OREANDA-NEWS. Fitch Ratings has downgraded BAE Systems Plc's (BAE) Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'BBB' from 'BBB+' and affirmed the Short-term IDR at 'F2'. The Outlook on the Long-term IDR is Stable. At the same time, Fitch has downgraded BAE Systems Holdings Inc's notes' senior unsecured rating to 'BBB' from 'BBB+' and affirmed its commercial paper programme's Short-term rating at 'F2'.

The downgrades reflect a weakening of certain financial ratios, specifically the funds from operations (FFO) and free cash flow (FCF) margins as well as gross leverage. This weakening has taken place over past several years as the business has generated relative low underlying profitability and exhibited shareholder friendly policies (as evidenced by a five-year cumulative pre-dividend FCF of GBP2.5bn relative to shareholder remuneration in excess of GBP4.2bn). This leaves the near-term profile more commensurate with a 'BBB' rating.

BAE's FCF has regularly been negative in recent years due to large working capital outflows as previous advance payments have been utilised. At the same time, as the business has shrunk since its peak in 2010 by around 20%, the absolute level of operating cash flow has declined while capex and dividends have remained broadly stable over the same period. This has further weakened the group's capacity to generate FCF and provides the company with little flexibility to reduce debt. A continuation of regular large negative FCF generation over the medium term, although not expected by Fitch, may also affect liquidity.

Debt levels rose in 2015 due to bond issuance in 4Q15, partly earmarked to pre-finance a 2019 maturity. This led to a deterioration in leverage, although this ratio is expected to gradually decline in the short to medium term. However, given BAE's relatively weak FFO, gross leverage has remained above Fitch's previous ratings downgrade guideline of 2.5x in three of the past four years and is likely to stay above that level for the next two to three years. This is despite the expectation that FFO will rise steadily over the period.

KEY RATING DRIVERS
Weak Cash Flows
FFO and FCF generation in recent years have been weak for a 'BBB+' rating, regularly coming in under Fitch's negative guidelines. In 2015, the FFO margin at 6.9% was weaker than the prior year as a result of a slowdown in Eurofighter deliveries in Europe, slightly higher tax and interest payments, the release of prior restructuring charges as well as higher expenses in some divisions. FCF has been negative in four of the past five years, and is likely to be so again in 2016, driven to a significant degree by large negative working capital outflows (specifically the unwinding of advance payments) and relatively high dividend payments.

High Leverage for 'BBB+' Rating
BAE's gross and net leverage have also been outside the previous downgrade guidelines as well as the expected parameters of a 'BBB+' rating for the past two years. The increase in gross leverage at end-2015, to 3.7x, from 3.4x at end-2014, is explained by the USD1.5bn bond issued in 4Q15 (leverage effect of 0.6x) partly earmarked to pre-finance the USD1bn 2019 bond maturity, but also helped shore up the company's liquidity at a time of large cash outflows resulting from advance payments utilisation.

Net adjusted debt at end-2016 is expected to increase by around GBP200m-GBP300m following another year of working capital outflows (expected by Fitch at around GBP500m) as well as the repayment of the USD350m bond maturing during the year. This is likely to be only slightly offset by the higher forecast FFO.

We assume that after 2016, net debt will gradually decrease as FCF generation improves due to a more balanced working capital cash flow profile. However, given that the company will retain a sizable negative net working capital position after 2016 (estimated by Fitch at around -GBP1.8bn) driven by close to GBP3bn of advance payments still on the balance sheet, further material working capital outflows after 2016 cannot be excluded.

Cash Deployment
In recent years, BAE has favoured a policy of shareholder friendliness ahead of debt repayment. Over the past five years, the group has returned to shareholders over GBP4.2bn (GBP3.2bn in dividends and GBP1bn via share buybacks) while cumulative pre-dividend FCF over that period was GBP2.7bn, and unadjusted net debt increased to GBP1.5bn from GBP0.2bn at end-2010. The company's cash deployment priorities remain balanced between its pension trustees, re-investment into the business (R&D, capex and M&A) and shareholders, with debt being repaid on maturity. However, we assume that future cash deployment is likely to be more restrained, with net debt levels decreasing after 2016, while shareholder distributions limited to broadly pre-dividend FCF generation. Fitch does not assume another share buyback over the short to medium term.

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.

End-Market Outlook
The bipartisan budget agreed in the US in 1Q15 was broadly positive for the defence industry, although, as always, the changes to programmes and sub-sector allocations need to be focused on. Some of the businesses in which BAE is in, such as US government cyber services, are unlikely to see strong growth, while the company may benefit from ground systems spending increases as well as the scheduled ramp-up of the F35 production. In the UK, the SDSR announced in 4Q15 was also positive for BAE and included continued investment in expanding Typhoon capabilities, an accelerated procurement of F-35 Lightning II aircraft as well as commitment to Astute and replacement for the Vanguard Class submarines and naval shipbuilding.

Structural Subordination
Fitch notes that four of the group's 11 bonds are 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 or earnings contribution to the group, rating separation would be possible.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for BAE Systems include:
- Revenue to increase by low single digits per annum over the short to medium term.
- Divisional earnings margins to be broadly within the lower to mid end of the target range.
- A large (around GBP500m) working capital outflow in 2016 followed by negligible working capital swings in the subsequent years.
- Capex to remain at around 2.5% of revenue.
- Dividend to rise gradually but no reinstatement of the share buy-back programme
- No large M&A activity.

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative ration action include:
- FFO lease-adjusted gross and net leverage above 3x and 2.5x, respectively, FFO margin below 8% (2015: 6.9%; 2016E: 7.7%), and FCF margin remaining under 2% (2015: -2.4%; 2016E: -1.4%). All ratios are on a sustainable basis.

Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- FFO lease-adjusted gross and net leverage below 2.5x and 2x, respectively, FFO margin above 9% and FCF margin above 3%. All ratios are on a sustainable basis.

LIQUIDITY
Good Liquidity
At end-2015, BAE had GBP1.5bn in cash (Fitch adjusted), against short-term debt of GBP237m. Following the pre-financing of the USD1bn 2019 bond in October 2015, the company has no material debt maturities in the next three years. Liquidity is supported by a GBP2bn revolving credit facility that matures in 2020, and expected positive, albeit small, FCF generation after 2016.