Fitch Ratings has removed from Rating Watch Negative and
affirmed Xylem, Inc.'s (XYL) Long-Term Issuer Default Rating (IDR)
at 'BBB' and affirmed the Short-Term IDR at 'F2'. The Rating
Outlook is Stable. The ratings apply to approximately $1.3 billion
in total debt. A full list of rating actions follows at the end of
the release.
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.
KEY ASSUMPTIONS
--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.
RATING SENSITIVITIES
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.
LIQUIDITY
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.
Additional information is available at
'www.fitchratings.com'.
Applicable Criteria
Criteria for Rating Non-Financial Corporates (pub. 27 Sep
2016)
https://www.fitchratings.com/site/re/885629
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Dodd-Frank Rating Information Disclosure Form
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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1012254
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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