Fitch Rates Tyco International's Planned Sr Unsecured Notes 'A-'; Outlook Stable
KEY RATING DRIVERS
Fitch expects Tyco's credit metrics will be weak in the near term due to pressure on operating results from challenging economic conditions in the company's end-markets and significant cash deployment for asbestos payments, acquisitions, share repurchases and restructuring. These actions have contributed to an increase in debt and low free cash flow (FCF). Fitch believes lower cash deployment for these items after 2015, combined with ongoing operating improvements, will lead to a return to stronger metrics. However, the company has less flexibility than in the past to cope with negative macroeconomic developments and Fitch would view future debt-funded acquisitions or share repurchases as negative rating drivers that could lead to a downgrade or a revision in the Outlook to Negative.
Total adjusted debt/EBITDAR was 2.35x at June 26, 2015, compared to levels near 2x at the end of fiscals 2013 and 2014; a level near 2x represents Fitch's expected mid-point for Tyco through the business cycle. Fitch also expects Tyco to build stronger FCF metrics during the next two years, including an increase in FCF/total adjusted debt to around 15% through the business cycle. FCF/total adjusted debt was 8.5% in 2014 and is estimated by Fitch to be minimal in 2015 due to the negative impact of asbestos payments and restructuring costs. In the event that adjusted debt/EBITDA is slow to improve toward 2x during the next two years, Fitch could consider a negative rating action. Fitch expects Tyco will achieve lower leverage through higher earnings and views material debt reduction from the current level as unlikely.
Tyco's ratings incorporate the company's well-established positions in its non-residential fire and security markets, improving cost structure, geographic diversification, and solid liquidity. Recurring services, which represent approximately 25% of the company's revenue as estimated by Fitch, are relatively stable and mitigate the impact of cyclicality in the installation business.
Rating concerns include slow overall growth in the company's end-markets associated with low energy prices and the negative impact of currency exchange rates; low FCF related to asbestos payments and restructuring costs; integration risks related to acquisitions; and tax litigation.
Fitch estimates FCF in 2015 will be approximately $400 million when excluding the negative impact of one-time large asbestos payments and the non-recurring portion of high restructuring costs. Fitch's estimate includes the impact of seasonal FCF, which is typically strong in the fourth quarter. When including these payments, actual FCF in 2015 as calculated by Fitch could be close to break-even, but Fitch expects FCF will improve in 2016 to $500 million or more as spending related to asbestos, restructuring and other special charges declines. FCF could also increase if Tyco generates higher margins as a result of restructuring and the company's focus on a more profitable mix of projects. However, currency rates and economic conditions in Tyco's end-markets are a risk.
Tyco increased its estimated restructuring and repositioning actions in 2015 to $225 million compared to the $75 million annually the company anticipates over the long term. Restructuring is part of the company's ongoing effort to reduce its cost base and Tyco's current restructuring program is expected to generate savings of at least $50 million annually. Fitch expects cash spending for restructuring will still have a negative, but smaller, impact on FCF in 2016 compared to 2015.
Asbestos payments represent a large use of cash in 2015. In August, the company completed the second of two payments during the year totaling approximately $600 million to resolve a large portion of the company's asbestos liabilities, most of which involve the company's Yarway Corporation and Grinnell LLC subsidiaries. Fitch believes future asbestos payments will not be meaningful as they are expected to be largely funded by insurance receivables and other asbestos-related assets. Prior to the most recent payment, Tyco's net asbestos liability was $331 million. There is a risk that remaining asbestos liabilities are larger than estimated and could require additional funding. This concern is mitigated by the extended period over which future additional payments might be required.
Other uses of cash include share repurchases and acquisitions which totaled more than $900 million through the first nine months of fiscal 2015. Acquisitions represent Tyco's first priority for cash deployment and amounted to more than $500 million through the first three quarters of the year, including the purchase of Industrial Safety Technology for $327 million. Tyco indicated it may announce $200 million to $500 million of additional acquisitions during the next six months. Fitch believes these transactions will be largely funded with cash. If FCF is less than expected by Fitch, Tyco could potentially use debt to fund the transactions, which would have a negative impact on leverage. The impact would be partly offset by acquired earnings and cash flow.
