NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the Issuer Default Rating (IDR) and long-term debt ratings of Flowserve Corporation (FLS) at 'BBB'. The Rating Outlook is Stable. The ratings cover approximately $1.6 billion of debt. A full list of ratings follows at the end of this press release.
KEY RATING DRIVERS
Fitch's ratings reflect FLS's product and geographic diversification, well-established market positions, a substantial portion of higher-margin aftermarket business, well-funded U.S. pension plans, consistently positive free cash flow (FCF) and solid backlog. The ratings and outlook are also supported by Fitch's expectation that the company's capital deployment will be balanced to maintain debt/EBITDA in the range of 1.6x to 2x.
Fitch considers FLS's leverage metrics to be weak for the current rating. The company's EBITDA margins were negatively affected by lower revenues, product mix and sizable realignment charges over the past four quarters. Fitch expects realignment charges are non-recurring and excludes them from EBITDA. However, even excluding the charges, EBITDA declined over the past four quarters resulting in a deterioration of the company's leverage ratios.
The company's revenue was negatively affected by lower CapEx and deferred maintenance by its customers, deferrals of large projects in the Oil and Gas and Chemical sectors, and currency headwinds. In addition, the company's EBITDA margin declined to 16.4% at June 30, 2016 on a latest 12 months (LTM) basis, down from 17.2% at the end of 2015 due to a relatively high cost structure on lower sales. FLS's EBITDA margin has ranged between 16% and 19% over the past four years. Despite recent deterioration, Fitch views current and historical margins as solid for the ratings. Fitch expects adjusted EBITDA margins will decline to approximately 16% in 2016 and will rebound to above 17% in 2017 as the company starts benefiting from the run rate savings achieved through its realignment efforts.
Debt/EBITDA deteriorated to 2.3x as of June 30, 2016, up from 2x as of Sept. 30, 2015, and adjusted debt/EBITDAR increased to 2.7x from 2.3x driven by lower EBITDA. Fitch expects leverage and adjusted leverage will deteriorate to approximately 2.4x and 2.8x by the end of 2016, respectively but will improve slightly in 2017 to 2.3x and 2.7x, respectively, due to scheduled amortization of the term loan and as EBITDA stabilizes following restructuring implemented in 2016. Fitch anticipates debt/EBITDA ratios will improve and stabilize in the range of 1.9x to 2.1x during 2018.
FLS historically generated strong cash flows and the company's FCF margin has been in the range of 5.5% to 7.2% from 2012 to 2014. FLS's FCF was significantly lower in 2015 due to elevated CapEx, lower revenues and operating margins, and significant restructuring charges. FLS generated $142 million FCF in 2015, down from $353 million generated in 2014. Fitch expects the company's FCF will be challenged over the next two years and the company will generate FCF in the range of $40 million-$100 million due to anticipated large restructuring charges and lower EBITDA. Weaker FCF will be mitigated by solid liquidity.
The company's operating cash generation should support its cash deployment strategy which includes $60 million of annual debt repayment, $300 million of cash expenditures to complete the realignment of operations by the end of 2017 which should generate approximately $230 million run rate savings, and annual dividend of more than $93 million.
FLS is well diversified by its exposure to various end markets and geographically. The company derives approximately 80% of sales from aftermarket and run-rate original equipment which tend to have higher margins than large scale original equipment projects and are more stable during economic downturns. The company has been increasing its aftermarket sales through developing a localized network of quick response centers (QRC) around the globe which have a capability of providing same day delivery of standard parts and offer expedited delivery of special order parts. FLS's sales are somewhat concentrated in Oil and Gas and Chemical end markets as evidenced by the company's bookings which comprised 36% and 22% in 2015, respectively. Bookings from other industries are less than 15% individually.
Rating concerns include FLS's execution of the $350 million operations realignment program, declining operating margins, significant revenue pressures due to the weakness in the Oil and Gas and Chemical end markets, exposure to unstable geopolitical regions; possible margin pressures due to higher raw material costs and the impact of project delays; seasonal cash generation; heavy cash requirements to support large swings in working capital; cyclicality in certain end-markets; and competitive pricing pressure throughout the industry.
