Fitch Ratings has assigned a 'B-/RR5' rating to $550 million of senior subordinated notes due 2020 issued by TransDigm, Inc. (TDI), an indirect subsidiary of TransDigm Group Inc. (NYSE: TDG). Fitch Ratings also assigns an 'BB/RR1' rating to $150 million of senior secured term loans, which is an add-on to the company's existing term loans. Approximately $4.3 billion of outstanding debt is covered by Fitch's ratings. A full list of ratings follows at the end of this release.
The company expects to use the majority of the proceeds from the issued debt to fund a $450 million to $850 million special dividend to its shareholders, make cash dividend equivalent payments under its stock option plans, and for general corporate purposes. Following the debt issuance, Fitch estimates TDG's leverage increased to approximately 5.9 times (x) from approximately 4.9x as of June 30, 2012. The increased leverage is in line with the company's historic leverage which typically fluctuates between approximately 4.5x and 6.0x, occasionally reaching higher than 7.0x.
TDG's ratings are supported by the company's strong free cash flow (FCF: cash from operations less capital expenditures and dividends), good liquidity, and financial flexibility which includes a favorable debt maturity schedule.
TDG benefits from high profit margins and low capital expenditures, diversification of its portfolio of products which support a variety of commercial and military platforms/programs, a large percentage of sales from a relatively stable aftermarket business, its role as a sole source provider for the majority of its sales, and management's history of successful acquisitions and subsequent integration. Fitch also notes that TDG does not have material pension liabilities and has no other post-employment benefit (OPEB) obligations.
Fitch's concerns include the company's high leverage, its long-term cash deployment strategy which focuses on acquisitions, and weak collateral support for the secured bank facility in terms of asset coverage. Additionally, Fitch is concerned with the risks to core defense spending after fiscal 2012; however, this risk is mitigated by TDG's relatively low exposure to the defense budget and by a highly diversified and program-agnostic product portfolio.
Fitch notes that TDG is exposed to the cyclicality of the aerospace industry, as it reported several quarters of organic sales declines during fiscal 2009 and 2010 driven by lower demand for aftermarket parts and by production cuts by commercial original equipment manufacturers (OEMs). While market cyclicality is somewhat mitigated by growth from acquisitions, high margins and sales diversification to the defense sector, the expected decline in defense spending coupled with a possible downturn may result in lower FCF.
The Recovery Ratings and notching in the debt structure reflect Fitch's recovery expectations under a scenario in which distressed enterprise value is allocated to the various debt classes. The expected recovery for bank-debt holders remains 'RR1', indicating recovery of 91% - 100%. The senior subordinated notes are 'RR5' which reflects an expectation of recovery in the 11% - 30% range.
At the end of fiscal 2011, TDG's leverage was approximately 5.6x, up from 5.0x at the end of fiscal 2010. TDG's leverage increased significantly following the acquisition of McKechnie Aerospace Holdings Inc. (MAH) at the beginning of fiscal 2011, reaching above 7.0x immediately after the MAH acquisition. The company's leverage receded to approximately 4.9x as of June 30, 2012. As of June 30, 2012 TDG had debt of $3.6 billion, up from $3.1 billion at Sept. 30, 2011. TDG's leverage is somewhat high for the rating; however, it is mitigated by strong margins and positive FCF generation. Fitch projects TDG's leverage to fluctuate between the historic range of 4.5x to 6.0x.
At June, 30, 2012, TDG's liquidity consisted of $303 million in cash and $303 million available under its revolver ($610 million less $7 million in letters of credit), partially offset by $20.5 million in current amortization payments under the $2.05 million term loan. Year-over-year, TDG's liquidity decreased by $180 million, mostly due to a decline in cash which was used to make several acquisitions during fiscal 2012. TDG does not have major maturities until 2017. Fitch expects TDG to maintain a solid liquidity position in fiscal 2012 and 2013.
Excluding a special dividend paid to shareholders in 2010, TDG generated nearly $200 million annual FCF over the past four years. In fiscal 2011, FCF totaled $239 million, up from negative $220 million in fiscal 2010. The negative FCF in 2010 was primarily due to the large one-time dividend payment. For the last twelve months ended June 30, 2012, TDG generated $349 million FCF. Solid positive FCF generation is aided by typically low capital spending and high margins. Capital expenditures tend to be less than 2% of sales per year.
