OREANDA-NEWS. S&P Global Ratings said today that it lowered to 'BBB' from 'BBB+' its long-term corporate credit and related debt ratings on U. K.-based global aerospace and defense company BAE Systems PLC (BAE). At the same time, we affirmed our 'A-2' short-term corporate credit rating on the company. The outlook is stable.

The downgrade reflects our view that BAE continues to demonstrate relatively weak S&P Global Ratings-adjusted leverage metrics due to a substantial pension deficit. For the 12 months to June 30, 2016, our ratios of adjusted debt to EBITDA and funds from operations (FFO) to adjusted debt were 3.7x and 21%, respectively. These metrics remain outside our expectations for the ratings. However, we forecast that they will improve to about 3.0x and 25%, respectively, by 2018, supported by steady operating results and improving cash flow generation.

As of June 30, 2016, our adjusted debt for BAE was ?8.3 billion, an increase of ?1.5 billion since Dec. 31, 2015, largely due to a ?1.6 billion increase in BAE's reported pension deficit to ?6.1 billion. There is a risk that this deficit will further increase as a result of its sensitivity to lower discount rates. Such updated disclosures in BAE's financial statements may have a negative effect on our adjusted credit ratios, but we do not assume this in our forecasts.

We acknowledge that the higher accounting deficit has no immediate material negative effect on cash flows. Furthermore, the company manages longevity, equity market, interest rate, and inflation rate risks through the use of derivatives, and has taken other actions to manage the deficit.

BAE views the pension deficit in the context of a triennial funding review cycle and valuation by the pension trustees, not on the basis of the accounting deficit. The last valuation was ?2.7 billion as of March 2014, at which time BAE agreed to make additional cash contributions to close the deficit by 2026. We expect payments under this deficit reduction plan to be around ?0.3 billion in 2016 and 2017, similar to amounts paid in 2015 and 2014.

The next funding review starts in April 2017 and depending on its outcome, BAE may increase its cash payments from 2018. At the same time, other options--including lengthening of the deficit reduction recovery plan beyond 2026--may be considered.

Aside from the pension deficit, we expect BAE to continue to demonstrate steady and robust operating results, supported by its backlog of ?36.3 billion and recurring revenues from its services businesses.

In our base-case scenario for 2016-2017, we assume: Broadly stable revenues in 2016, with annual growth thereafter of 2%-3%. Stable reported EBITDA margins at 12%-13%.Moderate working capital outflow in 2016, similar to 2015, reducing in 2017.Annual capital expenditure (capex) of about ?400 million, as in 2015, remaining above depreciation consistent with company guidance. Continued positive free operating cash flows (FOCF) in 2016, improving in 2017.Dividend payments stable at about ?650 million per year, no further share buybacks. No material acquisitions or disposals. Stable pension deficit and cash contributions. Based on these assumptions, we arrive at the following credit measures: Stable FFO, EBITDA and higher adjusted debt in 2016, compared with 2015.At year-end 2016, we forecast ratios of about 20% FFO to adjusted debt and about 3.6x adjusted debt to EBITDA. At year-end 2017, we forecast ratios of 20%-25% FFO to adjusted debt and about 3.3x adjusted debt to EBITDA. BAE's business risk profile continues to be supported by its well-established market position as a leading aerospace and defence contractor in key military programs in its major markets of the U. K., the U. S., Saudi Arabia, and Australia. BAE is active across a portfolio of high-priority, long-term, and diverse air, naval, and land military programs, as well as electronic systems and cyber and intelligence businesses, assisted by recurring support and services capabilities. Group revenues in 2015 were ?16.8 billion.

Constraining factors include BAE's significant exposure to the level of government defence spending in the U. S., the U. K., and Saudi Arabia and the outcome of government procurement decisions in awarding key contracts. Other factors include price competition, cost pressures, meeting service levels, and managing supply chain and execution risks.

BAE's financial risk profile is supported by positive free cash flow generation, but constrained by sizable payments to shareholders and a substantial pension deficit. We note that customer advance payments support working capital, although the amounts and timing of payments received and advances spent creates some volatility.

As of June 30, 2016, our-adjusted debt calculation for BAE was ?8.3 billion. Our adjustments to reported gross debt of ?4.4 billion comprise a ?2.0 billion deduction of surplus cash (excluding ?200 million of cash not immediately available for debt repayment), an addition of ?4.7 billion for pensions, and ?1.2 billion for operating leases.

The 'BBB' long-term corporate credit rating reflects an ongoing strong business risk and a revised significant financial risk profile.

The stable outlook reflects that we forecast improving leverage metrics over the next two years to about 3.0x debt to EBITDA and 25% FFO to debt by 2018, supported by steady operating results and improving cash flow generation.

We could lower the ratings if we expected BAE's S&P Global Ratings-adjusted leverage metrics to remain weaker than 3.5x debt to EBITDA and 25% FFO to debt for a sustained period. This could occur if the accounting pension deficit significantly widened further during the next year, without mitigating actions by management. Following the pension trustees' triennial review, a substantial increase in the additional annual cash contributions made by BAE to replenish its pension funds from 2018, would also weigh negatively on our rating.

While unlikely, we could raise the ratings if we expected BAE's S&P Global Ratings-adjusted leverage metrics to be sustainably stronger than 3.0x debt to EBITDA and 30% FFO to debt. This could occur if the pension deficit reduced and the company demonstrated a stronger operating or cash flow performance.