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Fitch Rates Harris Corporation 'BBB-', Outlook Stable

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04/02/2015 | 01:24pm EDT

Fitch Ratings has assigned a 'BBB-' Issuer Default Rating (IDR) to Harris Corporation (HRS). Fitch has also assigned an 'F3' short-term IDR and an 'F3' rating to the company's commercial paper program; 'BBB-' ratings to the senior unsecured $1 billion credit facility and senior unsecured indebtedness; and 'BBB- EXP' ratings to the $1.3 billion term loans announced on March 19, 2015. The Rating Outlook is Stable. A complete list of ratings is provided at the end of this release.

The ratings incorporate the expectation that HRS' announced acquisition of Exelis Inc. (XLS) will be completed on the expected terms. On Feb. 6, 2015, HRS announced the acquisition of XLS in a cash and stock transaction valued at $23.75 per share, or an approximately $4.75 billion enterprise value, to be financed through 70% cash and 30% equity. The agreement has been unanimously approved by the Boards of Directors of both companies. The deal is subject to the approval of XLS' shareholders. Under the terms of the transaction, XLS shareholders will receive $16.625 in cash and 0.1025 a share of HRS common stock, based on HRS' closing price as of Feb. 5, 2015, for each share of XLS common stock. Upon closing, HRS shareholders will own approximately 85% of the combined company, and XLS shareholders will own approximately 15%.

Fitch currently rates XLS 'BBB+/F2', with the ratings on Rating Watch Negative as a result of the announced acquisition. HRS entered into a $3.4 billion 364-day bridge loan agreement to backstop financing for the acquisition on February 6, 2015. On March 16, 2015, HRS reduced the bridge loan from $3.4 billion to $2.1 billion concurrently with entering into a $1.3 billion term loan agreement securing commitments of a three year $650 million term loan and a five year $650 million term loan. This term loan will be funded at the close of the acquisition. Fitch expects HRS will issue additional senior unsecured indebtedness in the near future in connection with the acquisition. Fitch's ratings are expected to cover approximately $5.3 billion of debt upon the completion of the XLS acquisition including assumed senior unsecured notes from XLS. The transaction is expected to close in June 2015.

Fitch considers HRS' existing credit profile, excluding the XLS acquisition, to be consistent with a strong 'BBB' category rating, and the IDR would likely be upgraded as much as two notches if the acquisition is not completed.

KEY RATING DRIVERS

HRS' ratings are supported by the company's competitive position in the defense industry; technology capability; sizable international and commercial sales; good product diversification; adequate liquidity; and large backlog. The company has solid cash generation and strong operating margins and is expected to realize significant cost savings from the XLS acquisition. Additionally, HRS is a sole source provider for many of XLS' products. The ratings are also supported by adequate financial flexibility and Fitch's expectations that the company will improve its credit metrics over the next three years largely driven by voluntary and scheduled debt reductions.

Acquisition benefits are likely to include better scale and a more balanced product portfolio. The company has identified more than $100 million of potential annual cost savings, though it will be partly offset by higher interest expenses and one-time integration expenditures in the range of $130 million to $150 million necessary to achieve the identified savings.

Some of HRS' post-acquisition leverage metrics will be weak for the ratings. Fitch estimates the company's leverage (debt to EBITDA) and adjusted leverage (adjusted debt / EBITDAR) will be 3.1x and 3.3x, respectively, a significant deterioration compared to 1.5x and 1.7x at the end of fiscal 2014 (ended June 30, 2014). Fitch estimates HRS' credit metrics will improve over the next two years driven by modest revenue growth and voluntary debt repayment. The recently announced $1.3 billion term loans will be repayable without penalties and HRS targets retiring approximately $1.8 billion in debt over the next three years to bring its net debt leverage to 1.5x (which Fitch estimates is equivalent to approximately 1.7x on a gross leverage basis) as communicated during the announcement of the XLS acquisition. Fitch expects HRS' leverage and adjusted leverage will decline to approximately 2.2x and 2.5x, respectively, by the end of fiscal 2017. Funds from operations (FFO) adjusted leverage is also expected to improve to approximately 3x during the same time frame.

Despite HRS' elevated post-acquisition leverage, Fitch believes the company will have an investment grade profile due to strong cash generation, solid financial flexibility, strong margins and technological advantages compared to some of its peers. Fitch notes HRS' management is committed to maintaining investment grade ratings and has publically stated its goal to de-lever rapidly. Fitch also notes that many of the company's other credit metrics (profitability, diversity, backlog, etc.) are indicative of a strong investment grade company.

The ratings are also supported by adequate financial flexibility. Fitch expects the post-acquisition company's liquidity will be in the range of $1.3 billion to $1.5 billion consisting of cash and nearly full availability under its $1 billion RCF. Fitch expects HRS' liquidity will remain steady over the next several years as Fitch anticipates the company's cash balances will not increase due to rapid debt repayment. Additionally, Fitch expects the company will generate approximately $600 million of annual free cash flow (FCF - Cash Flow from Operations less CapEx and Dividends).