In 2011, TDG generated approximately $272 million in cash by divesting two businesses. Fitch does not expect significant cash generation via divestitures going forward. Fitch expects TDG to generate more than $300 million of FCF in 2012 (excluding recently announced one time dividend). Projected cash flows should be sufficient to fund day-to-day operations while allowing the company the flexibility to pursue modest future acquisitions.
Acquisitions are the main focus of TDG's cash deployment strategy. In fiscal 2012, TDG made three acquisitions totaling approximately $868 million compared $1.7 billion spend on acquisitions in 2011. Historically, TDG had not paid regular annual dividends to its shareholders and had not engaged in significant share repurchases, though TDG's board authorized a $100 million share repurchase program on Aug. 22, 2011. Fitch expects TDG's cash deployment to maintain focus on acquisitions and special dividends if the company does not find suitable acquisition targets.
TDG is exposed to three business sectors: commercial airplane original equipment (OE), commercial aftermarket, and defense (both original equipment and aftermarket). TDG's sales growth rate during the latest economic downturn was primarily driven by acquisitions and the stability of defense spending which significantly moderated year-over-year organic sales declines in commercial OE and aftermarket sales.
Fitch considers the conditions within the industry to be supportive of the rating. Commercial aerospace markets have improved over the past year with increased production by major OE manufacturers and strong aftermarket activity. The industry's long-term health is supported by a growing global demand for air travel, and increasing demand for fuel-efficient and lighter weight modern planes. TDG has a niche position in the market because of the proprietary nature of many of the company's products and as a result, has the ability to charge high margins.
Approximately 25% of TDG's revenues are derived from the defense industry. U.S. defense spending has been on an upward trend for more than a decade, but the fiscal 2012 and fiscal 2013 budgets represent a turning point, with spending beginning to turn down in fiscal 2013, even excluding war spending, albeit from very high levels. The fiscal 2012 DoD base budget is up less than 1% compared to fiscal 2011, and the requested base budget for fiscal 2013 is down 1% to $525 billion. Fiscal 2013 Modernization Spending (procurement plus research and development [R&D]), the most relevant part of the budget for defense contractors, is down 4%, the third consecutive annual decline by Fitch's calculations.
The overhang of potential automatic cuts beginning in early 2013 related to the 'sequestration' situation, as well as the presidential election, add to the uncertainty faced by defense contractors in the current environment. The U.S. defense outlook will be uncertain and volatile over the next one to two years, and program details will be needed to evaluate the full effect on TDG's credit profile.
On Sept. 14, 2012, the Office of Management and Budget issued a Sequestration Transparency Act report detailing the potential impact of sequestration on funding reductions for both defense and nondefense budget accounts. The report assessed that unless the sequestration law is changed, the DoD budget will be cut by approximately $52 billion in FY2013. Budget cuts to Modernization Spending would be expected to account for approximately $23 billion or nearly 44% of the cuts despite comprising only 29% of the total DoD budget. The majority of the remaining cuts will be in the Operations and Maintenance account. Should sequestration occur the cuts in Modernization Spending could be partly mitigated by low outlay rates during the first year for the majority of Procurement and R&D programs.
Fitch would not expect sequestration-driven DoD spending declines alone to lead to negative rating actions for TDG. The company has a relatively limited exposure to DoD spending and it is mitigated by good liquidity and the diversification of its product line.
FUTURE RATING ACTIONS
Fitch is unlikely to consider a positive rating action in the near future given TDG's current leverage and the increase of its senior secured and senior subordinated debt. A negative rating action may be considered should TDG complete another acquisition financed by debt or should there be an unexpected downturn in the aerospace industry which could have a significant impact on TDG's financial results.
Fitch Rates TDG and TDI as follows:
TDG:
--Long-term IDR 'B'.
TDI:
--IDR at 'B';
--Senior secured revolving credit facility 'BB/RR1';
--Senior secured term loan 'BB/RR1';
--Senior subordinated notes 'B-/RR5'.
Additional information is available at 'www.fitchratings.com'. The ratings above were unsolicited and have been provided by Fitch as a service to investors. The issuer did not participate in the rating process other than through the medium of its public disclosure.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (Aug. 8, 2012).
Applicable Criteria and Related Research:
Corporate Rating Methodology
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=684460
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