Fitch Ratings-Chicago-05 September 2017: Fitch Ratings has placed the long-term Issuer Default Rating (IDR) and long-term debt ratings for United Technologies Corporation (UTC; NYSE: UTX) on Rating Watch Negative. In addition, Fitch has affirmed UTC's short-term IDR and commercial paper ratings. The rating actions follow UTC's announcement of an agreement to acquire Rockwell Collins, Inc. (COL) in a transaction valued at approximately $30 billion. A list of rating actions follows at the end of this release.
On Sept. 4, 2017, UTC announced an agreement to acquire COL for approximately $30 billion including approximately $7 billion of debt at COL, net of cash on hand. UTC plans to fund the acquisition of COL's equity, valued at nearly $23 billion, through the issuance of approximately $14 billion of new debt, $1 billion of cash repatriated from overseas, and $7 billion-$8 billion of UTC shares, subject to adjustments. The acquisition is expected to be completed by the third quarter of 2018, subject to approval by COL's shareholders, regulatory approval, and customary closing conditions. COL will be integrated with UTC's Aerospace Systems business (UTAS).
KEY RATING DRIVERS
Rating Watch Negative: The Rating Watch Negative reflects the incremental debt and leverage incurred by UTC to fund the acquisition of COL, as well as other concerns described below. Fitch expects UTC's leverage will be materially weaker immediately following the transaction but should recover over 2-3 years to near current levels as COL is integrated and UTC realizes expected benefits including cost synergies, a broader product line, and larger scale. UTC's debt/EBITDA was 2.6x at June 30, 2016, which Fitch estimates could approach a level near 4x immediately following the acquisition.
Resolution of Rating Watch: Fitch expects to resolve the Rating Watch after reviewing details of the transaction and the full impact on UTC's long-term operating and credit profiles. Fitch could affirm UTC's ratings if expected benefits from the acquisition are achievable within 2-3 years and UTC follows a disciplined cash deployment strategy that enables it to rebuild its balance sheet. Fitch believes that, if a downgrade of UTC's rating were to occur, it would be limited to one notch.
Deleveraging: Fitch expects UTC will reduce leverage through a combination of EBITDA growth and debt reduction. The company has suspended share repurchases and plans to limit spending for acquisitions. The company may also repatriate additional overseas cash when feasible and consider divesting non-core businesses to raise cash.
Rating Concerns: Fitch views UTC's credit metrics prior to the acquisition of COL as weak for the ratings, partly due to the use of free cash flow (FCF) in recent years to fund large share repurchases. The elimination of repurchases will partly address this concern, but significant debt used to fund the acquisition of COL will have a much larger offsetting negative impact. The integration of COL will also include the integration of B/E Aerospace, Inc. (BEA) which could magnify typical integration risks. BEA provides interior systems and was acquired by COL earlier in 2017 for $8.3 billion including debt at BEA repaid by COL. Other concerns include the valuation of the transaction and the exposure the company will have to an unexpected aerospace downturn while its leverage is elevated. UTC has encountered challenges around technology associated with the introduction and ramp up of the GTF engine; these challenges, while not unexpected for a new engine, have slowed deliveries to airframe customers and could potentially slow UTC's expected operating improvements.
Acquisition Rationale: The acquisition of COL complements UTC's already-broad aerospace business product line by adding avionics with which there is little overlap with UTAS. The combination could also improve UTC's bargaining position with aerospace manufacturers, as well as enhancing the company's ability to serve its airline customers. The addition of this business should support UTC's ability to control costs and take advantage of growth in digital applications. UTC estimates cost benefits at $500 million annually to be realized within four years of completing the acquisition. Other benefits include possible revenue synergies and larger scale. COL generates solid EBITDA margins in the low-mid 20% range and should support UTAS's cash flow margins after integration is complete. Much of COL's cash is generated domestically which should increase UTC's financial flexibility. Similar to other large global industrial companies, a large portion of UTC's cash is located overseas and is subject to income taxes if repatriated.
Key considerations by Fitch surrounding the acquisition include the pace of integrating COL, UTC's ability to realize cost synergies and stronger EBITDA, cash deployment for debt reduction. At UTC's existing businesses, important considerations include Otis's actions to boost market share and build long term recurring revenue that supports Otis's historically high margins. The resolution of reliability and technical challenges for the Geared Turbofan (GTF) will be key to long term performance at Pratt & Whitney.
