Fitch Places Lockheed Martin’s Long-Term Ratings on Watch Negative
By Business Wire News
By Business Wire News
Fitch Ratings has placed Lockheed Martin Corporation’s (LMT) long-term ‘A-‘ ratings on Rating Watch Negative. The action follows LMT’s announcement this morning of its agreement to purchase Sikorsky Aircraft from United Technologies (‘A’/Outlook Stable) for $9 billion cash. The transaction would be mostly funded with debt. LMT’s short-term ratings are not affected by this rating action. Fitch’s ratings for LMT cover approximately $9.25 billion of existing debt. A full list of ratings follows at the end of this release.
Fitch’s preliminary forecasts indicate that the additional debt from the acquisition, combined with a continuation of the company’s existing share repurchase plan, will weaken some of the company’s leverage metrics to levels inconsistent with an ‘A-‘ rating. Other financial metrics such as margins and liquidity, as well as qualitative factors such as market position and backlog, could remain consistent with the current ratings. LMT expects this transaction could be completed in late 2015 or early 2016.
LMT also announced this morning a strategic review of certain government IT and technical services businesses, which contributes to the rating action. The potential disposal of these assets adds some uncertainty to LMT’s future financial profile, and the impact on LMT’s ratings will depend on the use of any divestiture proceeds or spin-off dividends.
A downgrade of the ratings would likely be limited to one notch, or ‘BBB+’. Fitch will meet with LMT’s management team to obtain a fuller picture of its integration plans for Sikorsky, the regulatory approval process, the amount of current business conducted between the two firms, debt issuance plans (including intentions with 2016 maturities), and the potential actions with the IT businesses. Fitch will also assess LMT’s future acquisition appetite in the scenario that the Sikorsky acquisition is not completed. Based on its analysis, Fitch could resolve the Rating Watch Negative prior to the close of the acquisition and the issuance of the related debt.
KEY RATING DRIVERS
The proposed acquisition is a departure from LMT’s previous ‘string of pearls’ M&A strategy in both size and focus. LMT completed less than $1.5 billion acquisitions over the past three years. Fitch expects the Sikorsky transaction will be favorable from the perspective of shareholders because of the use of low coupon debt to fund the transaction, and Fitch believes this acquisition and LMT’s increased level of share repurchases illustrate a strategy that has become less committed to an ‘A-‘ credit rating and more committed to shareholder value.
Fitch expects that LMT’s previously announced plan to reduce outstanding shares to below 300 million by the end of 2017 will remain in place, and the company will not target debt reduction for the next several years.
Fitch believes the likelihood of regulatory approval is greater than 50%, and the focus of the regulatory review will probably be the helicopter systems market rather than the helicopter platform market. In Fitch’s view, potentially reduced competition in the helicopter systems market due to LMT’s increased vertical integration could attract some attention from regulators.
Positive credit considerations from the acquisition include a higher level of diversification within LMT’s core defense and security business, a larger aftermarket presence, and an enhanced backlog position. Sikorsky would add a new defense platform area to go with LMT’s existing aerospace platforms in fighter aircraft, transport aircraft, and space vehicles. Sikorsky’s amount of international revenues also furthers LMT’s goal of increasing its non-U.S. business.
Acquisition concerns include higher debt levels, integration risks, and the valuation.
As a result of the new debt for the Sikorsky purchase and LMT’s $2.25 billion debt issuance earlier in 2015, the company’s pro forma debt levels would be almost 2.5 times higher than at the end of 2014. Put another way, LMT’s pro forma debt would increase $10 billion, reaching more than $17 billion in 2016. This calculation assumes that maturities of existing debt in 2016 are refinanced. The resulting debt levels, although much higher, would still be a manageable level compared to either LMT’s pro forma revenues or enterprise value.
Fitch calculates the $9 billion purchase price represents a 13x enterprise value (EV) multiple based on Sikorsky’s expected 2015 EBITDA. LMT will receive some tax benefits from the transactions structure, and LMT estimates that the net present value of these benefits over 15 years could be nearly $2 billion, which would lower the transaction’s multiple to 10.3x. For perspective, Fitch calculates LMT’s pre-transaction EV at $69 billion, with a multiple of 10.7x.
Sikorsky Aircraft is a leader in the global helicopter business. Its adjusted segment revenues in 2014 were $6.6 billion and adjusted operating margin was 10.6%. Reported financial results in 2014 were distorted by large adjustments for the Canadian Maritime Helicopter program. Margins in 2015 will likely be hurt by the weak oil services market, and could decline as much as $125 million.
