OREANDA-NEWS.  Fitch Ratings has downgraded and removed from Rating Watch Negative Lockheed Martin's (LMT) long-term ratings to 'BBB+' from 'A-'. LMT's short-term ratings are affirmed at 'F2'. The Rating Outlook is Stable. A full list of ratings actions follows at the end of this release.

KEY RATING DRIVERS

The downgrade incorporates the impact on LMT's credit profile from the acquisition of Sikorsky Aircraft from United Technologies ('A-'/Outlook Stable) for $9 billion cash. The transaction closed on Nov. 6, and it will be funded mostly with debt. The downgrade also reflects LMT's cash deployment strategy, which has become more aggressive and share-holder focused in the past year. Finally, the rating action captures the likely credit impact from the spin-off or sale of LMT's government IT and technical services businesses.

After the completion of the Sikorsky and government IT/technical services transactions, Fitch estimates that LMT's revenues will be less than 5% higher than 2014 revenues, but debt and leverage will more than double compared to 2014 levels. Pro forma for both transactions, Fitch expects total debt to be in the range of $15.75 billion-$16.25 billion compared to $7 billion at the end of 2014, and debt to EBITDA to be in the 2.2x-2.5x range compared to 1.0x for 2014.

The Stable Outlook reflects LMT's competitive position in the global defense and security industry; the company's strategic importance to the U.S. government; healthy operating margins; significant cash generation; and financial flexibility.

Aside from higher leverage and the aggressive cash deployment strategy, Fitch believes LMT's credit profile is consistent with an 'A' category rating, and the rating could trend higher if the company materially reduces debt, although Fitch believes this is unlikely over the next several years.

LMT's ratings and outlook are also supported by the company's liquidity position; increasing international sales; successful cost reduction efforts; large backlog; and the stabilization and growth of the F-35 program. The outlook is also supported by the recent agreements regarding the fiscal 2016 and 2017 budgets and the debt ceiling, although appropriations still need to enacted prior to the end of the continuing resolution on Dec. 11.

Rating concerns include the integration of the Sikorsky acquisition; the large pension deficit ($11.2 billion at the end of 2014); some modest program concentration; and rising competitive pressures in parts of the space sector.

Shift In Cash Deployment

LMT's cash deployment strategy has become more focused on shareholders in the past 12 months, and its acquisition strategy has become more aggressive. In late 2014, LMT announced a shift in strategy, with an objective of returning the vast majority of free cash flow (FCF) to shareholders in 2015-2017. The company's goal is to reduce outstanding common shares to below 300 million by the end of 2017 (322.4 outstanding at the end of 2014). Part of this strategic shift resulted from a pension contribution holiday for the next three years, driven by past contributions, some changes in the pension plans, and legislation changes affecting pension funding requirements. Fitch forecasts that cash balances will decline for several years as cash deployment exceeds FCF.

Notably, LMT confirmed this new strategy when it announced the Sikorsky acquisition. Fitch previously expected LMT would reduce share repurchases if it executed a major acquisition. The Sikorsky debt plus the $2.25 billion of issuance in early 2015, will lead LMT's debt to more than double from the $7 billion outstanding at the end of 2014.

Sikorsky Acquisition

The proposed acquisition of Sikorsky for $9 billion cash is a departure from LMT's previous strategy in both size and focus. Fitch believes this acquisition and LMT's increased level of share repurchases illustrate a strategy that has become less committed to an 'A-' credit rating and more committed to shareholder value.

Positive credit considerations from the acquisition include a higher level of diversification within LMT's core defense and security business, a larger aftermarket presence, and an enhanced backlog position. Sikorsky will add a new defense platform area to go with LMT's existing aerospace platforms in fighter aircraft, transport aircraft, and space vehicles. Sikorsky's amount of international revenues also furthers LMT's goal of increasing its non-U.S. business. Acquisition concerns include higher debt levels, integration risks, and the valuation.

Exploration of Strategic Alternatives

In July, LMT also announced that it would conduct a strategic review of some of its government IT and technical services businesses, which could lead to either a spin-off or sale of these assets. LMT has been the largest provider of IT to the U.S. government for the past 10 years. Sales in these businesses total approximately $5.5 billion with lower margins compared to other LMT businesses. The company expects to complete the review by the end of the year, but Fitch expects a transaction would not likely be completed until 2016. Fitch expects that resulting cash inflows could be partly used to reduce debt from the Sikorsky acquisition, with the remainder returned to shareholders.

The rationale for the review includes changes in the relevant markets and the relative level of competitiveness in these businesses compared to the rest of LMT's portfolio. The assets under review include commercial cyber security, government healthcare IT, air traffic management, technical services, and government enterprise IT. LMT will retain assets including mission IT (including government cyber security), energy solutions, and space services.

Some of LMT's businesses, including the Civil group in the ISGS segment and the Technical Services operation in the MFC segment, have been particularly affected by Sequestration and market conditions. LMT has disclosed in its SEC filings that the carrying value of goodwill related to these businesses could be at risk if pressures continue. Fitch believes the units affected are mostly the units for which LMT is exploring strategic alternatives. The carrying value of the Civil unit includes approximately $2 billion of goodwill. The unit was not subject to an impairment in the last goodwill impairment analysis (4Q14), but could be in the next analysis (4Q15).

