CHICAGO--(BUSINESS WIRE)--Upon completion of ITT Corporation's (ITT) planned spin-off of the Defense and Water businesses, Fitch Ratings expects to assign Issuer Default Ratings (IDRs) to ITT's post-separation companies as follows:
--ITT Exelis, Inc. (ITT Exelis) 'BBB+';
--Xylem, Inc. (Xylem) 'BBB'.
In addition, Fitch expects to affirm the IDR for ITT Corporation, as structured after the separation, at
'A-'.
Fitch also expects to assign long term and short term debt ratings as debt is issued, refinanced or transferred as part of the separation transaction. In most cases, Fitch expects long-term debt ratings will be identical to the IDRs. Prospective ratings are discussed separately below for ITT and the two new companies.
The ratings will be subject to completion of the separation transaction consistent with the terms previously communicated by ITT. ITT currently expects the separation to occur by the end of 2011. The ratings are also subject to Fitch's final review of indentures for any new debt, new bank credit agreements, and sharing agreements for taxes or other liabilities.
Xylem
Fitch expects to rate Xylem as follows:
--IDR 'BBB';
--Senior unsecured bank credit facilities 'BBB';
--Senior unsecured long term debt 'BBB';
--Short-term IDR 'F2';
--Commercial paper 'F2'.
The Rating Outlook is expected to be Stable. Xylem plans to have approximately $1.2 billion of long-term debt at separation.
The expected ratings reflect Xylem's broad product offerings, diverse end markets and balanced geographic exposure. In addition, the company is expected to have a solid liquidity position and sufficient cash flows to support increased growth initiatives through higher capital expenditures and desired level of acquisition spending. The company will be organized in two segments: one focusing on the transport, test, and treatment of water and the other concentrating on usage applications of water, primarily in buildings, homes, industries and agriculture.
Rating Concerns - Financial metrics are expected to be weaker at Xylem compared to ITT's metrics prior to the separation. After completing the recently announced acquisition of YSI Incorporated, Fitch estimates debt/EBITDA will be approximately 2 times (x) on an unadjusted basis. Risks include discretionary spending for acquisitions, integration risks, and weak demand in Xylem's water markets which could result in higher-than-expected leverage. These concerns are somewhat offset by the company's commitment to maintaining solid investment grade metrics. Fitch expects the company to focus on organic growth during the next several quarters which would be supported by capital expenditures and research and development. Other concerns include Xylem's transition as a stand-alone company and any adjustments under a new management team.
Water Industry - Xylem should see consistent growth in demand for several reasons. In North America, infrastructure for potable and wastewater applications continues to age. In addition, water treatment solutions related to oil and gas extraction will drive increased demand for products within this market. In emerging markets, growing populations and economic development should drive demand for water treatment solutions.
Operating and Market Overview - Fitch estimates Xylem could experience revenue growth in the mid-single digits over the next few years as growth in industrial, public utilities and emerging markets more than offsets a slow recovery in commercial and residential markets. Fitch believes Xylem's dedication to areas such as China and India are significant contributors to the company's growth. As of December 31, 2010, the geographic mix by revenue was 39% in Europe, 35% in the United States, 11% within the Asia Pacific region, and finally 15% in other areas. On the industrial side, oil & gas, power, chemical, and mining end-markets are expected to continue to improve in the near term. Growing aftermarket activity is expected to offset the impact of weak commercial and residential markets. Aftermarket activities for parts and services accounted for approximately 16% of the revenues in 2010. The percentage of sales related to aftermarket activity increases even further when replacement parts are added.
Fitch believes Xylem's exposure to mid-, early- and late-cycle markets should provide some natural offset in future downturns. Early-cycle businesses, which describes those markets that are usually first to be affected by a slowdown in the economy, include residential and the manufacturing piece of industrial. Commercial construction is the largest component of it's exposure to mid-cycle businesses and the oil& gas exposure within industrial is considered a late-cycle business. However, residential and commercial construction markets have not recovered from the most recent downturn and remain at low levels. The company's exposure to public utilities, which represent 40% of revenue, is a relatively consistent business due to tariffs which are a primary funding source and are not dependent solely on municipality budgets.
Margin Risks - Excluding one-time separation costs, margins should improve in 2011 due to increased volumes, cost savings from prior restructuring actions, and synergies expected from 2010 acquisitions, partly offset by commodity inflation, higher corporate costs and research and development expenses. Risks to long-term margin growth include the company's ability to sustain the competitive aftermarket business, limit incremental back office costs following ITT's planned separation, and continue to expand highly engineered product lines and efficient acquisition implementations. These concerns are partially offset by water market growth trends in emerging markets which often can be more than twice as high as GDP, as well as the high margins earned on rentals and frequent turnover due to sales associated with the rental pool assets.
Cash Flows - Free cash flows are anticipated by Fitch to support the expected rating and will likely increase in later years as operating results improve. However, concerns remain around controlling working capital needs while growing aftermarket share and the extent of capital outflows needed to expand in emerging markets and grow the rental business.
