Fitch Affirms Northrop Grumman; Outlook Stable
KEY RATING DRIVERS
The ratings are supported by the company's competitive position within the defense industry, a highly diversified defense portfolio, strong margins, financial flexibility, solid cash generation, and adequate metrics for the rating. Fitch expects NOC's revenue will decline by low single digits in 2015 however will rebound in 2016 driven by the expected increase in the Department of Defense (DoD) budget and higher international orders. NOC's operating execution and cash deployment will drive the company's credit profile.
In February 2015, the company issued \$600 million of 30-year senior unsecured notes that rank equally with its existing unsecured notes. NOC has utilized \$500 million of the raised funds to make a discretionary contribution to its qualified U.S. pension plans and will use the remaining \$100 million to repay \$107 million senior unsecured notes maturing in March 2016. NOC's leverage metrics have deteriorated slightly with the issuance of the \$600 million of senior unsecured notes, and any further material weakening of the metrics could potentially pressure the ratings.
The company's leverage (debt to EBITDA) deteriorated to approximately 1.8x immediately following the issuance of the \$600 million senior unsecured notes up from 1.6x at the end of 2014. Similarly, FFO adjusted leverage has deteriorated to approximately 3.0x, up from 2.5x at the end of 2014. Fitch expects NOC's leverage will deteriorate slightly to 1.9x in 2015 driven by slight declines in revenues and operating margins. The company's leverage is expected to improve in 2016 due to the retirement of the \$107 million senior unsecured notes due in March, 2016, and an anticipated increase in revenues and margins fuelled by higher U.S. and international military spending. Fitch expects NOC's leverage will decline to approximately 1.7x by the end of 2016.
Despite DoD budgetary and corresponding top line pressures, NOC increased its operating margins for the fifth consecutive year and generated approximately \$1.5 billion FCF in 2014. Fitch expects NOC's FCF generation will be more challenged in the coming years primarily due to lower operating cash flows, higher capital expenditures and cash interest. NOC will likely generate strong FCF in the range of \$1.1 billion to \$1.3 billion annually, but it will be in the range of \$750 million to \$850 million in 2015 due to the aforementioned \$500 million discretionary contribution to the company's pension plans. NOC's FCF is seasonal as the company generates the majority of its cash during the second half of the year, but the large swings in operating cash generation and large quarterly working capital fluctuation is offset by solid liquidity.
Liquidity at March 31, 2015 was approximately \$4.4 billion down from \$5.7 billion from the prior year, consisting of \$2.6 billion of cash and securities as well as full availability under its senior unsecured credit facility totaling \$1.8 billion (expires in August 2018). Approximately \$0.5 billion of NOC's cash was held overseas at the end of 2014, slightly down from 2013. NOC does not have a significant maturity until 2018 when a total of \$1.1 billion of senior unsecured notes become due. Fitch expects NOC's liquidity to continue decreasing in 2015 as the company executes the share repurchase program announced in 2013. Fitch estimates NOC's liquidity will remain within the range of \$3.5 billion to \$4 billion after 2015.
The ratings and Stable Outlook are also supported by the stabilization of the U.S. military spending over the past two years. The DoD budget proposal for fiscal 2016 requested \$34 billion more funding than allowed by the spending caps under the Budget Control Act. Even if the current proposal is not approved, the sequestration-capped budget in fiscal 2016 will be higher than that of fiscal 2015, representing first increase in the total DoD budget since fiscal 2012. Fitch's base case projections incorporate the sequestration level budget for fiscal 2016 and beyond.
The DoD budget proposal for fiscal 2016 provides continued support for NOC's top programs such as F-35, E-2D, Triton, SBIRS, B-2 and Global Hawk. The company increased its backlog in 2014 despite flat DoD spending, driven by strong support for the company's programs and higher international sales. Additionally, NOC demonstrated the ability to reduce costs and generate strong margins while coping with the sequestration cuts during the past several years.
Rating concerns include NOC's exposure to uncertainty surrounding potential indiscriminate program wide cuts to core U.S. defense programs in fiscal 2016 driven by sequestration. The concern is somewhat mitigated by rising international sales and by NOC's demonstrated ability to reduce costs to manage lower revenue scenarios. Fitch's additional concerns include the large pension deficit and cash deployment strategies.
