Fitch Affirms Huntington Ingalls at 'BB'; Outlook Stable
Fitch Ratings has affirmed Huntington Ingalls Industries, Inc.'s (HII) Issuer Default Rating (IDR) and senior unsecured debt ratings at 'BB'. Fitch has also affirmed HII's senior secured facilities at 'BBB-'. The Rating Outlook is Stable. The ratings cover approximately $1.8 billion of outstanding debt.
HII's ratings are supported by a solid liquidity position, positive free cash flow (FCF; cash from operations less capital expenditures and dividends), the high level of current Department of Defense (DoD) spending, and HII's position in the current DoD spending environment with roles on three of the DoD's top 12 programs in the fiscal 2013 budget. Fitch also considered HII's role as a sole source manufacturer on about 70% of its revenues, and its large and highly visible backlog.
Fitch's rating concerns include risks to core defense spending during and after fiscal 2013, including sequestration, HII's revenue concentration with the U.S. Navy and Coast Guard, and the ongoing restructuring at the company's Ingalls operations. HII generates nearly all of its revenues from the U.S. government, exposing the company to changes in U.S. Navy and U.S. Coast Guard plans regarding future fleet needs. Fitch is also concerned by the company's program execution risks and the high percentage of the workforce that is unionized. In addition, Fitch is concerned with future potential cash deployment actions as the company continues refining its cash deployment strategy.
The notching up of the senior secured credit facility by two rating notches from the IDR of 'BB' to 'BBB-' is supported by the coverage provided by HII's tangible assets and operating EBITDA compared to the fully drawn facility. The collateral for the facility includes substantially all of HII's assets with the exception of the Avondale shipyard and a few other exclusions.
HII's leverage was approximately 3.1x for the last 12 months ended at Sept. 30, 2012. HII's current leverage is in line with Fitch's initial expectations. Fitch expects HII's leverage will remain in the 3.0x to 3.1x range over the next couple of years with the potential for steady improvement after that with some debt reduction and restructuring-driven margin expansion.
HII has a good liquidity position of approximately $1.4 billion which includes $766 million in cash and $604 million available under its $650 million domestic credit revolving facility, after giving effect to $46 million of outstanding letters of credit. Fitch expects HII's liquidity to remain strong; however, it will likely be lower once the company's board makes further decisions on the cash deployment strategy.
HII generated approximately $433 million of cash flow from operating activities during the last 12 months ended (LTM) Sept. 30, 2012, down from $528 million at the end of 2011. Lower cash flow was primarily due to higher pension contributions. Correspondingly, HII's FCF totaled $263 million during the LTM ended Sept. 30, 2012, down from $331 million at the end of 2011. Fitch expects HII's FCF in 2012 to be in line with the results of 2010 and LTM ended Sept. 30, 2011. Fitch also expects FCF margin to continue improving beyond 2013.
HII focuses its cash deployment towards capital expenditures and pension contributions. In the fourth quarter of 2012, HII announced a $150 million share repurchase program and declared a 10c per share quarterly dividend (approximately $5 million). Fitch expects that HII will refine its cash deployment strategies following the resolution of sequestration and higher clarity of future DoD plans.
At year end 2011 the company's pension plans were underfunded by $801 million (80% funded) while other post-employment benefits (OPEB) obligations totaled $753 million. The funded status deteriorated in 2011 due to a decline in the discount rate. As of Dec. 31, 2010, HII's pension plans were 92% funded. During 2012, HII expected to contribute $236 million to its defined benefit (DB) plans, of which $144 million was the expected minimum contributions for the company's defined benefit (DB) plans. HII also expected to contribute $33 million for its OPEB plans. Through the first nine months of the year, HII had contributed $233 million and $25 million to its DB and OPEB plans respectively.
The discount rate of 5.23% used to value HII's pension obligations in 2011 is likely to be lowered at year end 2012 due to market conditions. Therefore, pension obligations are likely to be somewhat higher. HII's status as a defense contractor mitigates some of the risks associated with its pension obligations. Most of HII's pension contributions are recoverable through government contracts because they qualify as allowable costs under government Cost Accounting Standards (CAS).
Most of HII's revenues are derived from the defense industry. High levels of defense spending currently support HII's ratings, but the Department of Defense (DoD) budget environment is highly uncertain after fiscal 2013 because of large U.S. government budget deficits and the potential for large, automatic spending cuts during fiscal 2013.
Fitch expects 2013 to be a challenging year for the U.S. defense contractors. However, it does not anticipate a significant deterioration in HII's credit profile. Sequestration continues to be a large threat in the near term, but Fitch's base case is that it will be avoided, at least in terms of timing. However, DOD spending reductions are likely to be a part of any deal that avoids sequestration. The spending environment will likely continue to be uncertain through 2013. Also, most of the proposed spending 'cuts' are from projected budget growth and come off of the existing high spending levels - inflation adjusted spending will likely decline, but modestly, over 10 years. A key risk in the sector remains cash deployment to offset the impact on earnings from lower revenues.
Fitch believes that modest declines in defense spending would not lead to negative rating actions given the strategic importance of HII's portfolio, long lead times for program execution and the amount of DOD funding HII received in both fiscal 2011 and fiscal 2012. The exposure to DoD spending is also mitigated by HII's good liquidity position.
What Could Trigger a Rating Action:
Fitch may consider a positive rating action if HII decreases its current leverage by either a reduction of debt or an increase in EBITDA driven by an execution of its margin improvement initiatives. A negative rating action may be considered should the company's leverage (debt to EBITDA) increase to above approximately 3.6-3.8x; or if defense spending cuts have a more significant impact on the company's earnings and FCF than currently anticipated.
Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology', Aug. 8, 2012;
--'2013 Outlook: Global Aerospace and Defense', Dec. 21, 2012.
Applicable Criteria and Related Research:
Corporate Rating Methodology
2013 Outlook: Global Aerospace and Defense
David Petu, CFA, +1-212-908-0280
One State Street Plaza
New York, NY 10004
Craig Fraser, +1-212-908-0310
James Rizzo, CFA, +1-212- 908-0548
Brian Bertsch, +1 212-908-0549
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