Free Cash Flow: UTC's FCF remains solidly positive but is negatively affected by modestly lower margins at Otis, higher debt levels and capital spending that could remain elevated through at least 2017 to support the GTF production ramp and other aerospace programs. Also, UTC typically incurs restructuring costs each year which could total approximately $300 million in 2017, roughly flat compared with $290 million incurred during 2016. UTC's FCF includes the negative impact of pension contributions and royalty payments to Canada related to government funding for engine research and development at P&W. UTC expects to contribute $300 million to global pension plans in 2017 including $150 million of discretionary contributions to domestic plans. Global pension plans were approximately 87% funded as of Dec. 31, 2016.
UTC has a strong credit profile but it is slightly weaker than some large global peers such as GE, Honeywell and Siemens even before considering the pending acquisition of COL. UTC generates strong margins that are comparable to peers in most of its businesses although margins are lower at P&W while it invests in new aerospace programs. Fitch expects leverage to be high immediately following the acquisition of COL. A key rating driver will be the pace at which UTC is able to integrate COL, generate stronger EBITDA and deploy cash to reduce debt.
Fitch's key assumptions within the rating case for the issuer, prior to the acquisition of COL, include:
--Slow sales growth is in the low single digits in 2017 before production rates on new aerospace programs begin to increase and Otis realizes improvements in market share;
--Segment margins decline slightly due to pricing pressure at Otis and negative margins on GTF production;
--UTC gains market share in commercial engines as GTF engine deliveries increase over the next several years;
--FCF remains solid but in the near term is below historical levels relative to sales and debt, largely reflecting cash requirements in the aerospace businesses;
--Cash deployment is high through 2017 for share repurchases (to be suspended to the COL acquisition), and capital expenditures remain elevated through at least 2017;
--Debt increases in 2017 to help fund share repurchases (to be suspended) and potentially for acquisitions (to be limited other than COL).
Fitch could resolve the Rating Watch Negative and affirm the ratings for UTC if, upon integration of COL, Fitch believes the following will occur:
--UTC realizes expected benefits from the COL acquisition including cost synergies of $500 million annually by year four and increased efficiencies within the combined UTAS/COL business;
--UTC reduces discretionary cash deployment for share repurchases and acquisitions to support a reduction in debt and leverage;
--GTF successfully addresses technical and reliability challenges and ramps up production as planned;
--Otis regains market share and continues to generate high margins;
--Debt/EBITDA is below 2.0x;
--FCF/total adjusted debt is near 10% or higher.
Fitch could resolve the Rating Watch Negative and downgrade UTC by one notch if Fitch expects:
--UTC is unable to integrate COL effectively;
--Execution challenges on the production ramp for the GTF engine reduce expected long-term benefits from market share gains and after-market expansion;
--FCF/total adjusted debt is consistently below 10% after the integration of COL is completed, Otis fully implements its market share strategy, and aerospace programs have ramped up;
--At Otis, a significant loss of market share or persistent deterioration in margins impairs UTC's overall profitability and FCF;
--Debt/EBITDA is sustained at levels materially above 2.5x beyond 2-3 years and is not on track to decline below 2.0x. Fitch's definition of EBITDA does not include recurring royalty, joint venture and other income that provide additional modest support to UTC's profitability.
At June 30, 2017, UTC's liquidity included $9.3 billion of cash, most of which was located outside the U.S. Liquidity also included $4.35 billion of committed bank facilities that mature in 2021. UTC generally has access to foreign cash and typically repatriates a portion which is subject to taxes. Liquidity was offset by $2.1 billion of long-term debt due within one year and $682 million of short-term borrowings, primarily commercial paper. UTC's outstanding debt totaled nearly $27 billion at June 30, 2017.
FULL LIST OF RATING ACTIONS
Fitch has placed the following long-term ratings on Rating Watch Negative:
United Technologies Corporation
--Long-term Issuer Default Rating (IDR) 'A-';
--Senior unsecured bank credit facilities 'A-';
--Senior unsecured notes 'A-';
--Junior unsecured subordinated debt 'BBB+'.
--Long-term IDR 'A-';
--Senior unsecured notes 'A-'.
Fitch has affirmed the following short-term ratings:
United Technologies Corporation
--Short-term IDR at 'F2';
--Commercial paper at 'F2'.