Fitch Affirms United Technologies' IDR at 'A'; Outlook Stable
KEY RATING DRIVERS
The ratings for UTC incorporate the company's product and geographic diversification, relatively stable operating performance through economic cycles, technological capabilities that support strong competitive positions, solid free cash flow (FCF) and financial flexibility. Significant aftermarket revenue generates favorable margins that mitigate the impact of cyclicality in UTC's aerospace and building markets. The company has attractive positions on commercial and military aerospace programs and is well positioned to benefit from rising production of commercial aircraft.
UTC announced in March 2015 it would consider divesting Sikorsky through a spin-off or other means. Fitch views the possible divestiture as neutral to the ratings. The immediate impact on debt/EBITDA and other credit metrics could be negative due to the loss of earnings and cash flow from Sikorsky which accounted for 6.5% of UTC's segment profit in 2014 before special items and eliminations. However, Fitch believes growth in UTC's financial results would enable UTC to strengthen its credit measures to current levels within 18-24 months. UTC would lose some diversification, but the reduction would be minimal due to UTC's large size and a good balance between aerospace and commercial businesses. Also, a divestiture would reduce platform development risks. The impact on UTC's credit profile will partly depend on the amount of any cash proceeds realized from a transaction. The timing of a possible transaction in 2015 could support a favorable valuation due to contract wins at Sikorsky that have contributed to a substantial backlog.
Credit metrics have improved as UTC pays down debt related to the Goodrich acquisition. However, debt reduction of approximately \$450 million in 2014 was less than the \$1 billion amount anticipated by Fitch, and debt/EBITDA of 1.86x at the end of 2014 remained above some other similarly rated peers. This concern is mitigated by UTC's operating stability, financial flexibility and consistent FCF which reduce its sensitivity to economic cycles and provide the capacity to reduce debt at the company's discretion.
Fitch estimates FCF in 2015 will increase slightly from \$3.6 billion in 2014 as modest growth in sales and earnings is offset by the negative impact of foreign currency. FCF includes the impact of capital expenditures are likely to remain at a higher-than-normal level while UTC prepares to increase production for a number of aerospace programs. Fitch estimates FCF/total adjusted debt could eventually return to a level approaching 20% or higher as UTC moves past the current investment cycle in aerospace. Historically, UTC maintained the ratio well above 20%, but the ratio is currently in the mid-teens due to higher debt levels and to increased development spending for aerospace programs.
FCF includes the impact of pension contributions. UTC expects to contribute \$350 million to global pension plans in 2015 compared to \$517 million in 2014. UTC estimated its U.S. plans were approximately 88% funded as of Dec. 31, 2014, which was down from 98% one year earlier due to a lower discount rate and unfavorable changes in assumptions underlining mortality rates. Globally, pension plans were underfunded by \$5.1 billion at the end of 2014 compared to \$1.7 billion at the end of 2013.
Cash deployment includes \$3 billion of share repurchases planned in 2015, including an accelerated share repurchase program implemented in March 2015. The amount is higher than usual and reflects limited acquisition activity. It also allows UTC to offset the impact of shares that could be issued this year under a remarketing process for outstanding equity units. The units, which were issued to help fund the Goodrich acquisition, include equity purchase contracts paired with \$1.1 billion of junior subordinated notes. The notes do not receive equity credit from Fitch.
Rating concerns include defense spending uncertainty in the U.S., a slow recovery in global construction markets outside the U.S., and contingent obligations including financing commitments and litigation. Concerns about military spending are mitigated by UTC's position as a key supplier on several military programs for which production is expected to remain stable or ramp up over several years, including the Joint Strike Fighter (JSF) and CH-53K heavy-lift helicopter.
Another concern includes risks related to developing new aerospace programs. Programs often involve substantial costs and long development periods, and are focused on attractive but highly competitive markets. UTC mitigates the risk through joint ventures, and its aerospace systems and engine businesses have exposure to multiple customer platforms. Risk can be more concentrated in Sikorsky's platform business. In 2014, Sikorsky recognized a \$430 million charge against earnings related to the CH-148 helicopter program for the Canadian government. The program has encountered significant delays and cost overruns and may not generate positive margins until 2018.
