Fitch Ratings-New York-06 July 2018: Fitch Ratings expects the proposed commercial aircraft transaction between The Boeing Company (BA, A/Stable) and Embraer (ERJ, BBB-/Stable) detailed yesterday would in most scenarios be positive for ERJ's debt ratings and neutral for BA's ratings.
Fitch is not taking formal rating actions today as the proposed JV is currently covered by only a non-binding memorandum of understanding, there are still material operational and financial terms to be negotiated, and key credit details have not yet been disclosed or fully determined, including the treatment of all of ERJ's outstanding debt. The financial impact on both companies would not be felt until 2019, likely in the second half.
Negotiations between BA and ERJ have been ongoing for more than seven months, and the companies announced on Thursday morning an outline of the proposed transaction. Under the current MOU, BA would acquire ERJ's commercial aircraft manufacturing and services business based on a valuation of $4.75 billion. BA's consideration for the ERJ unit would be $3.8 billion with ERJ retaining a 20% equity stake in the resulting JV. BA would control the JV, and Fitch believes it would be fully consolidated into BA's financial results. The $4.75 billion valuation is still subject to adjustment. ERJ would have a 10 year put option on its 20% stake.
ERJ's defense and business jet operations would not be included in the transaction, but the two companies said there would likely be a future JV covering defense products and services.
Combining with ERJ would broaden BA's commercial portfolio to the lower end of the narrowbody commercial aircraft market and the regional jet market with ERJ's E2 family. There would be little or no overlap with BA's existing portfolio, and a combination would provide a strategic answer to Airbus' takeover of Bombardier's CSeries program. Parts of the E2 program are likely to face more intense competition with Airbus running the CSeries program, and teaming with Boeing could help the E2 better compete for orders from airlines and aircraft lessors. Another benefit would be consistency with Boeing's strategic initiatives in services and vertical integration. Boeing would also gain access to ERJ's highly-regarded work force, including engineering talent. Key questions would include integration risks, cultural differences, and timing of anticipated synergies.
Boeing Credit Considerations
Fitch assumes the $3.8 billion consideration would be made in cash, although Fitch believes there could possibly also be an element of debt assumption. If all cash, Fitch expects BA would use cash on hand supplemented by new debt issuance.
Credit risks from M&A activity at BA have been rising as a result of potential strategic transactions, as illustrated by the proposed ERJ JV and the pending $4.25 billion acquisition of KLX Aerospace Solutions Group (KLX). These M&A risks are mitigated by BA's substantial cash generation (estimated post-dividend FCF of $8.0-9 billion annually), sizable liquidity position, and low leverage for the current rating. Fitch calculates BA's current leverage (adjusted debt to EBITDAR) at approximately 1.0x, at least a half turn below the mid-point for 'A' category aerospace & defense companies. At the current ratings, Fitch believes BA has several billion dollars of excess liquidity, and it also has several billion dollars of debt capacity.
Neither the acquisition of ERJ nor of KLX separately would affect Fitch's ratings covering BA. However, the combined impact, coupled with BA's continued intention of returning 100% of FCF to shareholders, could require permanent debt funding. This could use up much of BA's debt capacity at the current rating, possibly leading to a review of the BA's ratings or outlook depending the final terms ERJ transaction, cash generation in 2018 and 2019, and potential additional M&A. The company's credit profile could also be at greater risk in a downside scenario.
BA intends to fund the KLX transaction with cash on hand ($9.9 billion at the end of March), supplemented by debt if needed. Fitch believes debt would be temporarily issued commercial paper. BA expects to close the transaction in the third quarter, with closing contingent on the spin-off of KLX's Energy Services Group, as well as regulatory approval and KLX shareholder approval. Fitch's concerns with the transaction include valuation (more than 14x projected 2018 EBITDA) and integration risks.
Embraer Credit Considerations
Fitch believes a combination would likely be a positive for Embraer's ratings, but potential outcomes cover the credit spectrum, so Fitch would be able to evaluate the ratings impact only after seeing the final terms. The main issues to be addressed would be the ratings of ERJ's existing debt, some of which will migrate to the new JV, and the stand-alone issuer rating of the surviving ERJ entity. Key uncertainties include the treatment of the migrated debt and the use of cash proceeds by ERJ. In the case of Embraer's bonds, depending on the final structure, a combination could trigger a change of control clause.
ERJ indicated on Thursday that most bonds would migrate to the JV, but no amounts were given. The debt related to commercial aviation would go to the JV, but the company did not indicate how it would it define that debt. Fitch believes that most of ERJ's debt could be considered related to the commercial aviation operations, so the bulk of those bonds will likely go with the JV. The JV's balance sheet is one of the key elements of the transaction still being negotiated, so it is difficult to assess the credit profile of the bonds. Some scenarios included BA refinancing or assuming the debt. If not, Fitch would analyse how much support from BA should be incorporated into the JV's bond ratings.
ERJ said Thursday it would have substantial net cash at the close of the proposed transaction. It also referred to the possibility of special dividends and share repurchases. Both of these factors, as well as the amount of debt retained by ERJ, would be evaluated by Fitch in determining the ratings of the remaining business. Embraer controlling only the defense and business jet segment (+20% of the commercial aviation JV) would have a weaker business profile.