Ample Liquidity - Liquidity at Xylem should be more than sufficient to meet short-term funding requirements and support expected growth. The company's liquidity is expected to include a new revolving credit facility that supports a CP program of the same size, and solid free cash flow with minimal short term liabilities. The company will not have any asbestos liabilities and pension contributions are projected to be in the range of approximately $15 - $20 million in 2011.
Rating Action Triggers - If leverage metrics were to weaken to over 2x without an expected recovery in 12 to 18 months or if significant weakening in emerging economies were to occur, the ratings and/or Outlook could be reviewed for a downgrade. On the other hand, results and metrics could strengthen if XYLEM achieves favorable margins and competitive market shares in its water markets and maintains leverage at or below 1.5x which could potentially lead to an upgrade.
Management - Xylem expects a majority of its board of directors and senior management team to come from ITT which could limit near-term revisions in the near term compared to conservative financial policies followed by ITT in the past. The Executive Chairman of the board will be Steve Loranger, the current CEO of ITT. He will resign from the role of CEO concurrent with the completion of the spin-off. Also, Gretchen McClain, who was president of ITT's commercial businesses since 2008 will become Xylem's CEO upon completion.
ITT Exelis
Fitch expects to rate ITT Exelis as follows:
--Issuer Default Rating (IDR) 'BBB+';
--Senior unsecured bank credit facilities 'BBB+';
--Senior unsecured long term debt 'BBB+';
--Short-term IDR 'F2';
--Commercial paper 'F2'.
The Rating Outlook is expected to be Stable. ITT Exelis plans to have approximately $890 million of debt at separation.
ITT Exelis's ratings are supported by the company's highly diversified portfolio of defense-related products and services. Revenue is concentrated among U.S. military and government customers. ITT Exelis supplies a wide range of defense electronics for numerous applications which limits its exposure to specific programs. In addition, the company benefits from high levels of overall defense spending, strong cash flow, solid credit metrics for the ratings, and a large backlog. Fitch expects the company will follow a conservative financial strategy after the planned spin-off, and Fitch projects that most of ITT Exelis's financial metrics will be strong for the expected ratings.
Fitch's concerns include U.S. government budget deficits and their potential impact on defense spending after fiscal year (FY) 2012; the large pension deficit; future cash deployment strategy; high customer concentration with U.S. Government accounting for approximately 86% of sales; high percentage of revenues from contracts funded by DoD's Oversees Contingency Operations (OCO) budget; and expected decline in revenues accompanied with margin pressures as product mix is projected to be unfavorable in 2011. In addition, Fitch is concerned with ITT Exelis's lack of a track record as a standalone company as it will need to develop in-house support functions which are currently handled by ITT, including some information technology.
Industry Risk - Fitch believes DoD budget cuts are a risk given the U.S.'s deficit situation, as illustrated by the deficit reduction plan which President Barack Obama announced in April. This plan proposes $400 billion of national security cuts through 2023. Because of the projected growth over that period in existing plans, nominal defense spending would still rise modestly over the plan period, but defense spending would likely dip approximately 5% after being adjusted for inflation. Fitch notes that spending under this plan would still be robust, but the details of spending in specific accounts remain to be determined.
Fitch sees several main risks with respect to the U.S. defense sector's credit quality: the potential that the out years in the budget come under more pressure than the current debate indicates; cash deployment actions to offset lower revenue growth or possible revenue declines; margin pressures from tougher contract terms; and the chance that some of the planned efficiency savings are used to reduce the budget rather than to fund weapons accounts. International defense sales could offset some of the risks in the U.S., but fiscal pressures in some other countries and heavy regulations could pressure ITT's projected overseas growth rates. International revenues accounted for 11% of ITT's revenues in 2010.
Revenues expected to decline - Despite the high product diversification, a significant portion of ITT Exelis's 2010 revenues was derived from three major product offerings: U.S. SINCGARS, IED Jammers and Night Vision. Sales of these products were fueled by the high OCO and had been declining since 2009. Driven by sales trends of these products, Fitch expects a continued decline in ITT Exelis's revenues in 2011. Even with the projected revenue decline from these three product lines, some of ITT Exelis's future revenues are projected to be derived from OCO, exposing ITT Exelis to this highest risk section of the DoD budget.
Margin Risks - ITT Exelis's margins are projected to decline due to an ongoing shift in sales mix as ITT Exelis is expected to generate a higher percentage of revenues from the lower margin service operations as compared to product sales. Fitch expects revenues from service operations in 2011 will be higher than 40% reported as of year-end 2010. ITT Exelis expects sales mix to stabilize in the near term; however, Fitch is concerned with a possible continued increase in the service revenues as such a scenario will negatively affect the company's margins.
Cash Flows - Fitch expects ITT Exelis to generate positive free cash flows (FCF). The FCF may come under pressure in the near term due to possible contributions to fund current pension fund deficit. In addition, the FCF may be negatively impacted depending on the company's acquisitions and potential shareholder friendly cash deployment strategies.
Liquidity - ITT Exelis is expected to have adequate liquidity which is expected to include a revolving credit facility that supports a CP program of the same size, and $200 million in cash.