Tyco has indicated it will contribute at least the minimum required contribution of $36 million to its pension plans in 2015. At the end of fiscal 2014, pension plans were underfunded by $374 million (US$126 million; foreign $248 million). More than half (63%) of Tyco's gross pension obligations are outside the U.S.
Tax litigation is another rating concern. The IRS claims that Tyco owes income taxes of approximately $1 billion for the 1997-2000 tax years. The amount includes penalties but not interest, which could be substantial. The IRS claim relates to intercompany debt on which the IRS has disallowed $2.9 billion of interest and related deductions. If its claim is upheld, the IRS could demand additional income tax payments for similar deductions totaling $6.6 billion in subsequent periods. A court date for the trial is scheduled for October 2016. An adverse outcome is currently beyond the rating horizon but could lead to a negative rating action.
A resolution of the tax dispute could take several years, which would defer the cash impact. Any payments that might eventually be required would be shared with the other companies involved in both of Tyco's separations in 2012 and 2007. While viewed by Fitch as unlikely, an inability of the other companies to share in any future payments would increase Tyco's liability.
Lower oil and gas prices are having a negative effect on project activity at Tyco's customers, but the company's exposure to these markets is limited to 5% of total revenue. Tyco's sales declined 3% in the first nine months of 2015 although sales were slightly positive excluding the negative impact of currency movements. Currency likely will continue to pressure revenue in the near term. These concerns are mitigated by modest growth in Tyco's Global Products segment, the positive impact of higher non-residential construction activity in the U.S., and incremental revenue from acquisitions. Tyco continues to integrate its operations in North America and realize savings from restructuring actions.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for the issuer include:
--Fitch expects FCF, excluding asbestos payments and non-recurring cash restructuring costs, will be $400 million or more in 2015 and at least $500 million in 2016;
--Future annual asbestos payments will be relatively low beginning in 2016 following approximately $600 million of payments in 2015 to resolve a large portion of Tyco's asbestos liabilities;
--Adjusted debt/EBITDAR increases to a level near 2.5x at the end of fiscal 2015, followed by a decline toward 2x;
--The negative impact on sales and earnings from currency movements is expected to continue into early fiscal 2016, offsetting much of Tyco's organic growth;
--Adjusted operating margins, excluding special charges, improve modestly in 2015 and 2016 due to restructuring;
--The resolution of contingent tax liabilities occurs over several years and payments are shared with other companies involved in Tyco's previous separations.
RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to a negative rating action include:
--Total adjusted debt/EBITDAR does not decline toward 2x during the next two years from a level near 2.5x at the end of fiscal 2015, or funds from operations (FFO)-adjusted leverage does not decline below 3x compared to 4.5x at June 26, 2015, which includes the effect of special charges;
--FCF in 2015 is materially below the expected level of $400 million;
--FCF/total adjusted debt is consistently below 10%;
--An adverse outcome on income tax litigation impairs Tyco's liquidity or leads to an increase in debt and leverage.
Future developments that may, individually or collectively, lead to a positive rating action include:
--Strong earnings or material debt reduction lead to total adjusted debt/EBITDAR consistently below 1.50x;
--FCF/total adjusted debt improves to 20% or higher;
--Contingent tax liabilities are resolved with little negative impact on Tyco's credit metrics.
LIQUIDITY
Tyco's liquidity at June 26, 2015 included $531 million of cash and a $1.5 billion bank credit facility that matures in 2020. The bank facility backs commercial paper issued under a $1.5 billion program. Debt maturities are spread out including $277 million due within one year and an additional amount of less than $100 million due before calendar 2019. At June 26, 2015, total outstanding debt was $2 billion. Tyco also has substantial leases which Fitch considers in adjusted debt leverage metrics.
FULL LIST OF RATING ACTIONS
Fitch currently rates Tyco as follows:
Tyco International plc
--Long-term Issuer Default Rating (IDR) 'A-';
--Short-term IDR 'F2'.
Tyco International Finance S.A.
--Long-term IDR 'A-';
--Senior unsecured revolving credit facilities 'A-';
--Senior unsecured notes 'A-';
--Short-term IDR 'F2';
--Commercial paper 'F2'.
The Rating Outlook is Stable.
Date of Relevant Committee: Aug. 28, 2015.
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