New York, November 20, 2012 -- Moody's Investors Service affirmed Exelis, Inc.'s ("Exelis") Baa3 senior unsecured and Prime-3 ratings but revised the rating outlook to negative from stable. Following its 2011 distribution from ITT Corporation ("ITT"), Exelis' operating performance has met expectations. However, it, along with many defense contractors, now face a challenging environment from prospective declines in U.S. defense spending in 2013 and beyond. This coincides with an earlier significant widening of the underfunded position of its pension plan which will require substantial contributions for several years, keep adjusted leverage above levels anticipated at the time of the initial rating assignment, and limit financial flexibility should cuts in defense spending become more severe.
Going into ITT's separation into three independent organizations, ITT's consolidated pension plans were roughly $1.3 billion underfunded. The bulk of the domestic liabilities and related plan assets were channeled into Exelis at the time of its spin-off with an assumed underfunded position of roughly $1 billion at the time. The combination of lower discount rates and weaker asset valuations contributed to an increase in the underfunded position to approximately $1.9 billion at the end of 2011. Through September 2012Exelis contributed $265 million into the qualified plans, well in excess of its annual pension service costs. Although asset performance has been positive to date, the impact of low discount rates will likely keep the underfunded position at elevated levels for an extended period.
Exelis borrowed under its revolving credit and issued commercial paper during the first half of 2012 to fund its pension contribution and working capital needs. Those borrowings have since been reduced and the historical pattern of its cash flows (weighted toward the 2nd half) should enable it to repay the bulk of remaining commercial paper outstandings by the end of the year. Moody's still expects Exelis to generate cash flows net of capital expenditures and dividends in excess of its funding requirements for the plan liabilities. But the magnitude of that excess is less than previous expectations and will constrain Exelis's ability to either reduce funded debt or invest in growth initiatives that may otherwise strengthen its business position. The effect of MAP 21 (Moving Ahead for Progress in the 21st Century act) will defer pension contributions for the next 2 years but does not reduce the extent of underfunding. Furthermore, substantial uncertainties are involved on the level of future discount rates used in calculating pension liabilities as well as asset valuations in the plan, and, more importantly, the outcome of political decisions on military expenditures and priorities that would affect demand for the company's product and service offerings. In the interim, Moody's adjusted leverage will remain high for the Baa3 category (Moody's anticipates debt/EBITDA above 3 times at year-end 2012). Pressure on U.S. and European defense spending may also lead to weaker revenues and earnings going forward.
The Baa3 rating incorporates Exelis' stature as a leading provider of critical C4ISR equipment and technical services to the U.S. Department of Defense ("DoD") and other U.S. government agencies with a track record of consistent profitability and ongoing free cash flow generation. The rating also considers the company's elevated leverage resulting from both balance sheet indebtedness and adjustments for a significantly underfunded pension plan. The rating incorporates limited prospects for revenue driven earnings growth over the next several years as budgetary issues constrain DoD outlays. The company's business profile benefits from a backlog of contract awards providing revenue visibility and advantages of being an incumbent provider on critical information and support services on classified programs. Exelis possesses a diversified collection of technology applied across electronic communication, sensing and surveillance equipment, sectors that are viewed as less vulnerable to reductions in government expenditures and, to a lesser extent, used in commercial aviation. Significantly, Exelis has both a higher margin product/equipment segment and a less capital intensive service component with the blended mix still yielding solid margins for the defense sector. Nonetheless, pressure on margins in both its equipment and service segments is anticipated over the intermediate period as contracts come up for renewal and volumes are re-set in budgetary decisions.
Funded debt levels are relatively modest in comparison to revenues and EBITDA and the company is expected to generate meaningful free cash flow over the next few years even after contributions to its domestic pension plans. Although balance sheet cash is modest for the size of the organization, the company has a good liquidity profile flowing from ongoing free cash flow and access to a $600 million back-up revolving credit facility with no scheduled principal repayments of long-term debt until 2016. While the company's free cash flow will facilitate a moderate level of transactions, any significant acquisitions or shareholder returns that result in a higher debt burden while organic prospects for revenue or earnings growth remain limited would intensify downward pressure on the rating.
The negative rating outlook reflects the challenging environment for defense related businesses in the U.S. as significant political decisions are awaited over the coming year(s) on aggregate defense expenditures as well as the individual programs that will be affected. This could lead to further pressure on revenues and margins at a time when Exelis's leverage is elevated for the rating category.
A stable outlook or stronger ratings are not anticipated over the near term. A resumption of meaningful organic growth in revenues and operating profitability would be viewed favorably as would reduction in adjusted debt levels. Quantitatively, a stable outlook would involve debt/EBITDA falling below 3 times with EBITA/interest consistently above 5 times and retained cash flow/debt at or above 30%. Negative pressure on the rating could magnify should revenues or profitability appear likely to fall below expectations or if the company experiences negative free cash flow. Similarly, debt funded acquisitions, shareholder returns or deterioration in earnings which would cause debt/EBITDA to increase while its pension plans remained significantly underfunded or lead to EBIT/interest coverage under 3 times could lead to lower ratings.
Ratings affirmed: Senior unsecured, Baa3 Short-term, Prime-3 The last rating action was on October 19, 2011 at which time a Prime-3 short-term rating was assigned.
The principal methodology used in rating Exelis was the Global Aerospace & Defense Industry Methodology published in June 2010. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.
Exelis Inc., headquartered in McLean, VA, provides C4ISR (Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance) related products and systems as well as information and technical services to military, government and commercial customers in the U.S. and globally. Revenue in 2011 was approximately $5.8 billion.
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Edwin Wiest VP - Senior Credit Officer Corporate Finance Group Moody'sInvestors Service, Inc.250 Greenwich StreetNew York, NY 10007 U.S.A. JOURNALISTS: 212-553-0376 SUBSCRIBERS: 212-553-1653Michael J. Mulvaney MD - Corporate Finance Corporate Finance Group JOURNALISTS: 212-553-0376 SUBSCRIBERS: 212-553-1653 Releasing Office: Moody's Investors Service, Inc.250 Greenwich StreetNew York, NY 10007 U.S.A. JOURNALISTS: 212-553-0376 SUBSCRIBERS: 212-553-1653(C) 2012 Moody's Investors Service, Inc. and/or its licensors and affiliates (collectively, "MOODY'S"). All rights reserved.
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