Fitch Affirms L-3 Communications at 'BBB-'; Outlook Stable
KEY RATING DRIVERS
The ratings and Stable Outlook are supported by a diverse portfolio of products and services; good financial flexibility in the form of strong liquidity and substantial free cash flow generation (FCF; cash from operations less capital expenditures and dividends), with an historical net income conversion rate above 110%; expected improvements in U.S. and international military spending in fiscal 2016; and the recently announced plan to reduce debt by \\$500 million over the next year. Another positive rating factor is international military and commercial sales, which the company expects to generate 28% of its revenues in both 2015 and 2016.
Offsetting these positive factors are a series of operational issues over the past two years and many of LLL's credit metrics, which indicate a credit profile on the border between 'BBB-' and 'BB+' ratings. L-3 has experienced significant operating underperformance over the past several years, putting pressure on the ratings at their current level. The company's leverage (debt to LTM EBITDA) has increased to approximately 3.2x at Sept. 25, 2015 (Fitch estimate), up from 2.9x and 2.4x at year-end 2014 and 2013, respectively. Similarly, FFO adjusted leverage deteriorated gradually, increasing to approximately 3.7x at Sept. 25, 2015, up from 3.5x and 3.1x at the year-end 2014 and 2013, respectively. The deterioration of L-3's leverage metrics in 2015 was primarily driven by the divestiture of Marine Systems International (MSI) business for approximately \\$300 million in the second quarter of 2015 and by revenue and margin pressures in all reported segments, especially in the National Security and Solutions (NSS) and the Aerospace Systems segments.
L-3's leverage metrics breached Fitch's negative rating action guidelines in 2015, but Fitch considers the deterioration to be temporary and expects the company will improve its metrics within the next two years through debt reduction and improvements in operating performance. Fitch would expect the company to reduce its share repurchases and redeem additional debt if its operating results continue being challenged, and failure to do so would likely lead to a negative rating action.
On Dec. 7, 2015, L-3 commenced a cash tender offer for \\$300 million aggregate principal amount of senior unsecured notes maturing between 2016 and 2024. The company anticipates completing the debt reduction before Dec. 31, 2015. Additionally, on Dec. 8, 2015, L-3 announced it will further reduce debt by \\$200 million in connection with a sale of its NSS segment to CACI International Inc. (CACI) for \\$550 million. Even though the transaction is expected to close in the first quarter of 2016, Fitch anticipates L-3 will redeem \\$200 million of debt in Nov. 2016 when 3.95% \\$500 million senior notes are due.
Fitch expects L-3's leverage (debt to EBITDA)will improve to approximately 3.1x and 2.8x by the end of 2016 and 2017, respectively. The improvement in the credit metrics beyond 2016 will be driven by anticipated improvements in operating margins due to ongoing portfolio reshaping and cost reduction initiatives, and an anticipated increase in the global military spending. The divestitures of the MSI business and the NSS segment will not have a significant impact on the company's EBITDA and cash flow generation due to the low margins of the divested businesses.
Fitch's other rating concerns include the company's cash deployment strategy, which primarily focuses on share repurchases and dividends, declining revenues, and continued margin pressures. Even though L-3's management has publically expressed commitment to maintaining an investment grade rating, the company continues to deploy the majority of internally generated cash towards shareholders. Fitch expects the company will deploy above 100% if its pre-dividend cash flows towards shareholders in both 2015 and 2016.
The company's FCF has deteriorated for five consecutive years. Fitch believes L-3 will generate approximately \\$650 million and \\$600 million FCF in 2015 and 2016, respectively. Fitch expects L-3's FCF will stabilize in 2016 and will fluctuate in the range of \\$600 million to \\$650 million over the next several years. Even though L-3's cash generation is seasonal, its quarterly FCF has been positive historically.
L-3's capital expenditures were steady over the past four years and remained within the range of \\$180 million to \\$210 million, which translates into the range of 1.5% to 1.7% of sales. Fitch expects the company's annual capital expenditures will remain within the above range over the next several years. Pension contributions are not expected to be material for the company.