FLS began a multi-tiered realignment, specifically focused on optimizing its facilities' efficiency in early 2015. The first phase of the realignment was aimed to reduce and optimize non-strategic QRCs and manufacturing facilities particularly related to the SIHI acquisition in early 2015. The company incurred expenses of approximately $40 million related to the first phase. In the second quarter of 2015 (2Q15), the company began the second part of the realignment, which was more focused on reducing workforce, facility consolidation, and transferring operations from high cost facilities to lower cost facilities.
Overall, the company plans to reduce its footprint by 30% by closing and consolidating manufacturing sites from 80 to 57. The strategy also includes work force reduction plans by 15% to 20% and increasing manufacturing capacity in the emerging markets by 25%. Fitch estimates the company has made investments of approximately $150 million since inception through 2Q16, and spent approximately $79 million in cash related to the effort. Fitch expects the company will incur additional $180 million in charges and $300 million in cash outlays related to its ongoing realignment program through 2017. While Fitch is concerned with the execution risk of the realignment, the expected $230 million run rate reduction in the costs structure should enable the company to achieve stronger operating margins beginning 2018.
Additionally, Fitch is concerned with FLS's sizable currency exposure. While the company hedges project-specific cash flow risk associated with certain transactions, movements in foreign currency exchange rates contributed to an approximately 8% sales decline in 2015 and approximately 3% in the first half of 2016. Fitch expects the FX impact will be in the range of 3% to 5% for all of 2016.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for FLS include:
--Revenues will decline by approximately 12% in 2016 and 5% in 2017 before a slight rebound in 2018;
--EBITDA margins will be challenged in 2016; however, will rebound to 17% by 2017;
--Tax rate will be 31% and the company will pay 100% of the taxes in cash;
--The company will incur additional $180 million in charges and $300 million in cash outlays related to its ongoing realignment program through 2017;
--Share repurchases will be suspended through 2017 and will resume at approximately $150 million in 2018;
--The company's FCF generation will be in the range of $50 million to $100 million over the next two years compared to the historical FCF of approximately $300 million;
--Capital expenditures will be steady at approximately 3% of revenues, annually;
--Debt level will steadily decline by $60 million per annum as the company repays its term loan;
--The company will not make additional acquisitions over the rating horizon;
--Dividends will increase modestly on annual basis;
--Pension contributions will not have a material impact on the cash flows and will comprise approximately $30 million-$35 million on pre-tax basis.
RATING SENSITIVITIES
Fitch is not likely to consider a positive rating action in the near future given the recent increase in leverage which is slightly above credit metrics commensurate with the current ratings. The ratings may be reviewed for a positive action if the company consistently maintains debt/EBITDA lower than 1.5x and generates more than $250 million FCF annually.
Fitch expects revenue, margins, and leverage will be relatively weak into 2017 due to continued weakness in the Oil and Gas and Chemical sectors. In addition, Fitch expects FCF will be weak due to large cash outlays associated with the realignment program. Fitch could consider a negative rating action if debt/EBITDA and adjusted debt/EBITDAR do not decline below 2.3x and 2.8x, respectively, by the end of 2017. Fitch expects FLS's mid-cycle leverage would be lower than these levels, including debt/EBITDA below 2x and adjusted debt/EBITDAR below 2.5x, and that FCF margins would return to a range of 5%-7%.
LIQUIDITY
The company's liquidity as of June 30, 2016 was $1 billion, consisting of $897 million of credit facility availability and $119 million in readily available cash and equivalents. The company also held $266 million of its cash at its foreign subsidiaries, $147 million of which the company considers permanently reinvested outside the U.S. However, FLS estimated the cash taxes due upon repatriation of the full foreign cash balance, if needed, would range between $5 million and $15 million.
FLS's debt structure consists of Euro and USD denominated senior unsecured notes and a senior unsecured term loan maturing in 2020. The company has a favorable maturity schedule with no significant maturities until 2022. The company's term loan amortizes by $60 million per annum for the next four years.
FULL LIST OF RATING ACTIONS
Fitch affirms the following ratings:
Flowserve Corporation
--IDR at 'BBB';
--Senior unsecured bank facilities at 'BBB';
--Senior unsecured notes at 'BBB'.
The Rating Outlook is Stable.
Summary of Financial Statement Adjustments - Fitch has made no material adjustments that are not disclosed within the company's public filings.
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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