OREANDA-NEWS. Fitch Ratings has revised BAE Systems Plc's (BAE) Outlook to Negative from Stable. The agency has also affirmed the aerospace group's Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB+' and Short-term IDR at 'F2'.

BAE Systems Holdings Inc's notes' senior unsecured rating of 'BBB+' and its commercial paper programme's Short-term rating of 'F2' are also affirmed.

The change in the Outlook to Negative reflects a weakening of certain financial ratios in recent years, such as the company's free cash flow (FCF) margin and gross leverage, to outside the parameters expected of a 'BBB+' rating. While Fitch believes these metrics may improve in the short term, should they remain at present levels, the overall credit profile of the company may no longer be commensurate with the 'BBB+' rating.

KEY RATING DRIVERS

Weak Free Cash Flow Generation
Both funds from operations (FFO) and FCF generation in recent years have been weak for the present ratings. While BAE has maintained fairly stable EBITDAR margins as a consequence of a flexible cost structure and the nature of most defence procurement contracts, recent cash flows have not be in line with the levels of a 'BBB+' rating. FCF has been negative in three out of the past four years (and is likely to be so again in 2015) driven to a significant degree by large negative working capital swings (specifically the unwinding of advance payments) and fairly high dividend payments.

At the same time, the company's capacity to generate FCF and flexibility to reduce debt has weakened as a result of the business shrinking by around 25% over the past five years. While Fitch expects that the working capital outflows and top line decline will end in the short- to medium-term and the FCF margin is likely to return to over 3%, should this not eventuate, a downgrade is likely.

Good But Vulnerable Capital Structure
BAE's leverage, liquidity and financial flexibility remain at levels which are within the parameters of the present ratings, but these might deteriorate somewhat in the near term if FCF generation remains significantly negative. At end-2014, the company's gross and net leverage ratios were at 3.4x and 2.5x, respectively, although this was somewhat (0.5x) skewed by debt pre-financing which the company completed in 4Q14.

Debt levels have been fairly stable in recent years, and are expected to decline gradually over the short- to medium-term; however, the decline in FFO generated has raised gross leverage above the downgrade guideline of 2.5x in three of the past four years and is likely to stay above that level at end-2015. We expect that the group will be able to bring leverage back to under 2.5x over the medium term but this is contingent on the stabilisation of the top line and absolute FFO levels. Should this not eventuate, and prospective leverage remains above 2.5x, a downgrade is likely.

Share Buybacks
At end-2014, BAE had bought back around GBP500m of its shares under a three-year programme of up to GBP1bn announced in February 2013. While the final amount bought back could be under GBP1bn, we expect the cash allocated to the remaining portion of the buyback to be evenly spread over the coming 12 months and balanced with the company's investment and non-organic growth activities, and thus in itself unlikely to have a rating impact.

Market-Leading Position
BAE is the world's number-three defence company by revenue, giving it an advantage in prime contractor capability, accessing important programmes with large defence departments, and in spreading R&D costs. The company has also developed diverse revenue streams and is not overly dependent on any one division or geographical area.

Key US, UK Markets
While the US defence procurement budget is now fairly stable, with possible modest improvement in 2016, the threat of sequestration looms again in the US and may affect fiscal 2016 spending. Certain areas such as electronic systems, naval platforms and land armored vehicles have stabilised, while others such as intelligence and security face challenging conditions.

The UK defense and security environment has been stable in recent years, despite continued pressure on public spending. BAE benefits from a number of large long-term defence contracts which insulate the business to a large degree from annual budget pressures. Nevertheless, the country is now in an election year and later this year there will be another strategic defence and security review, which may affect the business in the long term.

Sound Liquidity Position
At end-2014, BAE had GBP1.3bn in cash (Fitch adjusted), against short-term debt of GBP482m. Following the pre-financing of the 2015 & 2016 bonds (totalling around GBP660m) in October 2014, the company has no material debt maturities until 2019. Liquidity is supported by a GBP2bn revolving credit facility that matures in 2019, and expected positive FCF generation after 2015. Given the intra-year swings in cash balances as well as the large amount of advance payments received, we have deducted cash of GBP1bn as not readily available.

We note that end-2014 liquidity was boosted by the 4Q14 bond pre-financing, which has offset the drain in cash caused by the negative FCF and the share buyback programme. In the event of negative FCF generation in 2015, the fundamental liquidity position of BAE could deteriorate as a result of the repayment of the already pre-financed USD750m bond maturing in September 2015 and the likely continuation of the share buyback programme.

Structural Subordination
Four of the group's nine public bonds are issued at holding company level (BAE Systems plc) without cross or upstream guarantees from any US-based operating entities, which makes them structurally subordinated to bonds issued by BAE Systems Holdings Inc, the group's US debt issuing entity. Fitch does not separate the ratings of these various bonds at present, owing to the equal strategic importance of all related group entities. However, if the amount of debt issued by any entity becomes materially disproportionate to its revenue, earnings or asset contribution to the group, rating separation in the future is possible.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
- Flat revenue in 2015, beyond which top line growth is expected to be in the low single digits, driven primarily by export demand
-The relative flexibility of the company's cost structure is likely to result in broadly flat EBITDA and FFO margins in the short to medium term
- Some further working capital cash outflows in 2015 as a result of prior advance payments being consumed, the timing effect of a GBP200m receivable received in late 2014 due to flat new orders; beyond 2015, we expect a stabilisation in working capital flows
- No M&A activity with any significant acquisitions treated as event risk
- The share buy-back programme to be completed in 1Q16 with cash deployment to be evenly spread over the next 12 months
- Capex to run at roughly 2% of revenue
- Dividend to continue to rise gradually each year
- No new debt issued, with existing bonds repaid at maturity from cash reserves

RATING SENSITIVITIES

Negative: Future developments that may result in a downgrade:
- FFO lease-adjusted gross and net leverage above 2.5x and 2x, respectively, FFO margin below 9% (2014: 7.5%), and FCF margin remains under 3% (2014: -1.5%).

The gross leverage negative guideline is tighter than the Fitch Navigator BBB midpoint of 3x for aerospace and defence companies to take into account the company's large negative net working capital position, not covered by its cash position, which at end-2014 was -GBP2.7bn, compared with a peak of -GBP4.4bn at end-2012.

Positive: Future developments that may result in the Outlook being revised to Stable:
-An improvement in the key ratios, specifically, FFO and free cash flow margins above 11% and 7%, respectively, and FFO lease-adjusted gross and net leverage below 1.5x and 1x, respectively