Fitch Affirms Exelis Inc. at 'BBB+'; Outlook Revised to Negative
Fitch Ratings has affirmed the 'BBB+' Issuer Default Rating (IDR), 'BBB+' long-term debt and revolving credit facility ratings, and 'F2' short-term rating of Exelis Inc. (XLS). The Rating Outlook is revised to Negative from Stable. The ratings cover $650 million of long-term debt and the $600 million commercial paper program. A full list of rating actions follows at the end of this release.
The Rating Outlook revision is driven by the uncertainty surrounding the U.S. Department of Defense (DoD) budget, including the looming risk of sequestration, and a deterioration in XLS' underfunded pension position. The underfunded pension obligation nearly doubled in 2011, reaching approximately $1.9 billion (66% funded) as of Dec. 31, 2011, and Fitch believes there could be additional deterioration by the end of 2012 given current interest rate levels. The size of the underfunded pension liabilities compared to the company's cash flows from operations is a concern for the ratings. Even though the deterioration is not expected to have immediate significant cash flow implications for XLS, it could negatively impact the company's long term cash deployment strategy.
The other main factor in the Outlook revision is the outlook for U.S. defense spending and the looming risk of sequestration. Should sequestration occur, it may have a significant impact on XLS' operations and cash generation. While sequestration will negatively impact the whole industry, Fitch believes XLS' exposure represents a higher credit risk because of a high percentage of operating cash flows needed to fund required pension contributions. The recently enacted MAP-21 Act will have a positive short term impact on XLS' minimum required cash pension contributions; however it affects only the timing of the cash flows, not the long-term funding requirements.
Fitch's other concerns include:
--Company's exposure to contracts funded by DoD's Oversees Contingency Operations (OCO) budget;
--Overall declining revenues;
--The shift in the product mix which continues to pressure operating margins.
XLS' ratings are supported by the company's highly diversified portfolio of defense-related products and services provided to U.S. military and government customers. XLS has more than 1,000 prime and sub contracts which mitigate the exposure to a major program cancelation. The company's core businesses focus on the DoD's high priority programs in information, surveillance and reconnaissance (ISR), electronic warfare, cyber, and information and technical services. Additionally, the company benefits from high levels of overall defense spending and solid credit metrics for the ratings.
Fitch expects the company to maintain solid credit metrics with liquidity approximately $800 million and leverage (gross debt to EBITDA) within the range of 0.9x to 1.2x through 2014. Leverage metrics based on FFO instead of EBITDA are not as strong because of the company's cash generation, including the impact of pension contributions. Fitch expects FFO Adjusted Leverage to be in the range of 2.9x to 3.1x.
While XLS had negative free cash flow (FCF - cash from operations less capex less dividends) of $199 million in the first half of 2012, Fitch expects the company's FCF for the year to be $125 million to $150 million in 2012, down from the 2011 level of $220 million due to larger dividend payout. FCF in the first half was negatively affected by large pension contributions. XLS' cash deployment strategy is expected to be conservative with approximately $76 million of cash dividends.
After the spin-off from ITT Corporation (ITT), XLS assumed the majority of ITT's pension obligations, or approximately $5.7 billion as of Dec. 31, 2011. At that date XLS had a pension deficit of approximately $1.9 billion, or 66% funded. The other postretirement benefit obligation was $267 million. Through June 2012 XLS contributed $261 million to qualified pension plans. The company plans to contribute up to additional $10 million for the remainder of the year. Fitch believes XLS' pension obligations are manageable due to the company's solid FCF generation; however the size of the underfunded obligations and significant funding requirements relative to the overall size of the company is a rating concern.
XLS generated approximately 87% of its 2011 revenues from the U.S. government, primarily the DoD. As a result, defense spending is a key driver of XLS' financial performance and credit quality. High levels of defense spending currently support XLS' ratings, but the DoD budget environment is highly uncertain after fiscal 2012 because of large U.S. government budget deficits and the potential for large, automatic spending cuts beginning in fiscal 2013.
U.S. defense spending has been on an upward trend for more than a decade, but the fiscal 2012 and fiscal 2013 budgets represent a turning point, with spending beginning to turn down in fiscal 2013, even excluding war spending, albeit from very high levels. The fiscal 2012 DoD base budget is up less than 1% compared to fiscal 2011, and the requested base budget for fiscal 2013 is down 1% to $525 billion. Fiscal 2013 modernization spending (procurement plus research and development [R&D]), the most relevant part of the budget for defense contractors, is down 4%, the third consecutive annual decline by Fitch's calculations.
The overhang of potential automatic cuts beginning in early 2013 related to the 'sequestration' situation, as well as the presidential election, add to the uncertainty faced by defense contractors in the current environment. The U.S. defense outlook will be uncertain and volatile over the next one to two years, and program details will be needed to evaluate the full effect on XLS' credit profile.
XLS' sales are not tied to any major program, limiting the company's exposure to significant cuts for any specific program. Accelerated withdrawal of the U.S. troops from Afghanistan may have a negative impact on the company; however it may also benefit XLS by potentially creating new, albeit temporary, services contracts.
Fitch would not expect modest declines in defense spending to lead to negative rating action, because XLS' exposure to DoD spending is mitigated by good liquidity and diversification of its product line. Sequestration-driven DoD spending declines may lead to negative rating actions for XLS, depending on the potential impact on the company's cash flow generation as discussed above.
What Could Trigger a Rating Action:
Fitch is not likely to consider a positive rating action given XLS' large pension liability, declining revenues, margin pressures and uncertainty surrounding U.S. DoD budget. A negative rating action may be considered if changes in U.S. defense spending policies have a significant impact on the company's cash generation.
Fitch affirms XLS' ratings as follows:
--IDR at 'BBB+';
--Senior unsecured notes at 'BBB+';
--Senior unsecured revolving credit facility at 'BBB+';
--Short Term IDR at 'F2';
--Commercial paper at 'F2'.
Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology', Aug. 8, 2012.
Applicable Criteria and Related Research:
Corporate Rating Methodology
David Petu, CFA
One State Street Plaza, New York, NY 10004