Fitch Places KLA-Tencor's 'BBB-' Rating on Watch Positive on Merger with Lam Research
OREANDA-NEWS. Fitch Ratings has placed the ratings for KLA-Tencor Corporation (KLA-Tencor), including the 'BBB-' long-term Issuer Default Rating (IDR), on Rating Watch Positive. The action follows the company's announcement of a planned merger with Lam Research Corp (Lam).
Fitch's rating actions affect $3.7 billion of total debt, including an undrawn $500 million revolving credit facility. A full list of current ratings follows at the end of this release.
KEY RATING DRIVERS
The Watch Positive reflects Fitch's expectations for increased scale and value within the semiconductor equipment supply chain as a result of combining the market and technology leader in wafer processing and process control. The deal also meaningfully strengthens the company's free cash flow (FCF) profile and provides a credible roadmap for debt reduction and returning credit protection measures to solid investment grade levels within two years after the deal closes.
Fitch believes the transaction further entrenches the combined company's importance to customers in solving increasingly complex problems (including FinFET, multi-patterning, 3D NAND) and enabling the continuation of Moore's Law, the observation that the number of transistors on an integrated circuit doubles every two years. The deal occurs at a time when industry consolidation is picking up, threatening to weaken semiconductor equipment players' bargaining power with customers.
The deal adds Lam's $6.5 billion to $7 billion of revenues to KLA-Tencor's roughly $3.5 billion to $4 billion, albeit at lower profit margins. The company believes the combination expands the addressable market and will yield $600 million of annualized revenue synergies by 2020. On a combined basis and pro forma for $250 million of annualized cost synergies exiting fiscal 2018, Fitch estimates operating EBITDA margin in the upper 20s (versus a range of high 20s to low 40s through the cycle presently) and more than $1 billion of recurring annual FCF.
KLA-Tencor and Lam announced a merger in a deal valuing KLA-Tencor at $10.6 billion. Lam will fund the deal with $5.6 billion of Lam shares, $3.9 billion of new senior debt, and $1.9 billion of available cash. The company will use a portion of this cash to repay KLA-Tencor's outstanding term loan at closing (roughly $600 million by mid-2016). The deal has been approved by both companies' Board of Directors and requires customary regulatory and shareholder approvals. Lam and KLA-Tencor expect to close the merger in mid-2016.
Pro forma for the debt issuance and term loan repayment, as well as Lam's repayment of $450 million of senior notes in May 2016, Fitch estimates $8.6 billion of total debt. Fitch expects voluntary debt reduction and operating EBITDA growth will drive total leverage (total debt to operating EBITDA) to 2.5x by the fiscal year ended June 30, 2018 from roughly 3.5x at closing. Upon achieving targeted leverage, Fitch expects the company will resume share shareholder returns with annual FCF.
The ratings on KLA-Tencor continue to be supported by:
--The company's technology leadership resulting in strong market share positions in the process control market for semiconductors and a growing mix of less volatile services revenues;
--Secular long-term growth trends, including increased technological complexity and shortened life cycles for semiconductor products (Moore's Law) and increased outsourcing to foundry partners;
--Solid annual free cash flow (FCF) through a typical cycle, driven by strong profitability and minimal capital intensity. Lower receivables and inventory support FCF in a downturn, as was the case in fiscal 2009 when KLA-Tencor generated positive FCF despite a 40% sales decline.
Fitch's ratings concerns focus on:
--KLA-Tencor's need for substantial ongoing investments in R&D and sales and marketing, each of which Fitch believes will continue to represent 10% - 20% of revenues (although capital spending for semiconductor equipment makers is comparatively low) to maintain technology and market leadership;
--Substantial customer concentration with expectations for ongoing customer consolidation, particularly at the leading edge;
--The highly cyclical demand patterns associated with the semiconductor equipment market.
Fitch's key assumptions within the rating case for KLA-Tencor's include:
--Solid mid-cycle revenue growth in the mid-single digits on a combined basis;
--The achievement of $250 million of annualized cost synergies exiting fiscal 2018, resulting in mid-cycle operating EBITDA margin in the high 20s;
--More than $1 billion of recurring annual FCF ($250 million of aggregate cash charges related to achieving cost synergies in fiscal 2017-2018) that is 100% used for voluntary debt reduction;
--Repayment of Lam's $450 million of senior notes due May 2016 at maturity and use of net proceeds to repay remaining KLA-Term Loan (approximately $600 million) at the merger's closing, resulting in $8.6 billion of total debt;
--The company will limit shareholder returns to Lam's current dividend and stock buybacks offsetting dilution from option exercises until total leverage is 2.5x in fiscal 2018.
Fitch expects a one-notch upgrade, provided the merger closes as currently contemplated, including management's commitment to using FCF for debt reduction and achieving total leverage near 2.5x.
Fitch would remove the Watch Positive and stabilize the ratings if the merger does not close or Fitch anticipates the company will sustain total leverage closer to 3x.
Fitch believes KLA-Tencor's liquidity on a standalone basis was solid as of September 30, 2015 and supported by:
--$2.3 billion of cash and cash equivalents, the majority of which Fitch believes was located in the U.S.;
--An undrawn $500 million RCF.
$250 million to $750 million of annual FCF also supports liquidity.
Total debt at Sept. 30, 2015 was $3.2 billion and Fitch believes consisted of:
--$250 million of 2.375% senior notes due Nov. 1, 2017;
--$250 million of 3.375% senior notes due Nov. 1, 2019;
--$500 million of 4.125% senior notes due Nov. 1, 2021;
--$1.25 billion of 4.650% senior notes due Nov. 1, 2024;
--$250 million of 5.65% senior notes due Nov. 1, 2034;
--Approximately $700 million of term loans.
FULL LIST OF RATING ACTIONS
Fitch currently rates KLA-Tencor as follows:
--Senior unsecured term loan 'BBB-';
--Senior unsecured revolving credit facility 'BBB-';
--Senior unsecured notes 'BBB-'.