September 6, 2012 / 8:00 PM / 5 years ago

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 
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