Fitch Affirms L-3 Communications at 'BBB-'; Outlook Stable
NEW YORK -- September 27, 2012
Fitch Ratings has affirmed the 'BBB-' Issuer Default Ratings (IDR) and debt
ratings for L-3 Communications Holdings, Inc. (L-3) and L-3 Communications
Corporation. The Rating Outlook is Stable. Approximately $3.9 billion of
outstanding debt is covered by these ratings. The senior subordinated ratings
remain one notch below L-3's IDR and senior unsecured debt due to contractual
subordination. Convertible contingent debt securities are also rated one notch
below the IDR and senior unsecured debt due to subordination of its
guarantees. See the full rating list at the end of this release.
Key factors that support the ratings include L-3's solid credit metrics;
strong liquidity position; and Fitch's expectation of solid, though declining
operating margins and substantial free cash flow (FCF; cash from operations
less capital expenditures and dividends). FCF totaled approximately $1 billion
for the last 12 months (LTM) ended June 29, 2012 and includes Engility
Corporation (Engility) operating results).
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
Fitch's concerns include:
--L-3's declining revenues and lower margins, which are expected to remain
under pressure due to continued redeployment of the U.S. troops from
Afghanistan and changing sales mix;
--The company's cash deployment strategy, which includes a focus on dividends
and share repurchases, though it is mitigated by the company's commitment to
retaining investment grade ratings and the recently implemented and announced
debt reductions; and
--Uncertainty surrounding defense spending after fiscal year (FY) 2012 due to
U.S. government budget deficits and the potential for an additional $500
billion of reductions to the DoD budget starting in January 2013.
Fitch's other concerns include L3's 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 DoD budgets related to
operations in Iraq and Afghanistan remain a concern but have lessened because
of the amount of related revenues that were a part of the spin-off.
On July 17, 2012, L-3 completed the spin-off of Engility while retaining its
cyber, intelligence and security solutions businesses, which is called
National Security Solutions going forward. 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 onetime $335 million gross dividend from
The spin-off resulted in increased pro forma leverage (Debt to EBITDA) for
L-3. In addition, L-3's 2012 year end forecasted leverage showed further
deterioration driven by declining sales and lower operating margins due to DoD
budgetary pressures, withdrawal of the troops from Iraq and Afghanistan, and
unfavorable sales mix. The company supported its credit metrics by redeeming
$250 million of 6.375% senior subordinated notes maturing in 2015 on July 26,
2012, and by initiating redemption of the remaining $250 million of 6.375%
senior subordinated notes due 2015 on Sept. 13, 2012. The notes will be
redeemed on Oct. 15, 2012.
L-3's total debt is expected to decline to approximately $3.6 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. After giving effect to the planned 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.
The company's liquidity as of June 29, 2012 was $1.5 billion, consisting of
$996 million of credit facility availability (expiring in February 2017) and
$481 million in cash and short-term investments. The liquidity is expected to
decline due to the announced redemption of the remaining $250 million 6.375%
senior subordinated notes due 2015; however, the remaining liquidity will
L-3 has no debt maturities through 2015 (giving effect to the discussed
redemption of the remaining $250 million 6.375% senior subordinated notes due
2015). The next material debt maturity is in 2016 when $500 million of 3.95%
senior unsecured notes are due.
L-3 has generated strong FCF through strong operating performance, working
capital management, and growth via prior acquisitions. In the LTM ending June
29, 2012, the company generated approximately $1 billion of FCF. L-3 reported
approximately $1.1 billion annual 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 L-3's FCF to
decline to approximately $800 to $900 million in 2012 and 2013, mostly driven
by the spin-off of Engility.
Fitch's rating and Outlook for L-3 incorporate the agency's expectations of
small- to medium-sized acquisitions and meaningful cash deployment toward
shareholders. In the first six months of 2012, L-3 deployed $216 million
towards acquisitions, $315 million for share repurchases and $98 million in
dividend payments. Additionally, L-3 acquired Thales Simulation & Training for
$134 million effective Aug. 6, 2012. Fitch expects L-3 to deploy approximately
$1 billion toward shareholders in 2012. Fitch expects the share repurchase
activity may decline significantly beyond 2012 depending on the extent of
declines in U.S. defense spending.
