From S&P:
Standard & Poor’s Ratings Services said today that its ratings and outlook on U.S.-based military supplier L-3 Communications Corp. (BBB-/Stable/–) are not affected by the spin-off of Engility Holdings Inc., parent of Engility Corp. (BB-/Stable/–), to shareholders. L-3 received a $325 million dividend in connection with the transaction and plans to use the proceeds to redeem $250 million of debt and repurchase $75 million of stock.
We affirmed our ratings on L-3 in July 2011 when the company first announced the spin-off. At that time, we stated our belief that the divestiture would be a slight positive for the company’s business profile, as it should allow for modestly higher revenue growth and profit margins for the remaining business. We also expect credit protection measures to remain fairly flat as the debt reduction offsets lost earnings, with pro forma 2012 funds from operations to debt of about 30% and debt to EBITDA of 2.5x-3x
Fitch had more to say, but also left ratings unchanged:
The spin-off of Engility Holdings, Inc. (Engility) completed by L-3 Communications Corporation (L-3) is credit neutral to L-3’s Issuer Default Rating (IDR), according to Fitch Ratings. The Rating Outlook is Stable. Fitch’s ratings on L-3 cover approximately $4.1 billion of outstanding debt. L-3’s existing ratings are listed at the end of this release.
Engility was a part of L-3’s Government Services segment representing approximately $1.6 billion of estimated 2012 revenues. Engility’s business was expected to account for approximately 8%-10% of L-3’s combined EBITDA and FCF in 2012. In connection with the spin-off, L-3 received a one-time dividend from Engility, resulting in net proceeds of approximately $325 million. L-3 announced a plan to utilize a majority of the received cash to redeem $250 million of senior subordinated notes maturing in 2015. The spin-off resulted in increased pro forma leverage (Debt to EBITDA) for L-3; however, the planned redemption somewhat mitigates the deterioration of the leverage ratio.
L-3’s total debt is expected to decline to approximately $3.9 billion following the redemption of the senior subordinated notes. The repayment of the notes will continue the company’s shift away from senior subordinated debt in its capital structure. The senior subordinated ratings remain one notch below L-3’s IDR and senior unsecured debt due to contractual subordination.
After giving effect to the planed redemption of the notes, Fitch estimates L-3’s leverage to be in the 2.2 times (x) to 2.3x range at the end of 2012, up from 2.1x as of Dec. 31, 2011. Despite a slight deterioration in the company’s leverage, its credit profile is still solid for the existing ‘BBB-‘ rating.
Key factors that support the ratings include L-3’s solid credit metrics, liquidity position, and Fitch’s expectation of steady operating margins and substantial free cash flow (FCF; cash from operations less capital expenditures and dividends) which totaled $1 billion for the last 12 months (LTM) ended March 30, 2012. Other positive factors include L-3’s diverse portfolio of products and services that are in line with the Department of Defense (DoD) requirements and a balanced contract mix. Additionally, some concerns about exposure to declining DoD supplemental budgets were lessened with the spin-off of Engility.
Fitch’s concerns include L-3’s cash deployment strategy, which includes a focus on acquisitions and share repurchases, U.S. government budget deficits and the impact on defense spending after fiscal year (FY) 2012. Fitch’s other concerns include the underfunded pension position totaling $967 million (64% funded status) as of Dec. 31, 2011, all of which stayed with L-3 after the spin-off. The longer-term outlook for supplemental DoD budgets related to operations in Iraq and Afghanistan remains a modest concern but is lessened by the related revenues that were part of the spin-off.
The company’s liquidity as of March 30, 2012 was $1.5 billion, consisting of $996 million of credit facility availability (expiring in Feb. 2017) and $493 million in cash and short-term investments. The company has no debt maturities through 2014. The next material debt maturity is $500 million in 2015, of which $250 million will be redeemed in connection with the spin-off of Engility.
L-3 has generated strong FCF through strong operating performance, working capital management, and acquisitions. In the LTM ending March 30, 2012, the company generated $1 billion of FCF. L-3 reported $1.1 billion FCF in 2011, 2010 and 2009. L-3’s FCF benefits from low capital expenditures as a percentage of sales; it has averaged 1.3% of sales between 2008 and 2011. Fitch expects 2012 FCF to decline to approximately $800 to $900 million mostly driven by the spin-off of Engility.
L-3’s rating and Outlook incorporate Fitch’s expectations of small- to medium-sized acquisitions and meaningful cash deployment toward shareholders. In the first three months of 2012, L-3 deployed $205 million towards acquisitions, $138 million for share repurchases and $49 million in dividend payments. Fitch expects to see approximately $1 billion and $180 million spent on share repurchases and dividends in 2012, respectively. Over the past four years, L-3 contributed $591 million to its pension plans, with $176 million contributed in 2011. The company expects to contribute approximately $173 million to its pension plans in 2012.
U.S. government spending trends are key drivers of L-3’s financial performance given that the company generates most of its revenues (82% in 2011) from the U.S. government, with the bulk (75%) coming from the Department of Defense (DoD).
U.S. defense spending has been on an upward trend for more than a decade, but the FY2012 and FY2013 budgets represent a turning point, with spending beginning to turn down in FY2013, even excluding war spending, although from very high levels. The FY2012 DOD base budget is up less than one percent compared to FY2011, and the requested base budget for FY2013 is down 1% to $525 billion. FY2013 modernization spending (procurement plus 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 L-3’s credit profile.
Fitch currently rates L-3 as follows:
L-3 Communications Holdings, Inc.
–IDR ‘BBB-‘;
–Contingent convertible subordinated notes ‘BB+’.
L-3 Communications Corporation
–IDR ‘BBB-‘;
–senior unsecured notes ‘BBB-‘;
–Senior unsecured revolving credit facility ‘BBB-‘;
–Senior subordinated debt ‘BB+’.
Disclosure: The author holds no position in any stock mentioned.
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