoming until 2016. The credit facility contains a covenant that limits
leverage to no more than 3.5x, and the company should have at least a 60%
cushion under the covenant for at least the next year.
Cash generation should be solid despite material required pension
contributions and lower earnings. We do not expect working capital to be a use
of cash, and capital expenditures are moderate, which we expect to be about
$110 million in 2012. Free cash flow was a use of $160 million in the first
half of 2012 because of $275 million of contributions to post retirement
plans, but we expect Exelis to generate at least $225 million for the full
year. The company also made two small acquisitions so far in 2012.
The outlook is stable. We believe revenues will be relatively flat and
earnings down modestly for the next few years owing to pressure on defense
budgets and a shift to lower-margin service business. Even so, good cash
generation and a declining pension liability should result in modestly
improving credit ratios. We do not expect to lower the ratings in the next
year but could if the impact of defense budget cuts are greater than we
currently expect, resulting in FFO to debt declining below 25% (adjusted for
pension recovery under government contracts) on a sustained basis. We also
don't expect to raise the ratings in the next year, but we could if the
company dedicates excess cash flows to reducing debt (including pension
obligations) and defense spending stabilizes, resulting in FFO to debt
(adjusted for pension recovery under government contracts) above 35%.
Related Criteria And Research
-- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18,
-- Standard & Poor's Standardizes Liquidity Descriptors For Global
Corporate Issuers, July 2, 2010
-- Key Credit Factors: Methodology And Assumptions On Risks In The
Aerospace And Defense Industries, June 24, 2009
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
Corporate Credit Rating BBB-/Stable/A-3 BBB/Stable/A-2
Senior Unsecured BBB- BBB
Commercial Paper A-3 A-2