In 2015, the company embarked on an initiative to reshape its portfolio by divesting non-core, and lower margin businesses. The company aims to re-focus on core markets in which it has leading positions and can command margin premiums. The sale of the NSS segment completes L-3's exit from the government services business which commenced with the spin-off of Engility Holdings, Inc., in 2012. Fitch views the ongoing initiative as credit positive for the company. The MSI and NSS divestitures along with the recent completion of several bolt-on acquisitions should improve L-3's growth prospects and operating margins in the long term.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for L-3 include:
--L-3's leverage will decrease below 3x by the middle of 2017;
--Low double digit revenue decline in 2016 primarily due to the announced divestiture of the NSS segment and organic pressures, with a slow rebound beginning in 2017;
--Steady EBITDA margin improvements. EBITDA margins are expected to increase to approximately 12.5% by 2018, up from 10.4% in 2015;
--Combined net share repurchases and dividend payments will be slightly above 100% of pre-dividend FCF. Fitch anticipates share repurchases will be elevated in 2016 due to the sale of the NSS segment and will be reduced in 2017;
--Post dividend FCF margin will remain above 5% throughout the rating period;
--L-3 will spend approximately \\$200 million in capital expenditures, annually;
--The company will fund small to medium sized bolt-on acquisitions (if any) using internally generated cash and will reduce share repurchases correspondingly if needed to maintain its credit profile;
--The company will maintain approximately \\$3.5 billion debt on its balance sheet;
--Pension contributions will be approximately 10% of funds from operations (FFO). Fitch does not anticipate the company will make discretionary contributions for the next several years.
RATING SENSITIVITIES
Fitch would consider a negative rating action if the company's leverage (debt / EBITDA) or FFO adjusted leverage were to remain within or above the ranges of 3.0x - 3.2x and 3.5x - 3.7x over the next 18 months, respectively. L-3's leverage breached Fitch's negative rating action guidelines in 2015, and Fitch anticipates the company's leverage will remain above the lower end of Fitch's negative guidelines throughout 2016. However, Fitch expects L-3's leverage ratios will improve in 2017 due to higher sales, planned debt reduction, and margin improvements. LLL has the financial flexibility to reduce debt if it lowers the amount of planned share repurchases.
A negative rating action could result from an upward revision in Fitch's expectations for the company's leverage at the end of 2017; a significant operating underperformance without reductions to share repurchases and corresponding debt redemption; or debt funded share repurchases and acquisitions.
Strong financial flexibility and FCF generation somewhat alleviates Fitch's concern regarding the company's elevated leverage for the ratings. Nevertheless, given the levels of its key credit metrics, the company does not have the flexibility to increase its debt at the current ratings.
Fitch is not likely to consider positive rating actions over the next several years because of the high leverage and the company's cash deployment strategy in form of share repurchases and dividends. Fitch could consider positive rating actions in the event of a change in cash deployment strategy, including the application of free cash flow to debt reduction. Financial metrics that could lead to a positive rating action include sustained debt to EBITDA below 2x and sustained FFO Adjusted Leverage below 3x.
LIQUIDITY
L-3 has historically maintained strong liquidity. The company's liquidity as of Sept. 25, 2015 was \\$1.32 billion, consisting of availability of all of its \\$1 billion credit facility (expiring in February 2017) and \\$323 million in cash and short-term investments. Liquidity is expected to remain solid in the range of \\$1.3 billion to \\$1.5 billion though it will dip temporarily to approximately \\$1.2 billion due to the redemption of \\$300 million senior notes December of 2015.
The company has large debt maturities over the next two years as \\$500 million senior notes become due in November 2016 and \\$350 million senior notes become due in May, 2017. Fitch expects L-3 will access the capital markets to partially finance the maturing notes while partially repaying some of the notes in connection with the abovementioned tender offer. In addition, Fitch anticipates L-3 will repay \\$200 million of the \\$500 million notes due in 2016 with the proceeds from the sale of the NSS segment.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
L-3 Communications Holdings, Inc.
--IDR at 'BBB-'.
L-3 Communications Corporation
--IDR at 'BBB-';
--Senior unsecured debt at 'BBB-';
--Credit facilities at 'BBB-'.
The Rating Outlook is Stable.
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