Fitch Ratings has affirmed L3Harris Technology's (LHX) and L3 Technology Inc.'s 'BBB+' Issuer Default Rating (IDR) following the announcement that the company plans to acquire Aerojet Rocketdyne (AJRD) for $4.7 billion, financed primarily with new debt and likely closing in 2H23.

Fitch has also affirmed the Long-Term ratings on LHX's senior unsecured notes at 'BBB+', and Short-Term IDR and CP ratings at 'F1'. Fitch also is assigning a 'BBB+' Long-Term rating to the company's term loan, issued by LHX, to be used for the previously announced Viasat Tactical Data Link transaction. The Rating Outlook is revised to Negative from Stable.

The Negative Outlook reflects the elevated post-transaction leverage profile with pro forma initial EBITDA leverage around 4x. Fitch currently forecasts EBITDA leverage will likely remain outside of its current 2.5x negative sensitivity for around two years following the transaction. Integration risks are also heightened as AJRD has experienced moderate operational and supply chain constraints in recent quarters, and it may take LHX time to fully evaluate any manufacturing challenges that may arise due to the differences with its current portfolio. LHX is also in the process of closing a separate transaction, the $2 billion debt-funded acquisition of Viasat's Tactical Data Links (TDL) business which could compound integration challenges.

Fitch believes these concerns are somewhat offset by the positive effect the transaction has on LHX's business profile. The acquisition of AJRD further enhances and diversifies the company's offerings with high-demand space-related assets which are longer-cycle than many of LHX's current programs and offer revenue visibility and additional backlog (1.5x revenue at ~$30 billion post-close). Prior to the acquisition, LHX already boasted a leading technology position with a strong product portfolio, sizable cash flow generation, stable and growing backlog, and substantial profitability with EBITDA margins nearing 20% and FCF margins greater than 6%. These positive factors will be supplemented by the expanded contract base and product capabilities brought on by AJRD.

Key Rating Drivers

Acquisition of Aerojet Rocketdyne: LHX announced it plans to acquire Aerojet Rocketdyne for approximately $4.7 billion. The transaction is expected to close towards the end of 2023 and be financed entirely with new debt. Fitch believes the transaction further enhances LHX's vast technological capabilities and offers some operational synergies to support large missile, propulsion, defense, and space programs.

Leverage Above 2.5x through 2025: Fitch projects EBITDA leverage will likely remain well outside of LHX's 2.5x negative sensitivity at around 3.0x one-year post-transaction and in the mid-2x range by YE 2025. The company's highly diversified product portfolio and through-the-cycle FCF profile (Fitch estimates about $1.2B/year proforma post-dividend FCF), and debt reduction-focused capital allocation priority helps mitigate Fitch's elevated leverage concerns.

Fitch believes management will need to demonstrate commitment to a financial policy consistent with a 'BBB+' rating in order for Fitch to stabilize the rating. This would likely include limiting or pausing share repurchases and shifting capital deployment to debt repayment until EBITDA leverage returns to around 2.5x.

Substantial Product Diversification, Technology: Fitch considers LHX's portfolio highly diversified by product and program with differentiating and advanced technology. The company annually self-funds its R&D in order to innovate, which Fitch estimates at approximately 3% to 4% of sales. Exposure to material cost overruns is limited, particularly compared to some of its more concentrated peers. However, the company maintains a healthy mix between the original equipment manufacturer (OEM) and aftermarket sales which would likely mitigate the impact of an individual prime contract materially weighing on the company's financial performance.

Generally Supportive U.S. Defense Environment: Fitch considers the U.S. budget environment generally favorable for most defense contractors, despite near-term supply chain headwinds. Fitch expects changes in spending on Procurement and Research, Development, Test, & Evaluation (RDTE) -- the two areas of the budget that have the most direct effect on defense contractors-will be fairly positive over the next few years, though the impact to individual contractors depends on program allocations.

RDTE, highly technological platforms, and classified spending should continue to grow over the next several years given the significant focus on modernization. A lesser degree of domestic spending on legacy platforms, O&M, and training could offset part of this growth. Fitch believes large, diversified prime contractors and their suppliers are well-positioned to compete over the long term given the large degree of research and development funding that will be required. This includes LHX, which operates as both a prime and a supplier, depending on the program, and offers a highly diversified product portfolio that spans several different areas of defense spending.

International Growth: LHX has opportunities to expand further into international channels. Many governments are facing pressure to increase defense spending in the face of heightened tensions in multiple theatres, including eastern Europe, the Middle East, and across Asia. Areas where LHX could see growth in international sales over the next several years include modernizing tactical radios, where they already hold a strong market position; F-16 modernization; ship building and modernization; various space platforms including payloads and missile defense; and signals intelligence capabilities, among others.

Derivation Summary

Fitch expects the LHX's profitability will remain stronger than similarly rated peers Northrop Grumman (NOC) and Lockheed Martin (LMT). Fitch expects leverage will be weaker than NOC (BBB+/Stable) and LMT (A-/Stable) following the recent announced transactions. Although NOC and LMT benefit from being prime OEMs on sizable programs critical to U.S. national security, they also carry additional risks of cost overruns that are less severe in LHX. LHX is equally or more diversified by contract and offerings than most of its defense peers.

Key Assumptions

Tactical Data Link acquisition is finalized in mid-2023 and Aerojet Rocketdyne closes at the end of 2023; both transactions funded with more than $6.5 billion of new debt in aggregate;

Flattish revenue growth in 2023; Low-to-mid single digit organic revenue growth beginning in 2024, driven by Space & Airborne Systems and munition demand;

High-teens EBITDA margins throughout the forecasted period, beginning with flattish margins in 2023, but improving steadily as supply chain issues and inflationary pressures dissipate;

Company shifts capital deployment strategy to debt repayment while integrating both acquisitions; Share repurchases are minimal beyond 2022 until EBITDA leverage gets below 3.0x;

Minimal integration issues or cost overruns with either of the announced acquisitions.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Public commitment to improving credit metrics and debt reduction to achieve debt to EBITDA approaching 1.5x.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Financial metrics that could lead to a negative rating action include sustained debt/EBITDA above 2.5x;

Execution issues on key programs; significant debt-funded shareholder focused actions;

FCF margins below 5% absent a simultaneous improvement in leverage metrics.

Fitch could stabilize the ratings if management demonstrates commitment to a financial policy consistent with the 'BBB+' level. This would likely include limiting or pausing share repurchases and shifting capital deployment to debt repayment until EBITDA leverage returns to around 2.5x.

Fitch believes the EBITDA leverage sensitivities could widen following the transaction after integration risks dissipate given Fitch's view that the proforma cash flow risk profile will become incrementally more resilient via the more diversified, highly technological portfolio with industry leading margins and lower individual contract risk than competitors.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Fitch expects LHX will maintain robust liquidity in excess of $2.4 billion, which is likely to consist of a revolving credit facility of at least $2 billion with cash balances of greater than $400 million. Liquidity and financial flexibility are further bolstered by the company's significant cash generation. Fitch expects the company to generate post-dividend FCF of greater than $1.8 billion per year over the rating horizon. The company's capital structure is comprised predominantly of senior unsecured notes with varying maturities. It also has an unsecured revolving credit facility and CP program.

Issuer Profile

L3Harris Technologies (LHX) provides advanced, technology-based solutions to government and commercial customers across three segments: Integrated Mission Systems, Space & Airborne Systems, and Communication Systems.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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