L-3 has a pension deficit of approximately $1 billion, and the pension funds
are 64% funded. The pension benefit obligation (PBO) comprised $2.7 billion at
the end of 2011, while the other postretirement benefit obligation was $216
million. Over the past four years, L-3 contributed $591 million to its pension
plans, with $176 million contributed in 2011. Given the low interest rate
environment, it is likely that L-3's funding position could further
deteriorate by the end of this year. L-3 expects to contribute approximately
$175 million over the next several years; however the company has flexibility
to decrease the contributions as permitted under the MAP-21 Act enacted on
July 6, 2012.
U.S. government spending trends are key drivers of L-3's financial performance
given that the company expects to generates most of its revenues (82% in 2011
including Engility results) from the U.S. government, with the bulk (75% in
2011 including Engility results) coming from the Department of Defense (DoD).
U.S. defense spending has been on an upward trend for more than a decade, but
the fiscal 2012 and fiscal 2013 budgets represent a turning point, with
spending beginning to turn down in fiscal 2013, even excluding war spending,
albeit from very high levels. The fiscal 2012 DoD base budget is up less than
1% compared to fiscal 2011, and the requested base budget for fiscal 2013 is
down 1% to $525 billion. Fiscal 2013 Modernization Spending (procurement plus
research and development [R&D]), the most relevant part of the budget for
defense contractors, is down 4%, the third consecutive annual decline by
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 LLL's
On Sept. 14, 2012, the Office of Management and Budget issued a Sequestration
Transparency Act report detailing the potential impact of sequestration on
funding reductions for both defense and nondefense budget accounts. The report
assessed that unless the sequestration law is changed, the DoD budget will be
cut by approximately $52 billion in FY2013. Budget cuts to Modernization
Spending would be expected to account for approximately $23 billion or nearly
44% of the cuts despite comprising only 29% of the total DoD budget. The
majority of the remaining cuts will be in the Operations and Maintenance
account. Should sequestration occur, the cuts in Modernization Spending could
be partly mitigated by low outlay rates during the first year for the majority
of Procurement and R&D programs.
Fitch would not expect sequestration-driven DoD spending declines alone to
lead to negative rating actions for L-3. The company's exposure to DoD
spending is mitigated by good liquidity and the diversification of its product
line. L-3's sales are not tied to any major program as the company does not
have a contract which represents more than 3% of its revenues. A higher
percentage of sales to foreign customers also mitigate the budget cut risks.
What Could Trigger a Rating Action:
Fitch may consider a positive rating action should L-3 improve its credit
profile by further decreasing leverage and moderating its shareholder friendly
cash deployment strategies in form of share repurchases and dividends. A
negative rating action may be considered if L-3 completes a large debt-funded
acquisition which weakens L-3's credit profile. A negative action is also
possible should there be a dramatic change in U.S. defense spending policies,
but an action would depend on L-3's efforts to reduce costs in line with lower
Fitch affirms L-3's ratings as follows:
L-3 Communications Holdings, Inc.
--IDR at 'BBB-';
--Convertible contingent debt securities at 'BB+'.
L-3 Communications Corporation
--senior unsecured notes at 'BBB-';
--Senior unsecured revolving credit facility at 'BBB-';
--Senior subordinated debt at 'BB+'.
Additional information is available at 'www.fitchratings.com'. The ratings
above were unsolicited and have been provided by Fitch as a service to
Applicable Criteria and Related Research:
--'Corporate Rating Methodology', Aug. 8, 2012.
Applicable Criteria and Related Research:
Corporate Rating Methodology
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David Petu, CFA
One State Street Plaza, New York, NY 10004
Brian Bertsch, +1-212-908-0549 (New York)
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