F-35 Stabilization and Growth

LMT is the lead contractor on the F-35 Joint Strike Fighter program, the DOD's largest military program. After facing some challenges regarding cost and schedule, the program has stabilized over the past several years, and it will likely be a long-term credit positive for LMT. The program accounts for 20% of LMT's revenues, or roughly $9 billion. Through September, the program's revenues were up nearly $1 billion compared to last year with good incremental profitability. There have been 140 deliveries since the start of the program, there are 69 aircraft in backlog, and the company looks to deliver approximately 45 aircraft in 2015. In July of 2015, the F-35B variant (Marine Corps) achieved initial operating capability. Milestones to watch going forward include the signing of production lot 9 (potentially by year-end) and production lot 10 (potentially in early 2016). The target for initial operating capability for the USAF is 2016 and for the USN is 2019. Full production is planned for 2019.

Pension

LMT has a pension contribution holiday from 2015-2017, driven by past contributions, some changes in the pension plans, and legislation changes affecting pension funding requirements. At the end of 2014, LMT's underfunded pension liability was $11.2 billion (versus $9.2 billion at the end of 2013), leaving the company's pension plans 76% funded based on a benefit obligation of $45.9 billion (versus $42.2 billion at the end of 2013). LMT made contributions of approximately $2.0 billion in 2014, $2.25 billion in 2013, and $3.6 billion in 2012. Fitch expects required contributions could resume after 2017. The pension funds are 94% funded on an ERISA basis.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for LMT include:

--A spin-off or sale of government IT and technical services assets will occur in 2016;
--The company's current share repurchase program continues through 2017;
--Dividends will continue to rise at double digit rates and acquisitions will be minimal for the next several years;
--Debt reduction in 2016 and 2017 will be limited to 2016 debt maturities and the possible application of some spin-off proceeds;
--LMT's consolidated revenues after the Sikorsky acquisition and government IT/technical services disposition will be modestly higher than 2014 levels;
--EBITDA margins in 2016 slip due to the addition of Sikorsky and the continued growth of the F-35 program;
--FCF will be lower over the next several years, with higher net pension recoveries only partly offsetting higher capex, interest expense, taxes, and dividends.

RATING SENSITIVITIES
Fitch may consider negative rating actions in the event of sharp declines in U.S. DOD spending that affect some of LMT's key programs, execution problems on key programs (especially the F-35), debt-funded cash deployment actions, unsuccessful attempts to reduce costs, or lower than expected international revenue growth.

Financial metrics that could lead to a negative rating action include sustained adjusted debt to EBITDAR above 2.75x-3.0x, sustained funds from operations (FFO) adjusted leverage above 3x-3.25x, sustained FFO fixed charge coverage below 4.5x-5.5x, and sustained EBIT margins below 9%-10%.

Fitch does not anticipate an upgrade in LMT's ratings in the next few years because of the high debt levels taken on to fund the Sikorsky acquisition, coupled with the expectation that little debt will be paid down through 2017. Fitch could consider positive rating actions in the event of a change in cash deployment strategy, including the application of FCF to debt reduction.

Financial metrics that could lead to a positive rating action include sustained adjusted debt to EBITDAR below 2.25x and sustained FFO Adjusted Leverage below 2.5x.

LIQUIDITY
The company's liquidity as of Sept. 27, 2015 was $4.8 billion, consisting of $1.5 billion of credit facility availability (expiring in August 2019) and $3.3 billion in cash and equivalents. As of Sept. 27, 2015, LMT held $550 million of its cash at its foreign subsidiaries, and it estimated the cash taxes due upon repatriation would not be significant.

On Oct. 9, 2015, the company entered into a new $2.5 billion revolving facility (expiring in October 2020) to replace its previously outstanding $1.5 billion program. The new facility is available for general corporate purposes, and it also backs up the company's commercial paper program, which could be used to fund part of the Sikorsky acquisition.

The company also entered into a 364-day revolving credit facility that provides up to $7 billion of funding for general corporate purposes, as part of its pending Sikorsky acquisition. In aggregate, the new facilities would combine to total $9.5 billion in funding and resulted in a liquidity increase to about $12.8 billion as of Oct. 9, 2015. The new 364-day revolving credit facility expires in October 2016. The company has stated its intention to repay borrowings under this facility with proceeds from future long-term debt issuances.

Other sources of liquidity include FCF (cash from operations less capex less dividends) and potential cash flow for the disposal of the government IT/technical services businesses. Fitch expects FCF in 2015 will be approximately $2 billion. Fitch expects annual FCF will be several hundred million lower over the next several years, with higher net pension recoveries only partly offsetting higher capex, interest expense, taxes, and dividends.

The company's next material debt maturities come in 2016 when $952 million of notes become due; beyond that, there is $900 million due in 2019. This maturity schedule could change depending on the mix of long-term debt issued to refinance the bank lines used to fund the Sikorsky acquisition.

The company has no required pension contributions through 2017, but Fitch expects required contributions could resume in 2018.

FULL LIST OF RATING ACTIONS

The following ratings have been removed from Rating Watch Negative and downgraded:

--Issuer Default Rating (IDR) to 'BBB+' from 'A-';
--Senior unsecured debt to 'BBB+' from 'A-';
--Bank facility to 'BBB+' from 'A-'.

The Rating Outlook is Stable.

Fitch has affirmed the following short-term ratings:

--Short-term IDR at 'F2';
--Commercial paper programs at 'F2'.