OREANDA-NEWS. December 08, 2015. Fitch Ratings has assigned BAE Systems Holdings Inc's proposed bond issuance of up to USD1.5bn with varying maturities an expected rating of 'BBB+(EXP)'. The proposed bond will be fully guaranteed by BAE Systems plc (BAE), the ultimate parent entity.

The proceeds of the notes will be used to pre-finance the group's existing debt, primarily a USD1bn bond maturing in 2019, and for general corporate purposes. The expected rating is in line with BAE's 'BBB+' long-term Issuer Default Rating (IDR), as the notes will constitute direct, unsecured and unconditional obligations of the issuer. The notes will rank equally among themselves and with all other present or future unsecured and unsubordinated obligations of the issuer.

The notes will not have specific covenants other than a negative pledge clause, in respect of present or future debt.

The final rating on the notes is contingent upon the receipt of final documentation conforming to information already received.

KEY RATING DRIVERS
Revision of Outlook
The revision of the Outlook on the Long-term IDR to Negative from Stable on 2 April 2015 reflected 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 company's overall credit profile may no longer be commensurate with a 'BBB+' rating.

Weak FCF Generation
Funds from operations (FFO) and FCF generation in recent years have been weak for the ratings. For the last 12 months (LTM) to 30 June 2015, these margins were at 7% and -3%, respectively. 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 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 relatively 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. 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 within the parameters of the current ratings, but these might deteriorate somewhat in the near term if FCF generation remains significantly negative. At end-1H15, the company's gross and net leverage ratios were 3.1x and 2.2x, respectively, although this was somewhat (0.5x) skewed by debt pre-financing that the company completed in 4Q14.

Debt levels have been fairly stable in recent years. 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-October 2015, BAE had bought back around GBP500m of its shares under a three-year programme of up to GBP1bn announced in February 2013, with only minimal share repurchases completed during 2015. The final amount bought back could be under GBP1bn, and Fitch expects the cash allocated to the buyback to be 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
The US defence procurement budget is now fairly stable, with modest improvement in 2016 now possible. Certain areas such as electronic systems, naval platforms and land armoured vehicles have stabilised, while others such as intelligence and security face challenging conditions. In the UK, BAE benefits from a number of large long-term defence contracts, which insulate the business to a large degree from annual budget pressures. These pressures have subsided to some degree following the October 2015 strategic defence and security review.

Structural Subordination
Following the new bond issuance, four of the group's 10 public bonds will be 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 would be 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
- Capex to run at roughly 2% of revenue
- Dividend to continue to rise gradually each year

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%; 2015E: 8.5%), and FCF margin remains under 3% (2014: -1.5%; 2015E: -0.7%).

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.

LIQUIDITY
At end-1H15, BAE had GBP1.4bn in cash (YE2014: GBP2.3bn), against short-term debt of GBP485m. Following the pre-financing of the USD350m 2016 bond 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, Fitch deducts GBP1bn of year-end reported cash as not readily available.