S&P Boosts Harman International Rating

The home- and car-audio giant's improved operating performance has bolstered its credit measures

By Martin King

On Oct. 28, Standard & Poor's Ratings Services raised its corporate credit rating on Washington, D.C.-based Harman International (HAR ) to 'BBB' from 'BBB-', reflecting the company's improved operating performance and strong credit statistics, despite the challenges of the global automotive industry.

Although Harman plans to complete the acquisition of QNX Software Systems for $145 million by the end of November, the company has ample excess cash and debt capacity to complete the acquisition and maintain a solid investment-grade credit profile.

Harman had total debt of $496 million (including the present value of operating leases) and cash of $343 million on Sept. 30. The rating outlook is stable.

Harman has an average business profile, reflecting its well-recognized brand names in audio products, such as Harman Kardon, JBL, and Infinity; its leading market positions in the branded automotive audio and professional audio markets; fair geographic diversity; and solid profit margins and returns. The company's business profile is somewhat constrained by technology risks associated with its sophisticated audio systems; intense competition in the consumer home electronics market; and the challenges of the automotive industry, including a large and demanding customer base, cyclical demand for new vehicles, tough competition, and the need to realize ongoing efficiencies to offset pricing pressure.

To date, Harman has weathered these challenges, reporting improved operating results. The company posted gains of 22% in sales and 50% in net income during the fiscal year ended June 30, 2004. First-quarter 2005 sales were up 16%, and net income was up 70%. Harman is benefiting from strong demand for its "infotainment" systems for the original equipment (OE) automotive market. These electronic systems integrate vehicle audio, Internet, and navigation features, primarily for luxury cars, and offer a significant growth opportunity, potentially a $13 billion market in the medium term.

As the developer of the key systems architecture, Harman enjoys technological leadership in the OE automotive segment. Harman continues to penetrate this market and has received contracts for branded audio and infotainment systems from DaimlerChrysler (DCX ), Toyota Motor (TM ), BMW, Mitsubishi Motors, Jaguar, and Audi. Vertically integrated manufacturing and a commitment to R&D protect its market position. Meanwhile, the company's consumer home and professional businesses have also reported profit gains.

Harman's automotive business continues to generate the bulk of its income, with OE products commanding higher margins and faster inventory turnover than its historical consumer and professional audio businesses. Although cash flow has strengthened in the past several years, Harman has incurred significant capital expenditure and R&D costs to maintain its technological leadership. The company's capital spending totaled $136 million (5% of sales) in fiscal 2004.

Free cash flow generation was strong, totaling more than $300 million, but more than half came from working capital reductions, which are not expected to continue in future years. Nevertheless, Standard & Poor's expects Harman to generate at least $100 million of free cash flow a year.

With net debt down by $350 million in the past year, higher profitability has resulted in improved credit ratios that are strong for the rating. Adjusted for operating leases and restructuring expenses, EBITDA (earnings before interest, taxes, depreciation and amortization) coverage of interest expense exceeds 10 times, and total debt to EBITDA is less than 1.5 times.

Standard & Poor's expects Harman to make acquisitions to improve its customer, geographic, and product diversity, which could lead to a more leveraged capital structure. The planned purchase of QNX will not significantly impair Harman's credit statistics because of its excess cash balances and debt capacity, although the company expects its earnings to decline by 5% for two or three years. Integration of QNX is expected to be smooth because of the companies' close working relationship before the acquisition, with QNX providing the operating system for Harman's infotainment software.

We expect Harman to continue to make acquisitions that broaden its product capabilities and customer and geographic diversity. Acquisitions could lead to a more leveraged capital structure, but Harman is expected to maintain a moderate financial policy consistent with an investment-grade rating.

Liquidity: Harman's liquidity is strong. The company has $343 million in cash on hand and a mostly unused $150 million revolving credit facility, which expires in August, 2005. Harman is in compliance with all financial covenants. Debt maturities are modest, with only $7 million of short-term debt due within one year. The company generates good free cash flow, which we expect to reach or exceed $100 million annually.

Outlook: The outlook is stable. Opportunities for growth in the automotive business, continued focus on improving profitability, and management's commitment to an investment-grade rating despite acquisitions and other investment opportunities are expected to result in maintenance of a financial profile consistent with the rating.

King is a credit analyst for Standard & Poor's Ratings Services

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