United Technologies (UTX) Ratings Affirmed by Fitch Following Recent Review; Outlook Stable
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Fitch Ratings has affirmed United Technologies Corporation's (NYSE: UTX) long-term Issuer Default Rating (IDR) and long-term debt ratings at 'A-' and affirmed the short-term IDR and commercial paper ratings at 'F2'. Fitch has also assigned a rating of 'F2' to UTC's $2 billion euro commercial paper program. The program is fully backed by a $2.15 billion multicurrency revolving credit facility that matures in 2021. The Rating Outlook is Stable. A detailed list of rating actions follows at the end of this release.
KEY RATING DRIVERS
The ratings for UTC incorporate Fitch expectations that credit metrics will be weak while the company deploys cash to fund large share repurchases and support the aerospace business. The aerospace business is using significant cash for development programs at Aerospace Systems and Pratt & Whitney (P&W) including the Geared Turbofan (GTF) engine. UTC's share repurchase program involves $16 billion of repurchases during the three-year period between 2015 and 2017, including $10 billion in 2015 and $2 billion to $3 billion in 2016. Repurchases totaled $528 million during the first nine months of 2016. UTC also has a $1 billion placeholder for acquisitions in 2016.
Cash deployment is being funded by UTC's free cash flow (FCF) and an increase in debt. In October 2016 the company issued $4 billion of long term debt with proceeds allocated for the repayment of $1 billion of debt scheduled to mature in 2017, $1.25 billion scheduled to mature in 2019, and a reduction in commercial paper balances. Fitch believes additional increases in debt are possible after 2016 to help fund the company's high cash usage.
Fitch views UTC's cash deployment plans as aggressive, and the company's credit metrics are weak for the ratings. It is possible UTC could exceed some of Fitch's negative rating sensitivities for up to two years or longer before the company begins to fully realize benefits from restructuring, a stronger focus by Otis on market share that would help expand its aftermarket business, and the production ramp for the Geared Turbofan (GTF).
A key driver of UTC's long-term performance is the company's product positioning in the aerospace cycle, which is contributing to elevated capital expenditures and reduced margins in the near term but should generate solid profitability over the product life-cycles. A near-term concern is the production ramp for the Geared Turbofan (GTF), which is proceeding more slowly than expected, including a roughly 25% reduction in projected deliveries in 2016 to 150 engines.
Delayed GTF deliveries are largely due to slow deliveries from suppliers and to technical challenges, particularly the build-time for the GTF fan blade which is moving down the learning curve more slowly than anticipated. These developments are pressuring UTC's near-term financial results but a large backlog of more than 8,400 orders for GTF engines, including options, should lead to higher margins and prospects for significant after-market business.
UTC has also adjusted its strategy for Otis, which has typically generated the highest profit margins among UTC's business segments. UTC intends to rebuild market share in China and Europe, and Fitch expects margins could decline slightly in favor of stronger sales growth. The impact would be offset by increasing Otis' installed base that typically produces high-margin service and parts business.
UTC's free cash flow (FCF) margin has been declining due to high spending for aerospace development. FCF/total adjusted debt was approximately 11% in 2015 compared with 15% in 2014 and could remain at lower levels through 2017. As a result of higher debt levels and margin pressure, Fitch believes UTC will be slow to rebuild FCF/total adjusted debt.
Fitch estimates FCF after dividends in 2016 will be steady near $2.5 billion excluding the negative impact of taxes in 2016 related to the divestiture of Sikorsky in 2015. Capital spending could remain elevated through at least 2017 to support the GTF production ramp and other aerospace programs. Also, UTC typically incurs restructuring each year which should total $350 million to $400 million in 2016.
FCF includes the negative impact of pension contributions and royalty payments to Canada. Royalty payments are related to government funding for engine research and development at Pratt & Whitney. Under a 2015 agreement to amend existing support arrangements, P&W will make four annual royalty payments of CAD327 million between 2016 and 2019 to settle its future contractual obligations that would have extended well beyond 2019.
UTC expects to contribute $200 million to global pension plans in 2016 although there are no required contributions through 2020. Global pension plans were underfunded by $4.4 billion at the end of 2015. U.S. plans were approximately 84% funded as of Sept. 30, 2016.
Rating strengths include UTC's technological capabilities and competitive positions in key aerospace and building-related markets, product and geographic diversification, a large installed base that supports attractive aftermarket revenue, and relatively stable operating performance and FCF through economic cycles compared to industrial peers. The company has attractive positions on commercial and military aerospace programs and is well positioned to benefit from rising production of commercial aircraft.
In addition to large cash deployment, rating concerns include slower growth in China and other developing markets, mixed global construction markets, typical risks associated with aerospace development programs, and negative currency movements. Large acquisitions could exacerbate UTC's increased leverage although UTC would benefit from acquired EBITDA.
Fitch's key assumptions within the rating case for the issuer include:
--Slow sales growth is in the low single digits through 2017 before production rates on new aerospace programs begin to increase and Otis realizes improvements in market share;
--Segment margins decline slightly through the next one to two years 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, and capital expenditures remain elevated through at least 2017;
--Debt increases in 2016 and 2017 to help fund share repurchases and potentially for acquisitions.
Future developments that may, individually or collectively, lead to a negative rating action include:
--Execution challenges on the production ramp for the GTF engine that could reduce expected long-term benefits from market share gains and after-market expansion;
--At Otis, a significant loss of market share or persistent deterioration in margins that impairs UTC's overall profitability and FCF;
--Weak operating results or FCF resulting in FCF/total adjusted debt consistently below 10% after Otis fully implements its market share strategy and aerospace programs have ramped up;
--Shareholder-focused cash deployment results in debt/EBITDA sustained at levels materially above 2.5x or prevents an eventual improvement in debt/EBITDA 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.
An upgrade is unlikely in the near term given near-term challenges to UTC's performance and credit metrics that are weak for the current rating level.
At Sept. 30, 2016 UTC's liquidity included $7.1 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 $1.6 billion of long term debt maturities due within one year and $871 million of short-term debt. UTC's outstanding debt totaled $22.7 billion at Sept. 30, 2016.
FULL LIST OF RATINGS
Fitch has affirmed the following ratings:
United Technologies Corporation
--Long-term Issuer Default Rating (IDR) at 'A-';
--Senior unsecured bank credit facilities at 'A-';
--Senior unsecured notes at 'A-';
--Junior unsecured subordinated debt at 'BBB+';
--Short-term IDR at 'F2';
--Commercial paper at 'F2'.
--Long-term IDR at 'A-';
--Senior unsecured notes at 'A-'.
Fitch has assigned the following rating:
United Technologies Corporation
--Euro commercial paper 'F2'.
The Rating Outlook is Stable.
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