P&W's large backlog for the geared turbofan (GTF) engine should reverse a long term decline in legacy engines and support future aftermarket revenue and profitability. Margins will be pressured in the next several years by the expected increase in engine sales which typically generate negative margins before related aftermarket revenue eventually increases, leading to profitability over the life-cycle of the engines. Risks associated with the GTF include the magnitude of the production ramp-up and long term performance of the engines.
The revenue mix between UTC's Aerospace and Building & Industrial Systems (BIS) businesses is well balanced, with Aerospace representing 55% of sales. Segment profit is slightly skewed toward BIS, partly due to margins at Sikorsky that are lower than UTC's other segments. Sikorsky's margins reflect its reliance on military sales, its production of aircraft platforms compared to sales of systems, and a lower proportion of higher-margin aftermarket revenue.
At Dec. 31, 2014, UTC's liquidity included \$5.2 billion of cash and equivalents, of which more than 80% was located outside the U.S., and \$4.35 billion of committed bank facilities that mature in 2019. UTC generally has access to foreign cash, and while much of it would be subject to taxes, Fitch believes UTC has considerable flexibility regarding repatriation. Liquidity was offset by \$1.9 billion of debt due within one year. Fitch expects UTC will generally refinance scheduled debt maturities. UTC's outstanding debt totaled nearly \$20 billion at the end of 2014.
Fitch rates Goodrich's debt at the same level as UTC due to UTC's implied support for Goodrich. UTC did not assume or guarantee Goodrich's debt, but Goodrich is important to UTC's aerospace strategy and has been integrated into UTC's Aerospace Systems segment. As of Dec. 31, 2014, UTC had repaid approximately \$2.2 billion principal amount of \$2.9 billion of Goodrich debt assumed with the acquisition.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for the issuer include:
--Financial results are flat to slightly better in 2015 as internal growth is offset by the negative impact of foreign currency;
--Aerospace businesses benefit from high industry production of new aircraft during the next several years;
--UTC's development spending in the aerospace businesses remains elevated through 2015;
--Cash deployment is directed toward \$3 billion of planned share repurchases, with no material debt reduction anticipated;
--Restructuring and integration support modest operating margin improvement;
--A divestiture of Sikorsky, if it occurs, would be structured to minimize the impact on UTC's capital structure and credit metrics.
RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to a negative rating action include:
--Weak operating results or FCF that prevents an eventual increase in FCF/total adjusted debt to a level near 20% or above;
--Sustained shareholder-focused cash deployment that results in permanently higher leverage, including total adjusted debt/EBITDAR above 2.0x compared to 2.1x at the end of 2014;
--Negative events in UTC's commercial aerospace markets that could reduce airline profitability and limit demand for large commercial aircraft;
--Slower global economic growth that impairs construction activity in UTC's commercial businesses.
Fitch views an upgrade to UTC's ratings as unlikely in the near term due to near term spending on share repurchases. However, future developments that may, individually or collectively, lead to a positive rating action include:
--Consistently stronger credit metrics including debt/EBITDA near 1.0x, funds from operations (FFO) adjusted leverage below 1.5x and FCF/total adjusted debt approaching 30%;
--Significant, sustained long term market share gains or higher aftermarket revenue at Otis, particularly in China and developing regions;
--Materially higher margins resulting from the realignment in the Business & Industrial Systems businesses;
--Successful long term execution on aerospace development projects such as the GTF, CH-53K heavy-lift helicopter and F135 engines on the JSF.
Fitch has affirmed the following ratings:
United Technologies Corporation
--IDR at A';
--Senior unsecured bank credit facilities at 'A';
--Senior unsecured notes at 'A';
--Junior unsecured subordinated debt at 'BBB+';
--Short-term IDR at 'F1';
--Commercial paper at 'F1'.
Goodrich Corporation:
--IDR at 'A';
--Senior unsecured notes at 'A'.
The Rating Outlook is Stable.
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