Share repurchases have been a significant use of cash in the past several years and Fitch expects this will continue. NOC repurchased 21.4 million shares for \$2.7 billion in 2014 and \$825 million in the first quarter of 2015. During the first quarter of 2015 NOC exhausted a \$4 billion share repurchase program announced in 2013.
On Dec. 4, 2014, the company's board of directors authorized a new share repurchase program of up to an additional \$3 billion of the company's common stock (2014 Repurchase Program). NOC has \$2.6 billion remaining under the 2014 Repurchase Program as of March 31, 2015. NOC's aggressive cash deployment remains the main rating concern, but Fitch believes the company will limit future cash distributions beginning 2015 to internally generated cash.
As of Dec. 31, 2014, NOC had a sizable pension deficit of \$5.5 billion (82% funded) up from \$1.9 billion (92% funded) as of Dec. 31, 2013. The significant year over year deterioration was mainly driven by adverse movement in interest rates and new mortality tables released by the Society of Actuaries in 2014.
NOC's pension benefit obligations totaled \$30.5 billion, and assets were \$25.1 billion as of Dec. 31, 2014. Required pension contributions in 2014 were \$74 million, and the company projects \$77 million of required funding in 2015. The company did not make discretionary pension contributions in 2014 and has already made a discretionary \$500 million contribution in 2015. Fitch does not expect pension contributions to be a large part of the company's cash deployment in the near future.
Fitch expects the funded status of the pension plan may continue being pressured in 2015, depending on the stability of prevailing interest rates. Interest rates have declined in 2015, and the continued decline in interest rates will pressure pension discount rates and will result in additional deterioration in the funded status of NOC's pension plans in 2015. Offsetting this possible deterioration in the funding position is the beneficial impact on pension cash flows through 2017 resulting from the passage of the Highway and Transportation Funding Act of 2014 (HATFA).
NOC's status as a defense contractor mitigates some of the risks associated with its pension obligations. The majority of NOC's pension contributions are recoverable through government contracts because they qualify as allowable costs under government Cost Accounting Standards (CAS).
As of March 31, 2015, approximately 76% of the company's consolidated debt was issued by the holding company (NOC), with the rest issued by NGSC. The holding company's bonds are structurally subordinated to NGSC's debt because there are no upstream guarantees from NGSC, the company's primary operating subsidiary after the Huntington Ingalls Industries (HII) spin off. For this reason, the holding company notes sit in a weaker credit position than NGSC's debt, but Fitch does not consider the difference to be great enough for the holdco's ratings to be lower than the operating subsidiary's ratings, for two reasons: the credit strength of the consolidated enterprise, and the holding company's 100% ownership and strong management control of the subsidiary. Unlike NOC's bonds, the bank facilities, which are located at NOC, benefit from upstream guarantees from NGSC.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for NOC include:
--Flat sales over the next two years and low single digit revenue growth thereafter;
--Steady EBITDA margins at approximately 15%;
--Share repurchases will subside to approximately \$1 billion annually beginning 2016;
--FCF margin will remain steady at approximately 5%;
--Capital expenditures will be steady at 2.5% of revenues, annually;
--Debt level will remain steady and the company will refinance its maturities;
--The company will not make acquisitions;
--The company will not have significant tax deferrals.
RATING SENSITIVITIES
Fitch does not anticipate positive ratings actions in the near term given current credit metrics, and the company's significant share repurchases. Positive rating actions could be considered if the company modifies its cash deployment strategy and focuses on debt reduction.
Negative rating actions may be driven by issuance of additional debt to fund share repurchases or acquisitions; if the company experiences significant performance issues on large contracts; or if there are material unexpected changes in U.S. defense spending trends. Fitch will likely consider a negative rating action if NOC's leverage (debt to EBITDA) increases and remains above 2.0x or if the company's FCF margin declines and remains below 3.5%.
Fitch affirms the following ratings:
Northrop Grumman Corporation
--IDR at 'BBB+';
--Senior unsecured debt at 'BBB+';
--Bank facilities a 'BBB+'.
Northrop Grumman Systems Corporation
--IDR at 'BBB+';
--Senior unsecured debt at 'BBB+'.
The Rating Outlook is Stable.
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