OREANDA-NEWS. Fitch Ratings has placed Xylem's (XYL) Long-Term Issuer Default Rating (IDR) and senior unsecured debt rating of 'BBB' on Rating Watch Negative. Fitch has also placed XYL's short-term IDR and commercial paper programs rating of 'F2' on Rating Watch Negative.

The action follows XYL's announcement of its agreement to purchase Sensus USA, Inc. (Sensus) for $1.7 billion in cash. The transaction will be funded with the deployment of approximately $400 million of Xylem's non-U. S. cash and debt, including the use of new and existing credit facilities. The transaction is expected to close in the fourth quarter of 2016. Fitch's ratings for XYL cover approximately $1.2 billion of debt. A full list of XYL's current ratings follows at the end of this release.

The Negative Watch incorporates Fitch's concern that the increase in debt to fund the Sensus acquisition may increase XYL's long-term leverage above levels that support the company's current ratings. XYL expects its pro forma leverage to rise to roughly 3.6x following the acquisition and has a stated target to return to the 2.5x - 3.0x leverage range within 12 to 18 months of closing. XYL's adjusted debt/EBITDAR and FFO adjusted leverage was 2.6x and 3.0x respectively on an LTM basis as of June 30, 2016.

Fitch's primary credit concern is the timing and cadence of the company's deleveraging process. In resolving the Rating Watch, Fitch expects to further evaluate the impact of the transaction on XYL's operating profile, liquidity and credit metrics. Fitch expects to resolve the Rating Watch closer to the completion of the acquisition. A downgrade of the long-term and short-term ratings would likely be limited to one notch or to 'BBB-' and 'F3' respectively. The transaction is subject to anti-trust approvals in the U. S., Germany, and Australia. XYL is also seeking approvals by the Federal Communications Commission pertaining to the transfer of certain spectrum licenses.

KEY RATING DRIVERS

Xylem's ratings are supported by its adequate credit metrics, solid liquidity, conservative financial policies and sound margins. The significant aftermarket and replacement equipment content, which account for nearly 40% of revenue, underpins its credit profile. The public utility sector represents roughly one third of the firm's total revenue adding stability to revenue. The company generates stable and steady free cash flows as a result of its solid operations, low historical margin volatility and low capital intensity requirements. Fitch expects XYL to continue to generate at least low-single-digit organic growth globally, though operating results may be negatively affected by foreign exchange rates as roughly 20% of sales are generated in emerging markets and 32% of 2015 revenue was from Europe. XYL does not have material contingent liabilities.

The proposed acquisition represents a significant investment in advanced technology solutions enabling intelligent use and conversion of critical water and energy resources. Sensus has demonstrated significant capability in areas such as metering technologies, applications and data analytics. Fitch views the potential revenue synergies that this combination will create favorably with respect to XYL's long-term growth and margin profile. While the two firms do not exhibit any material product overlap, amongst Sensus' 14,000 global customers are major cities, governments and utilities, all currently representing significant end markets for Xylem.

Positive credit considerations from the acquisition include a significant potential reduction in XYL's debt-to-currency mismatch as 59% of the firm's total revenue was generated outside of the U. S. in 2015 and most of its current cash balance is domiciled internationally. This mismatch was partially addressed earlier in Q1-2016 when XYL issued EUR500 million of senior unsecured notes and should be further mitigated as 67% of Sensus' 2016 revenue was achieved within the U. S.

Sensus is a U. S. company that generated $837 million in adjusted revenue and $159 million in adjusted EBITDA in fiscal 2016 (which ended March 31, 2016). The $1.7 billion cash purchase price is 10.7x Sensus' fiscal year 2016 adjusted EBITDA. XYL expects to achieve at least $50 million in annual cost synergies within three years of closing.

Additional acquisition concerns include higher debt levels, integration risks, and the target valuation.

KEY ASSUMPTIONS

--If completed, the acquisition will be funded with cash and incremental debt;

--No Sensus debt will remain outstanding following the closing of the transaction;

--Limited future negative impacts from currency fluctuations;

--Consolidated EBITDA margins will expand at least 200bps over the intermediate term;

--A significant reduction in the share repurchase program prior to returning to the company's target leverage profile;

--Moderate annual increases in the size of the dividend.

RATING SENSITIVITIES

XYL's ratings could be downgraded if Fitch concludes that its post-acquisition leverage profile will remain above levels that support the company's current ratings:

--An increase in adjusted debt/EBITDAR above 3.0x on a sustained basis;

--An increase in FFO adjusted leverage above 3.25x on a sustained basis;

--FCF margin below 1.5% for a prolonged period.

The Negative Watch could be resolved and the ratings affirmed at 'BBB' if the acquisition is not completed or Fitch comes to expect that post-acquisition, XYL will not maintain elevated leverage metrics for a sustained period.

LIQUIDITY

Fitch expects XYL's financial flexibility to remain suitable over the medium term supported by adequate liquidity. The company's aggregate liquidity stands at approximately $1.2 billion at Q2-2016 comprised of $586 million of cash and equivalents and $600 million of availability under its senior unsecured revolving credit facility. Fitch also believes that XYL has adequate financial flexibility given Fitch's expectation that XYL will achieve a FCF margin (after dividends) north of 6% in 2016.

FULL LIST OF RATING ACTIONS

Fitch has placed the following ratings for XYL on Rating Watch Negative:

--IDR at 'BBB';

--Senior unsecured debt at 'BBB';

--Senior unsecured bank facility at 'BBB';

--Short-term IDR at 'F2';

--Commercial paper programs at 'F2'.