Fitch Affirms Xylem's IDR at 'BBB'; Outlook Stable
The affirmation reflects Fitch's expectation that XYL will be able to meet its stated deleveraging profile following the cash acquisition of Sensus USA, Inc. (Sensus) expected to close in Q4-2016. The company expects its pro forma leverage to rise to roughly 3.6x following the acquisition and has stated an intention to return to its adjusted debt/EBITDAR target of 2.5x-3.0x within 12 to 18 months of closing. XYL had adjusted debt/EBITDAR and FFO adjusted leverage metrics of 2.6x and 3.0x respectively as of June 30, 2016. Fitch expects the company to meet these targets largely due to the likelihood of robust FCF generation and the company's willingness to repatriate foreign cash in order to pay down debt if necessary.
KEY RATING DRIVERS
XYL's ratings are supported by adequate credit metrics, solid liquidity, conservative financial policies and sound margins. Significant aftermarket and replacement equipment content, which accounts for nearly 40% of revenue, underpins its credit profile. The public utility sector represents roughly one-third of the firm's total revenue, adding stability to revenue. The company generates stable and steady free cash flows as a result of solid operations, low historical margin volatility, low capital expenditure requirements and the firm's conservative cash deployment strategy. Fitch expects XYL to continue to generate low-single-digit organic growth globally, though operating results may be negatively affected by foreign exchange rates as roughly 20% of sales emanate from emerging markets and 32% of 2015 revenue was from Europe.
Fitch views the Sensus transaction positively with respect to market position and strategic rationale as Sensus has grown rapidly over recent years and holds considerable market share in the smart meter segment, particularly in North America and EMEA. Sensus has demonstrated significant capability in areas such as metering technologies, applications and data analytics. Fitch views the potential revenue that this combination will create favorably which should improve XYL's long-term growth and margin profile. While the two firms do not exhibit any material overlap, among Sensus' 14,000 global customers are major cities, governments and utilities, all currently representing significant end markets for XYL.
Fitch remains concerned with the level of incremental debt necessary to fund the transaction as total debt is likely to rise to roughly $2.5 billion by year-end 2016. Fitch is further concerned that much of the expected leverage normalization may potentially be driven by a fairly brisk organic growth profile for the pro forma entity. XYL has experienced tepid organic growth in recent years, and Fitch is concerned that the company may finance the transaction with too large a proportion of long-term debt leaving it with little flexibility to reduce leverage if revenue targets are not achieved. Fitch is also concerned that expected synergies and operating margin expansion may be delayed in the event of a recession and or end market weakness. In this scenario, Fitch would expect the deleveraging timeframe to be lengthened considerably potentially approaching 3 years after acquisition closing. XYL has maintained steady EBITDA margins near 16.5% in recent years and while Sensus produced a 19% margin in 2016, potential increased competition in the smart meter segment could pressure margins and hinder projected free cash flow levels.
Positive credit considerations from the acquisition include a significant potential reduction in XYL's debt-to-currency mismatch as 59% of its total revenue was generated outside of the U. S. in 2015 and most of its current cash balance is domiciled internationally. This mismatch was partially addressed earlier in Q1-2016 when XYL issued EUR500 million of senior unsecured notes and should be further mitigated as 67% of Sensus' 2016 revenue was achieved within the U. S. Fitch expects that the U. S. domiciled FCF Sensus will generate will materially reduce some cash repatriation pressure for XYL. The rating also reflects Fitch's expectation that in the event XYL needs to repatriate foreign cash in order to relieve potential future liquidity pressure or paydown debt to maintain its stated leverage target, the firm would accept the incremental tax costs, if necessary.
Sensus is a U. S. company that generated $837 million in adjusted revenue and $159 million in adjusted EBITDA in fiscal 2016 (ended March 31, 2016). The $1.7 billion cash purchase price is 10.7x Sensus' fiscal year 2016 adjusted EBITDA. XYL expects to achieve at least $50 million in annual cost synergies within three years of closing.
--If completed, the acquisition will be funded with cash and incremental debt;
--No Sensus debt will remain outstanding following the closing of the transaction;
--Limited future negative impacts from currency fluctuations;
--Consolidated EBITDA margins will expand at least 200bps over the intermediate term;
--No share repurchases occur prior to 2019 or the stated deleveraging targets have been met;
--Moderate annual increases in the size of the dividend.
Negative: Future developments that may individually or collectively, lead to a negative rating action include:
--An increase in adjusted debt/EBITDAR above 3.0x on a sustained basis;
--An increase in FFO adjusted leverage above 3.25x on a sustained basis;
--FCF margin below 1.5% for a prolonged period.
Positive: A positive rating action is not likely in the near future given the companies cash deployment policies and cyclicality in some key end markets however developments that may individually or collectively, lead to a positive rating action include:
--Adjusted debt/EBITDAR leverage below 2.0x for a sustained period;
--FCF margins above 7% for a prolonged period.
Fitch expects XYL's financial flexibility to remain suitable over the medium term supported by adequate liquidity. The company's aggregate liquidity stands at approximately $1.2 billion at Q2-2016 comprised of $586 million of cash and equivalents and $600 million of availability under its senior unsecured revolving credit facility. Fitch also believes that XYL has adequate financial flexibility given Fitch's expectation that the company will achieve a FCF margin (after dividends) north of 6% in 2016.
FULL LIST OF RATING ACTIONS
Fitch has affirmed XYL's long-term ratings as follows:
--Long-Term IDR at 'BBB';
--Senior unsecured bank facility at 'BBB';
--Senior unsecured notes at 'BBB'.
Fitch has affirmed XYL's short-term ratings as follows:
--Short-term IDR at 'F2';
--Commercial paper at 'F2';
The Rating Outlook is Stable.