Fitch Affirms Exelis at 'BBB+'; Outlook Negative

Fitch Ratings has affirmed the 'BBB+' Issuer Default Rating (IDR), 'BBB+' long-term debt and revolving credit facility ratings, and 'F2' short-term rating of Exelis Inc. (XLS). The Rating Outlook is Negative. The ratings cover $650 million of long-term debt and the $600 million commercial paper program. A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS

XLS's large underfunded pension obligations; the uncertainty surrounding the U.S. Department of Defense (DoD) budget; the impact of the second phase of sequestration beginning fiscal 2014; and deteriorating revenues accompanied with slight margin pressures are Fitch's main rating concerns.

The company's pension obligation reached approximately $2 billion (68% funded) as of Dec. 31, 2012. Even though large underfunded pension liabilities are not expected to have an immediate impact on the company's liquidity, the significant long term cash outflows is a concern for the ratings. Fitch believes that the funded status of XLS's pension liabilities will improve by the end of 2013 driven by favorable interest rate movements, strong performance of the global equity markets and some of the company's actions, including offering lump sum buyouts to some employees and freezing the plan as of 2016.

XLS's revenues declined more than expected during the first half of 2013 mainly driven by the implementation of sequestration and lower military activities in Afghanistan. While sequestration negatively impacts the whole industry, revenue pressures is a higher credit risk for XLS because of a high percentage of cash flows needed to fund required pension contributions. Additionally, XLS's margins in the C4ISR Electronics and Systems segment declined sharply in 2013, significantly driven by charges related to an ongoing restructuring.

While the operating profit declines in the segment are somewhat mitigated by stronger than expected performance in the Information and Technical Services segment, Fitch is concerned with the potential future deterioration in the company's operating margins. Fitch is also concerned with the company's long term ability to maintain the cost reduction pace with possible further declines in U.S. military spending.

XLS's ratings are supported by the company's highly diversified portfolio of defense-related products and services provided to U.S. military and government customers. XLS has more than 1,000 prime and sub contracts which mitigate the exposure to a major program cancelation. The company's core businesses focus on the DoD's high priority programs in information, surveillance and reconnaissance (ISR), electronic warfare, cyber, and information and technical services. Additionally, the company benefits from strong cash flow generation, a good backlog and adequate credit metrics for the ratings.

Fitch expects the company to maintain solid credit metrics with liquidity in the $900 million to $1 billion range, and leverage (gross debt to EBITDA) within the range of 0.9x to 1.1x through 2015. Leverage metrics based on funds from operations (FFO) instead of EBITDA are not as strong because of the company's significant cash pension contributions. Fitch expects FFO adjusted leverage to be in the range of 3.1x to 3.3x, which is high for the ratings.

XLS typically generates negative free cash flow (FCF - cash from operations less capex less dividends) during the first half of a year. During the first half of 2013 (1H'13), the company's FCF totaled negative $11 million, a significant year over year improvement from the negative FCF of $199 million in 1H'12 driven by better operating results and lower working capital requirements. Fitch expects the company's FCF for the year to be in the range of $140 million to $160 million in 2013, slightly down from the $189 million FCF generated in 2012. XLS's cash deployment strategy is expected to be conservative with approximately $76 million of cash dividends and minimal share repurchases.

As of Dec. 31, 2012, XLS's pension obligations totaled approximately $6.1 billion with a pension deficit of approximately $2 billion (68% funded). The other postretirement benefit obligation was $255 million. XLS plans to contribute approximately $160 million to the pension in 2013 and had already contributed $62 million as of June 30, 2013. Fitch believes XLS's pension obligations are manageable due to the company's solid FCF generation; however, the size of the underfunded obligations and significant funding requirements relative to the overall size of the company is a rating concern.

U.S. government spending trends are key drivers of XLS's financial performance given that the company generates approximately 69% of its revenues from the DoD and U.S. Intelligence Community. The DoD budget environment is highly uncertain during fiscal 2014 because of the large, automatic spending cuts which went into effect on March 1, 2013. The full implementation of sequestration driven defense spending reductions beginning with fiscal 2014 will increase pressure on revenues for most U.S. contractors. However, Fitch believes it will not necessarily have a significant effect on credit ratings in the U.S. aerospace and defense sector if companies take actions to offset the impact of the sequester.

The fiscal 2014 budget request submitted by President Obama in April 2013 attempted to avert sequestration cuts for the DoD and stabilize defense spending at the fiscal 2013 budget request level. The fiscal 2014 DoD budget may be significantly reduced from fiscal 2013 levels as the proposal had not been approved at the end of fiscal 2013. A continuing resolution (CR) to fund the DOD was put into place as part of the deal ending the recent government shutdown, but the CR is in effect only until January 15th, leaving the spending outlook unclear for the rest of fiscal 2014. Such uncertainty creates a significant challenge for defense contractors because it impairs their ability to plan appropriate cost cutting measures to counter the potential DoD spending cuts.

Sequestration is incorporated into Fitch's ratings for XLS, and Fitch believes that the implementation of sequestration cuts in fiscal 2014 would not lead to negative rating actions given XLS's good liquidity, product line diversification, and solid program execution. Additionally, sequestration is expected to impact new awards and Fitch believes XLS will be able to adjust its cost structure to maintain profitability.

RATING SENSITIVITIES

Fitch may consider a negative rating action if there is a large increase in required pension contributions or if the pension deficit does not decline as expected at the end of 2013. A negative rating action could also be considered if the company's cash generation declines significantly either due to poor operating performance or unexpected negative changes in U.S. defense spending policies. Fitch is not likely to consider a positive rating action given XLS's large pension liability, declining revenues, margin pressures and uncertainty surrounding U.S. DoD budget.

Fitch affirms XLS's ratings as follows:

--IDR at 'BBB+';

--Senior unsecured notes at 'BBB+';

--Senior unsecured revolving credit facility at 'BBB+';

--Short-term IDR at 'F2';

--Commercial paper at 'F2'.

The Rating Outlook is Negative.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage' (Aug. 5, 2013).

Applicable Criteria and Related Research:

Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715139

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=806184

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Fitch Ratings
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