Fitch will focus on merger integration risks, but these risks are mitigated by the significant experience of HRS' current management team members in successfully integrating businesses, as it has participated in numerous acquisitions. Additionally, Fitch views the friendly nature of the acquisition as a positive in overcoming challenges associated with an integration of this scale.

Other concerns include uncertainty surrounding HRS' ability to realize identified synergies, XLS' large pension deficit (including a relatively high percentage of Level III assets), and corresponding future pension funding requirements. Fitch is also concerned with the accelerated timetable for the acquisition. HRS expects to complete the acquisition by June 2015 and the company will incur significant costs if the acquisition does not proceed as planned. Additionally, Fitch is concerned about HRS' future cash deployment strategies, but expects the company's share repurchases will be moderate.

There is also likely to be some strategic uncertainty given the possibility of future portfolio actions, but Fitch anticipates HRS will not make sizable acquisitions until it completes XLS' integration and reduces its leverage. The company's ratings will also be exposed to shocks and downturns in U.S. military spending or shifts in spending mix, although Fitch believes there is a good chance that spending is now at or near a trough. Fitch also notes that despite the larger scale that will result from the acquisition, HRS will remain smaller than many of its key competitors.

HRS will assume XLS's sizable pension deficit of $1.9 billion (70% funded) as of Dec. 31, 2014, up from $1.2 billion (78% funded) at the end of 2013. The deterioration in the funded status of the pension plans was primarily driven by a decrease in discount rates and new mortality/actuarial assumptions. The domestic pension benefit obligation was $6.8 billion at the end of 2014. Required cash contributions to the company's plans were $133 million in 2014; however, the large pension deficit and required contributions are mitigated by the expected reimbursements from the U.S. government, which treats a part of pension costs as allowable, and reimbursable costs under some contracts.

KEY ASSUMPTIONS

Fitch's key assumptions within its rating case for the issuer include:

--Low single-digit revenue growth.

--EBITDA margins at approximately 21% immediately following the merger, with modest increases in the following years, reflecting Fitch's conservative view of the realized merger synergies. Fitch excluded synergies in its modeling resulting in slower than possible revenue and margin improvements.

--Debt repayment will be accelerated and driven by the company's cash generation. Fitch notes HRS' leverage may be reduced faster if the company realizes planned synergies, allocates less cash to share repurchases and dividend increases, or divests assets.

--Dividend payout ratio will remain unchanged from HRS' pre-acquisition targets.

--Share repurchases will be suspended in fiscal 2016, but will resume in fiscal 2017. Fitch expects share repurchase amounts will depend on internal cash generation and may not resume in fiscal 2017 if the company's is not on target to achieving its 1.5x net leverage goal by the end of fiscal 2018.

--Cash flow generation will be solid and the company will generate above approximately $600 million FCF annually after giving effect to pension contributions and dividends.

--The company will contribute approximately $160 million towards its pension liabilities annually.

--Capital expenditures will fluctuate in the range of 2.25% to 2.75% of revenues.

RATING SENSITIVITIES

Fitch does not expect to take positive rating actions until HRS reduces its leverage and makes progress on the merger integration. Fitch will consider upgrading HRS if the acquisition is not completed and HRS continues operating with its existing capital structure. Any upgrade would likely be limited to two notches.

Fitch may take a negative rating action if the post-acquisition company's leverage and adjusted leverage remain above 2.5x and 2.75x for a prolonged and sustained period of time. Fitch may also consider a negative rating action if the company's FCF margin declines and remains below 4%. Additionally, a negative rating action may be considered if the merger results in unforeseen operating challenges and the company fails to achieve expected financial results, or if the company engages in sizable share repurchases or acquisitions prior to reducing leverage.

Fitch has assigned the following ratings to HRS:

--IDR 'BBB-';

--Senior unsecured revolving credit facility 'BBB-';

--Senior unsecured three- and five-year term loans 'BBB- EXP';

--Senior unsecured notes and debentures 'BBB-';

--Short-term IDR 'F3';

--Commercial paper 'F3'.

The Rating Outlook is Stable.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage' (May 28, 2014);

--'2015 Outlook: Global Aerospace and Defense (Traffic and Order Backlogs Trump Fuel)' (Dec. 17, 2014);

--'Fitch Places Exelis Inc. on Rating Watch Negative Following Acquisition Announcement' (Feb. 9, 2015);

--'Aerospace and Defense: Ratings Navigator Companion' (Nov. 14, 2014).

Applicable Criteria and Related Research:

Aerospace and Defense: Ratings Navigator Companion

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=804088

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=982431

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.


© Business Wire 2015
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