Leverage and Coverage - Fitch projects ITT Exelis's leverage (gross debt-to-EBITDA) to be approximately 1.1x to 1.3x at year-end 2011. The EBITDA margin is expected to decline at the year-end 2011 compared to 14.9% in 2010, mainly due to the unfavorable sales mix. The interest coverage is expected to be approximately 15x to 16x at the year-end 2011.
Rating Actions - ITT Exelis's financial metrics are strong for the expected ratings. Fitch may consider a positive rating action if ITT Exelis's leverage declines and its post spin-off long-term financial strategy and particularly cash deployment strategies remain conservative. Fitch may consider a negative rating action following a major change in DoD budget and unexpected decline in OCO spending which may have a significant impact on ITT Exelis's revenues. In addition, Fitch may review the ratings if there is a permanent shift in the revenue composition to 40%/60% product to service mix. Such a change in the sales mix could result in significant declines in the operating margins and free cash flows.
Defense spending trends will be a key driver of ITT Exelis's credit profile, although Fitch believes that modest declines in defense spending would not necessarily lead to negative rating actions given ITT Exelis's product diversification and its liquidity position.
Management - ITT Exelis plans to assemble the majority of the board from the current ITT board. The Chairman of the board will be Ralph F. Hake, former Chairman and Chief Executive Officer of Maytag Corporation. Fitch expects the company to be managed conservatively with the management team of ITT Exelis remaining mostly intact. The CEO will be David F. Melcher, who currently serves as the President of ITT Defense & Information Solutions and as a corporate Senior Vice President and member of the ITT Strategic Council. Fitch believes the transition will be smooth for the management team of ITT Exelis. ITT Exelis is in the process of identifying the individuals who will be additional directors following the spin-off.
ITT
ITT's existing ratings remain in place until the separation is completed. Upon completion of the separation, Fitch expects to affirm ITT's ratings as follows:
--Issuer Default Rating (IDR) at 'A-';
--Senior unsecured bank credit facilities at 'A-';
--Senior unsecured long term debt at 'A-' and withdrawn;
--Short-term IDR at 'F2' and withdrawn;
--Commercial paper at 'F2' and withdrawn.
The ratings are currently on Rating Watch Evolving. At separation, the Rating Outlook is expected to be Stable.
As of March 31, 2011, ITTs outstanding debt totaled approximately $1.4 billion. The company plans to have no
long-term debt at separation.
Business Overview - The expected ratings incorporate ITT's post-separation business profile including well-established market positions, conservative financial policies and solid liquidity. ITT will continue to be a diversified global manufacturer of highly engineered industrial products and high-tech solutions. Primary end-markets include automotive, energy and mining, industrial processing, aerospace and defense, general industrials, as well as rail, bus, truck, and trailer. ITT is also expected to benefit from a well balanced exposure to markets with early-, mid- and late-business cycles.
No Debt Outstanding - Leverage metrics are expected to be fairly strong compared to ITT's measures prior to the separation. ITT plans to maintain little or no debt immediately after the separation, but it will retain all of the asbestos liabilities. ITT's leverage metrics are expected remain well below 1.0x over the next few years. Fitch's calculation of total debt/EBITDA does not include asbestos liabilities as part of the debt amount. However, Fitch believes the company will manage its liabilities carefully due to risks surrounding legacy asbestos and environmental issues. Concerns regarding leverage and other metrics include the possibility of material borrowings in the near term or weaker than expected cash flows. These concerns are somewhat offset by the company's anticipated liquidity position, ability to generate free cash flows and ITT's historical commitment to its ratings.
Strong Liquidity Position - Fitch believes the company's liquidity should be more than sufficient to meet short-term funding requirements. The company's liquidity is expected to include a multi-year revolving credit facility, a beginning cash balance of approximately $600 million, positive free cash flows, with minimal short-term liabilities. Risks to the liquidity in the long-term include higher than anticipated asbestos settlements and another downturn in the economy.
Strategic Risks - In Fitch's view, the reduction in scope in ITT's business model increases the company's exposure to cyclicality and its smaller scale relative to larger competitors. Partially offsetting these risks is the fragmented nature of the markets for the company's products. In addition, overall revenue opportunities are well balanced between projects, after-market customers, and original equipment manufacturing and platforms. While there are few synergies among its primary businesses, the majority of the company's products are highly engineered and involve critical applications for specific applications. Other concerns include the amount of investment that may be needed to expand ITT's businesses following the separation.
Rating Actions - The rating could be revised if the company requires material debt or is subject to unexpected post-separation obligations related to the new water or defense businesses. A rating upgrade is unlikely in the near-term due to limited free cash flow. In addition, the company will likely need time to demonstrate consistent operating results as a stand-alone company.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research::
--'Corporate Rating Methodology' (Aug. 16, 2010);
--'Rating Aerospace and Defense Companies: Sector Credit Factors' (June 10, 2010).
Applicable Criteria and Related Research:
Corporate Rating Methodology - Amended
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=546646
Rating Aerospace and Defence Companies
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=529973
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