OREANDA-NEWS. S&P Global Ratings said today that it has affirmed all of its ratings on Xylem Inc., including our 'BBB' corporate credit rating, and removed the ratings from CreditWatch, where we placed them with negative implications on Aug. 15, 2016. The outlook is negative.

"Xylem's debt balance will increase at the close of its acquisition of Sensus U. S.A., which will leave the company with temporarily weak credit measures at the end of 2016," said S&P Global credit analyst Carissa Schreck. "Specifically, we expect the company to have a funds from operations (FFO)-to-debt ratio of about 20% (down from about 46% as of June 30, 2016) and a debt-to-EBITDA metric in the high-3x area (up from about 1.7x as of June 30, 2016) at the end of this year." Notwithstanding the elevated leverage metrics at the close of the transaction, we believe that the acquisition of Sensus will modestly enhance Xylem's business. In addition, we expect that Xylem will be able to improve its credit measures following the close of the acquisition by using its free cash flow generation to reduce its debt balance. Under our base-case forecast, we expect that Xylem will generate free cash flow in excess of $400 million in 2017 and that it will use a portion of this cash flow to repay some of its debt. Therefore, we expect the company's FFO-to-debt ratio to improve to about 30% and its debt-to-EBITDA metric to improve to the mid-2x area by the end of 2017, which is in line with our intermediate assessment of the company's financial risk profile. Our forecast also incorporates our expectation that Xylem's management will make financial policy decisions related to share repurchases and future debt-financed acquisitions that will enable the company to maintain its credit measures near these levels. Our negative outlook on the company reflects its weak leverage metrics over the next 12 months and the potential integration risk related to the acquisition. We could lower our ratings on Xylem if we believe that the company will be unable to improve its FFO-to-debt ratio above 30% and reduce its debt-to-EBITDA metric below 3x over the next 12-24 months.

The negative outlook on Xylem reflects our expectation that the company's FFO-to-debt ratio will be below 30% and its debt-to-EBITDA metric will be above 3x at the close of the company's acquisition of Sensus before gradually improving to about 30% and below 3x, respectively, over the following 12 months. Although we believe the company has a credible path to reduce its leverage after the Sensus transaction closes, there is minimal room for any adverse developments, such as the company's failure to pursue an expected debt repayment plan, integration challenges, or unexpected operating weakness.

We could lower our ratings on Xylem if we expect that its FFO-to-debt ratio will remain below 30% and its debt-to-EBITDA metric will be about 3x with limited near-term prospects for improvement. This could occur if the company fails to use its free cash flow to reduce its debt, experiences disruptions from the integration of Sensus, faces a significant decline in demand from its key end markets, or management pursues material share repurchases or additional debt-financed acquisitions.

We could revise our outlook on Xylem to stable if we believe that its integration of Sensus is on track and the company has demonstrated a willingness to repay its debt over the next 12 months, resulting in a FFO-to-debt ratio at or above 30% and a debt-to-EBITDA metric of less than 3x.