Sikorsky has had a strong run of contract wins including the Turkish Utility Helicopter, U.S. Air Force Combat Rescue Helicopter, and the U.S. Presidential Helicopter. The company’s order backlog at the end of 2014 was $15.8 billion, but future business on its programs likely push the order book to nearly $50 billion. Defense sales account for approximately three-quarters of Sikorsky’s revenues, and international sales account for approximately half of revenues. Fitch estimates that aftermarket services (both defense and commercial) accounts for approximately one-third of Sikorsky’s business. Fitch expects Sikorsky’s free cash flow generation will be low in the next few years as the company ramps up on new programs, but afterwards cash generation should be solid.
Government IT and Technical Services Strategic Review
LMT also announced that it will conduct a strategic review of some of its IT and technical services businesses, which could lead to either a spin-off or sale of these assets. LMT has been the largest provider of IT to the U.S. government for the past 10 years. Sales in these businesses total approximately $6 billion with lower margins compared to other LMT businesses.
The rationale for the review includes changes in the relevant markets and the relative level of competitiveness in these businesses compared to the rest of LMT’s portfolio. Most of the assets under review are located in LMT’s Information Systems & Global Solutions (ISGS) segment, with some in the Missiles and Fire Control (M&FC) segment. The assets under review include commercial cyber security, government healthcare IT, air traffic management, technical services, and government enterprise IT. Fitch believes that these assets likely include some recent acquisitions, such as Industrial Defender in 2014, illustrating the direction change LMT is considering. LMT will retain assets including mission IT (including government cyber security), energy solutions, and space services.
This review is consistent with numerous similar reviews in the government IT sector. Various companies within the industry have conducted such reviews, and several spin-offs or asset sales have been completed or are in progress.
LMT’s potential actions highlight the diverging cyber security strategies in the defense sector. LMT and GD have decided to focus on government cyber, while de-emphasizing commercial cyber. RTN on the other hand has moved to combine its government and commercial cyber activities, illustrated by its $1.9 billion transaction with Websense earlier this year.
Fitch’s key assumptions within its rating case for the issuer include:
–Sequestration continues in fiscal 2016 and beyond;
–EBITDA margins will continue to rise in 2015;
–FCF will be fairly steady in the next few years, with higher net pension recoveries offsetting higher capex, taxes, and dividends;
–Dividends will continue to rise at double digit rates and share repurchases will continue at or below FCF levels in 2015;
–If completed, the Sikorsky acquisition will be funded mostly with debt;
–The company’s current share repurchase program will continue if the Sikorsky acquisition is completed;
–A spin-off or sale of government IT and technical services assets would occur in 2016.
A downgrade of the ratings could be driven by the Sikorsky acquisition and/or the IT strategic review, and the resulting action would likely be limited to one notch, or ‘BBB+’. Fitch will meet with LMT’s management team to obtain a fuller picture of its integration plans for Sikorsky, the regulatory approval process, the amount of current business conducted between the two businesses, debt issuance plans (including intentions with 2016 maturities), and the potential actions with the IT businesses. Fitch will also assess LMT’s future acquisition appetite in the scenario that the Sikorsky acquisition is not completed. Based on its analysis, Fitch could resolve the Rating Watch Negative prior to the close of the acquisition and the issuance of the related debt. Fitch will evaluate both quantitative and qualitative factors in its review.
Aside from the potential Sikorsky and government IT transactions, Fitch may consider negative rating actions in the event of sharper than expected declines in U.S. DOD spending that affect some of LMT’s key programs, execution problems on key programs (especially the F-35), additional debt-funded cash deployment actions, unsuccessful attempts to reduce costs in line with revenue reductions, or lower than expected international revenue growth.
Financial metrics that could lead to a negative rating action include sustained FFO Adjusted Leverage above 2.5x, sustained FFO fixed charge coverage below 5.5-6.0x, and sustained EBIT margins below 10%.
Fitch does not anticipate an upgrade in LMT’s ratings because of the expectation that most FCF will be deployed to shareholders, the levels of some pro forma financial metrics after the proposed Sikorsky acquisition, the continued uncertainty in the defense spending outlook, and the company’s large pension deficit.
The company’s liquidity at the end of the first quarter of 2015 was $5 billion, consisting of $1.5 billion of credit facility availability (expiring in August 2019) and $3.5 billion in cash and equivalents. LMT held approximately $525 million of its cash at its foreign subsidiaries, and it estimated the cash taxes due upon repatriation would not be significant. The company’s next material debt maturities come in 2016 when $952 million of notes become due.
FULL LIST OF RATING ACTIONS
Fitch has placed the following ratings for LMT on Rating Watch Negative:
–Issuer Default Rating (IDR) ‘A-‘;
–Senior unsecured debt ‘A-‘;
–Bank facility ‘A-‘.
Fitch currently rates LMT’s short-term ratings as follows:
–Short-term IDR ‘F2’;
–Commercial paper programs ‘F2’.
Additional information is available on www.fitchratings.com
Corporate Rating Methodology – Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 28 May 2014)
Craig D. Fraser
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
David Petu, CFA
Alyssa Castelli, +1-212-908-0540