Fitch: L-3's Q2 Charge/Internal Review Raises Future Concern

The second quarter $84 million charge to L-3 Communications Holdings, Inc.'s (L-3) driven by accounting matters is credit neutral for the company's current ratings and Rating Outlook, according to Fitch Ratings. We do not expect the charge and the related internal review to have a material impact on the company's credit metrics, but note the ongoing nature of the internal investigation and the potential for future charges.

We believe the most serious impact of the accounting issues is the potential effect on free cash flow (FCF), with L-3 lowering its annual forecast by $50 million-$100 million, bringing the forecast range down to $900 million-$950 million from $1 billion. However, after dividends, this new range is still consistent with Fitch's own forecast for L-3's 2014 FCF.

The charge and the internal review are the results of what L-3 believes are misconduct and accounting errors in its aerospace segment. Fitch notes that the issues appear to be related to one contract and the amount of the charge is small relative to L-3's annual revenues and profits.

Fitch's rating concerns include a possibility that the company may find the accounting matters to be spread wider than initially believed, which could result in additional charges or effect Fitch's view of L-3's future operating results. The company's declining revenues are also expected to remain under modest pressure for at least the next two years due to lower U.S. Department of Defense spending and the continued withdrawal of the U.S. troops from Afghanistan. Finally, the company's cash deployment strategy includes a focus on dividends and share repurchases.

Key factors that support the ratings include L-3's adequate credit metrics, strong liquidity position, and Fitch's expectation of solid margins and substantial FCF. Other positive rating factors include L-3's diverse portfolio of products and services and L-3's increasing percentage of international military and commercial sales which accounted for 27% of sales in 2013, up from 24% and 18% in 2012 and 2011, respectively.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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