S&P: Israel Aerospace Industries Ltd. Outlook Revised To Negative; 'BBB-/A-3' Ratings Affirmed
The outlook revision reflects the execution risk of the recently announced reorganization plan and intense competition in the industry. While we understand that the program could be translated into benefits of more than $100 million per year over the medium term, delays in the implementation or soft demand for the company's products could limit the actual benefits, leaving the company with tight margins and weak cash flows.
According to IAI, the reorganization program will result in about 800 employees (about 5% of the workforce) leaving the company with a total cost of $150 million-$250 million and the remaining workforce agreeing to take some benefit cuts for a period of three years. This historical agreement comes after long negotiations with the labor union and the regulators. In the past few years, the company introduced several voluntary packages (about 400 employees left over the last three years) and saw a natural retirement of about 500 employees a year in the last few years. However, those did not result in an obvious change in the company's cost structure.
The agreement comes as IAI is going through a downturn with stagnation in its business on the back of more pressure on defense industries around the globe. We understand that armies are moving from state-of-art packages to more affordable products, and with some shift towards cyber security. In the first half of 2016, the company recorded EBITDA of $90 million, after already weak results in 2015. IAI's weak civilian activities (the maintenance and conversion of civilian aircrafts and commercial aircrafts), which suffer from weak competitive positions, are going to remain with the company post the reorganization, with no material change in their contribution to the bottom line. As of June 30, 2016, IAI's backlog was about $8.6 billion, representing about 2.5 years of operations.
In early September, the Israeli government signed a $38 billion security framework agreement with the U. S. government covering the next 10 years. Unlike the previous agreement, the Israeli government will not be able to utilize 26% of the annual support to acquire Israeli products. In our view, this feature, which will kick in after seven years into the agreement, will have a medium-term negative implication on the Israeli defense industry (about $800 million a year). In 2015, IAI's sales to the Israeli ministry of defense were about $660 million or 20% of its turnover. The change in the U. S. policy is not unique and we see similar demand in India, where the Indian government put emphasis on local production. At the moment, all of IAI's production capabilities are focused in Israel. Our base-case scenario does not factor the costs linked to IAI expanding its footprint outside Israel, and may lead to some pressure on the rating if the company decided to pursue sizable mergers and acquisitions.
Under our base-case scenario, we project that IAI's S&P Global Ratings-adjusted EBITDA will be slightly positive in 2016 (or about $200 million-$210 million excluding the reorganization costs) and $250 million-$270 million in 2017, compared with EBITDA of $183 million in 2015. In the first half of 2016, IAI reported weaker-than-expected adjusted EBITDA of $90 million. The following assumptions underpin our estimation of:Flat revenues, or a slight drop, in 2016 and in 2017, compared with 2015. This reflects the existing backlog of about $8.6 billion as of June 30, 2016. We note that about 80% of the revenues in 2017 are already secured. A U. S. dollar to Israeli new shekel exchange rate of about 1:3.8, slightly better than the exchange rate the company realized in 2015. Implementation of the early retirement program through the second quarter of 2017, with benefits of about $50 million-$70 million in 2017 (the company expects benefits in excess of $100 million already in 2017). We do not assume further voluntary programs beyond the existing one. Working capital swings will remain volatile, but without a direct impact on the company's financial debt (as of today most of the cash on the balance sheet stems from customer advance payments, which we do not deduct from the debt).Capital expenditure (capex) remains at the level of previous years. Full imbursement (about $170 million) from the insurance company over the blown-up communication satellite ("Amos 6") earlier this month. Potential bolt-on acquisitions. These assumptions translate into neutral free operating cash flow (FOCF), excluding changes in working capital in 2016 and 2017. We project that funds from operations (FFO) to debt in 2016 will be close to zero, after taking into account the full costs of the re-org program (excluding program costs it would be 24%-25%). The ratio is expected to improve in 2017, in access of 25%, as labor costs come down. We see the range of 20%-25% as commensurate with the rating.
As of Dec. 31, 2015, IAI's adjusted debt was $734 million, which included $530 million in long-term debt and material pension liabilities. IAI has a comfortable debt maturity profile. While the company carries sizable cash and liquid sources on its balance sheet (about $1.1 billion as of June 30, 2016, compared to a peak balance of about $1.5 billion in late 2014), we deduct relatively small amounts from the debt equal to the company's maturities in the next two years. According to the company, the cash balance is expected to increase materially in the second half of the year, as some payments from customers are coming due. We believe that the rest of the cash, which stems from the customer advance payments (about $1.6 billion as of June 30, 2016), is not fully available to service the debt and may decrease unless the company maintains the same level of backlog. The negative outlook reflects the competitive environment in which IAI is operating, some delays in signing multi-million U. S. dollar transactions, and some uncertainties relating to the execution of the recently agreed reorganization plan. We may downgrade IAI in the next six-12 months, unless the company was to present a clear contribution from reorganization changes (for example restoring EBITDA margins above 5%). We will take a negative rating action if the company coverage ratios are not in line with what we expect for the current rating, that is, an FFO-to-debt ratio of 20%-25% or if FOCF became negative in 2017 leading to a steep deterioration in the company's cash balance.
Over the medium term, we could also consider lowering the ratings if we revised down our assessment of the likelihood of extraordinary government support. This could happen if the government moves forward with its plan to issue a minority stake in IAI or sales to the Israeli government decline. In addition, we can see some pressure on the rating if the company pursued sizable acquisitions.
We may revise the outlook to stable if IAI executed its reorganization plan, leading to healthy EBITDA margins of more than 5% and with a positive FOCF (before changes in working capital). In addition, such a change would be subject to reassessment of the company's financial policy and likelihood of becoming more acquisitive. We consider an FFO-to-debt ratio of 20%-25% as commensurate with the current rating.
In accordance with our criteria for rating government-related entities, we view the likelihood of timely and sufficient extraordinary financial support from the Israeli government for IAI, if needed, as high, resulting in three notches of uplift to the stand-alone credit profile (SACP). We base this view on our assessment of IAI's:Very important role in Israel's economy, due to the group's range of defense products, some of which are important for the Ministry of Defense. In this respect, the link between the two goes beyond the 20% sales to the state; andStrong link with the Israeli state, which fully owns IAI. On several occasions over the last few years, the government has discussed issuing a minority share in the company, while maintaining ownership. At this stage, we are not aware of a concrete and defined timeline for such a transaction. Although an issue could reduce IAI's link with the government, it could also reduce bureaucracy and improve operational flexibility. Our view of potential governmental support does not include influence on the group in the form of research and development subsidies (a relatively common feature in the aerospace and defense industry), favorable contracts, or access to preferential funding or guarantees. On the other hand, the Israeli government puts numerous restrictions on the company, including on technology exports and on acquiring companies overseas. These factors are incorporated in our SACP assessment.