S&P Removes Leidos (LDOS) from CreditWatch Negative Amid Completion of Merger with Lockheed's IS&GS

August 16, 2016 3:36 PM EDT

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S&P Global Ratings said that it has affirmed its 'BBB-' corporate credit ratings on Leidos Holdings Inc. (NYSE: LDOS) and its subsidiaries Leidos Inc. and Abacus Innovations Corp. and removed the ratings from CreditWatch, where we placed them with negative implications on Jan. 26, 2016. The outlook on all three entities is stable.

At the same time, we affirmed our 'BBB-' issue-level ratings on the secured credit facilities issued by Leidos Inc. and Abacus to fund the merger transaction, as well as the notes issued by Leidos Holdings due 2020 and 2040 that are now secured by the same collateral as the credit facilities. We removed our issue-level ratings on the notes due 2020 and 2040 from CreditWatch, where we placed them with negative implications on Jan. 26, 2016.

We lowered our issue-level ratings on Leidos Inc.'s $250 million 7.125% notes due 2032 and $300 million 5.5% notes due 2033 to 'BB+' from 'BBB-' and removed the ratings from CreditWatch, where we placed them with negative implications on Jan. 26, 2016, because these notes will remain unsecured.

"The affirmation reflects the recent completion of Leidos' merger with Lockheed's former IS&GS unit and our belief that the deterioration in Leidos credit ratios, which was caused by the increased debt it took on to fund the acquisition, will be offset by the improvement in the combined company's business risk profile," said S&P Global credit analyst Christopher Denicolo. "Although integration risks are always a concern for a transaction of this magnitude, these risks are mitigated by the limited overlap between the two companies and the lack of large facility consolidations that we often see with mergers between manufacturing companies." We also expect that Leidos' leverage will decline over the next several years as the company applies its discretionary cash flow to debt reduction, causing its debt-to-EBITDA metric to decline to about 3x and leading its funds from operations (FFO)-to-debt ratio to increase to about 20% by 2018.

The stable outlook on Leidos reflects our expectation that, although the company's credit ratios will initially deteriorate because of the increased debt it took on to fund the merger, they will improve steadily over the next 12-24 months as the company applies its excess cash flows toward debt reduction and its earnings benefit from merger synergies and modest revenue growth. While the merger will almost double the size of the company, we do not expect that there will be significant integration problems, though that is always a risk with a transaction of this size.

We could lower our ratings on Leidos over the next 12 months if its FFO-to-debt ratio declines below 15% and we do not expect that it will improve. This could be caused by integration problems or if the company is unable to realize the expected cost synergies from the merger, reducing its earnings, cash flow, and expected debt reduction. Although less likely, this could be caused by a decline in U.S. government demand, the loss of key contracts, or a decision by the company to resume share repurchases before reaching its leverage reduction targets.

Although unlikely in the next year, we could raise our ratings on Leidos if its FFO-to-debt ratio increases above 25%, its debt-to EBITDA metric declines below 2.5x, and we believe that the company is committed to maintaining its ratios at these levels. This could be caused by a higher-than-expected level of earnings or cash flow due to increased merger synergies or more robust government demand that enables the company to speed up its debt reduction.

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