Fitch Affirms Eaton Corp.'s IDR at 'BBB '; Outlook Stable
KEY RATING DRIVERS
The ratings incorporate Fitch's expectations that Eaton's credit metrics will recover further as it completes the integration of Cooper Industries plc (Cooper) and repays an additional \$1.2 billion of debt scheduled to mature through the first quarter of 2016 (1Q16), including \$400 million in 2Q15. Credit metrics have improved since the Cooper acquisition in late 2012 which was partly funded with debt. Incremental cost synergies expected to be realized through 2016, combined with internal sales growth, should support higher EBITDA margins and contribute to higher margins and free cash flow (FCF).
Fitch estimates improved EBITDA margins, together with debt reduction, will help reduce debt/EBITDA to around 2.25x by the end of 2015, compared to 2.6x at March 31, 2015 and well above 3x shortly after Cooper was acquired. Leverage and other credit metrics have not improved as quickly as originally expected by Fitch and remain weak for the current ratings, partly due to slow growth in Eaton's end-markets. However, the integration of Cooper has been successful and operating synergies have exceeded Eaton's initial estimates.
Stronger operating results beyond 2015 could eventually lead to further improvements in leverage and cash flow measures, but the pace of improvement in credit metrics could be slow, including a reduction of debt/EBITDA to approximately 2.0x by the end of 2016 as estimated by Fitch. In addition, funds from operations (FFO) adjusted leverage could decline below 3.0x by the end of 2015 from just over 4.0x at the end of 2014. These metrics could improve more quickly if Eaton's end-markets or operating results are stronger than expected by Fitch. Fitch does not anticipate material debt reduction after 1Q16.
Rating concerns include cyclical end-markets and the negative impact of currency movements which are expected to reduce sales in 2015, although most segments could generate modestly higher sales excluding currency. These concerns are mitigated by Eaton's technological capabilities, competitive market positions, and solid liquidity. Another concern is the potential for future debt-funded acquisitions which previously have contributed to higher leverage. However, Fitch believes the company intends to maintain a strong balance sheet over the long term as demonstrated by its issuance of equity to partly fund the Cooper acquisition and reduce the negative impact on leverage.
Cash flow was reduced in 2014 by \$648 million of pre-tax settlement payments related to the Meritor and Triumph litigation. Although the cash impact was material, the settlements removed uncertainty and concerns about potentially larger settlements. The absence of settlement payments will contribute to strong FCF in 2015 which Fitch expects will increase to approximately \$1.1 billion compared to \$317 million in 2014. The expected improvement in FCF also reflects the impact of stronger operating results as Eaton realizes additional synergies and lower integration costs related to the integration of Cooper.
Capital expenditures remain near 3% of sales, and Fitch believes dividends are likely to generally increase in line with earnings. Acquisitions could increase as Eaton nears the end of its planned debt repayment in early 2016 and generates excess cash. Other cash deployment includes share repurchases, which increased substantially to \$650 million in 2014 and \$170 million in 1Q15. Fitch expects share repurchases will be funded largely from FCF and that Eaton's use of debt to fund discretionary spending will be minimal while it continues to rebuild credit metrics.
FCF also includes the impact of pension contributions which Eaton estimates will be \$326 million in 2015, down slightly from \$362 million in 2014. Eaton contributed \$223 million in 1Q15. As of Dec. 31, 2014, global plans were underfunded by nearly \$1.8 billion (72% funded) including U.S. plans that were underfunded by \$961 million (76% funded). Eaton closed its U.S. plans to new entrants in 2013. The U.S. plan assumed with the Cooper acquisition was closed and frozen in 2007.
Eaton's end-markets are seeing slow growth as improving conditions in the U.S. offset slower growth in other regions. The company has balanced exposure to early, middle and late parts of the economic cycle which should smooth financial results over time despite exposure to cyclical markets such as aerospace, heavy duty trucks and construction. Eaton's electrical products and services business should see further cost and revenue synergies from the integration of Cooper.
In other segments, aerospace is positioned to benefit from a strong commercial aircraft cycle during the next several years as airlines invest in newer fleets. In Eaton's vehicle business, conditions are favorable in both the heavy duty truck market and in U.S. automotive production. However, demand in the hydraulics segment continues to decline due to a weak global market for large agricultural equipment and slow activity in the China construction market.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for the issuer include:
--FCF after dividends recovers in 2015 to a level of around \$1.1 billion;
--Eaton reduces outstanding debt by approximately \$1.2 billion in 2015 and 1Q16;
--EBITDA margins increase by at least 50 bps in 2015 as Eaton realizes additional cost synergies;
--All segments except Hydraulics generate higher organic revenue growth;
--Acquisition activity could increase beginning in 2016 after Eaton completes the integration of Cooper;
--Business portfolio continues to be well diversified across end-markets and geographies.
RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to a positive rating action include:
--Fitch's expectations for sustainably higher EBITDA profit margins;
--Additional debt reduction and stronger earnings that contribute to expectations for debt/EBITDA to decline and remain below 2x on a sustained basis;
--FCF/total adjusted debt increases to a range near the mid-teens or higher compared to approximately 3% as of March 31, 2015 (estimated by Fitch at 7% excluding after-tax litigation payments);
--FFO adjusted leverage declines to 2.5x or below.
Future developments that may, individually or collectively, lead to a negative rating action include:
--Inability to realize higher margins from incremental synergies with Cooper;
--Loss of market share due to ineffective product development or higher competition;
--Less diversification that could result in more cyclical results;
--Cash deployment for share repurchases or other purposes that prevent further improvement in credit measures expected by Fitch, including a reduction of debt/EBITDA to well below 2.5x and FCF/total adjusted debt above 10%.
LIQUIDITY
Liquidity at March 31, 2015 included approximately \$800 million of cash and short-term investments, plus availability under three revolving credit facilities totaling \$2 billion. The revolving credit facilities have staggered maturities between 2017 and 2019 and are used to back commercial paper. Liquidity was offset by \$1.5 billion of short-term debt and current maturities of long-term debt. Debt totaled \$9.3 billion at March 31, 2015, including \$267 million of short-term debt. The bank credit revolvers and substantially all of Eaton's and Cooper's long-term debt are guaranteed by Eaton Corporation plc and certain of its subsidiaries. Eaton was in compliance with all debt covenants at March 31, 2015.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
Eaton Corporation plc
--Issuer Default Rating (IDR) at 'BBB+';
--Senior unsecured bank credit facilities at 'BBB+';
--Short-term IDR at 'F2';
--Commercial paper at 'F2'.
Eaton Corporation
--IDR 'BBB+';
--Senior unsecured bank credit facilities at 'BBB+';
--Senior unsecured debt at 'BBB+';
--Short-term IDR at 'F2';
--Commercial paper at 'F2'.
Cooper U.S., Inc.
--IDR at 'BBB+';
--Senior unsecured debt at 'BBB+'.
The Rating Outlook is Stable.
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