The ratings on Germany-based defense contractor Heckler & Koch reflect Standard & Poor's Ratings Services' assessment of the company's business risk profile as "weak" and financial risk profile as "highly leveraged" under our criteria.
Our assessment of Heckler's business risk profile reflects the company's limited size, competitive pressure, and high customer concentration. These risks are partially offset by Heckler & Koch's strong brand recognition and satisfactory profitability.
The company's weak liquidity, weak credit measures, and very aggressive financial policy are the main reasons for our classification of its financial risk profile as "highly leveraged". We also envisage that Heckler & Koch will have limited financial flexibility to meet any high-impact, low-probability events, particularly as the group has only a small revolving credit facility to draw on.
S&P base-case operating scenario
In the first nine months of 2012, the group's revenues increased by 22% on the same period of the previous year, largely due to the shipment of certain items delayed from 2011. In our base-case scenario, we estimate that Heckler & Koch's 2012 revenues will be about 15% higher than in 2011. This results mainly from the postponement of deliveries from the fourth quarter of 2011 to the first quarter of 2012 and some new contract wins. For 2013, we expect revenues to decline by about 10% compared with 2012, based on the current order book and excluding significant postponements of deliveries from the fourth quarter of 2012 to the first quarter of 2013. We further assume that potentially negative effects of defense spending cuts introduced by various European governments, particularly the U.K. government, will be mostly offset by winning new contracts in other geographic regions. The current order book provides us with comfort that the revenue increase in financial 2012 and 2013 is unlikely to be much lower than our current estimate. At the end of September 2012, Heckler & Koch's contracted order book was EUR198 million, of which EUR69 million was due for delivery within 2012. We will, however, monitor Heckler & Koch's order intake in the fourth quarter and for 2013 closely through the year to evaluate any effects arising from generally lower government spending on defense contracts and postponements of deliveries.
The group's Standard & Poor's-adjusted EBITDA margin for financial 2011 stood at 20%, but we anticipate that the margin for financial 2012 will improve to about 22% due to higher sales and changes in its product and customer mix. For 2013, we expect that the company will maintain that level.
S&P base-case cash flow and capital-structure scenario Under our base-case credit scenario, we estimate that Heckler & Koch's ratios of debt to EBITDA and funds from operations (FFO) to debt will improve to about 7.0x and 5%, respectively, by financial year-end Dec. 31, 2012, from 9x and 1% by the end of 2011. The projected improvement in these ratios is largely due to higher revenues and a change in product and customer mix compared with the previous year. As a result, we project that the group will generate a small amount of free operating cash flow (FOCF) in 2012. Although we have seen some liquidity improvements in the nine months of 2012 due to cash inflows from delayed deliveries, we think any delay in improving the cash flow further could endanger the bond interest payment of EUR14 million in May 2013.
In our view, Heckler & Koch's liquidity is "weak", as defined by our criteria. Heckler & Koch's sources of liquidity consist of surplus cash and cash flow from operating activities. As of Sept. 30, 2012, the group reported a cash balance of EUR24.0 million. We believe that the cash was fully utilized by its guarantee lines, operating needs (which we assume to be EUR10.0 million), and the bond interest payment of EUR14 million made in November 2012. We therefore believe that Heckler & Koch will have limited financial flexibility to meet any significant operating challenges, and that its liquidity sources may not be sufficient to cover its liquidity uses.
Heckler & Koch's current credit facilities are mainly for the issue of advance payments or performance guarantees. The company only has a EUR5 million credit line in place, which could be used for cash drawings and of which EUR3.3 million was undrawn by end of September 2012.
Heckler & Koch's senior secured notes are not subject to maintenance financial covenant tests or a material adverse change clause. However, there is an incurrence-based test restricting Heckler & Koch from raising additional debt above 2x fixed-charge coverage.
The issue rating on the existing EUR295 million 9.5% senior secured notes due May 2018 issued by Heckler & Koch GmbH is 'CCC', in line with the corporate credit rating. The recovery rating on the notes is unchanged at '4', indicating our expectation of recovery at the low end of the (30%-50%) range in the event of a payment default.
The recovery rating on the senior secured notes is supported by the company's going concern valuation, the limited amount of priority liabilities ahead of the notes, and the favorable insolvency regime in Germany. At the same time, the recovery rating is constrained by the notes' weak security package consisting only of share pledges and fairly loose debt baskets covenants included in their documentation.
To calculate recoveries, Standard & Poor's simulates a hypothetical default scenario. We believe that a default would most likely be triggered by a difficult operating environment resulting in lower revenues and negative cash flows with an inability to meet the scheduled interest payments. We have simulated our hypothetical default scenario in 2013.
We have valued the group on a going concern basis at default, as we believe that, in case of a hypothetical default, given the company's good brand name and market position, it would probably be reorganized and sold. 'For this reason, we have not included performance guarantees, outstanding in the amount of EUR20 million, in our waterfall.
We value the business using a discrete asset valuation, applying haircuts to the book value of the group's assets. From the gross enterprise value at the point of default of about EUR144 million, we deducted a prior-ranking revolving credit facility of EUR5 million and priority obligations comprising enforcement costs and 50% of the unfunded pension deficit, to arrive at the residual amount of about EUR102 million available for the senior secured noteholders. At the point of default, we assume EUR309 million of senior secured notes outstanding (including six months of prepetition interest) resulting in recovery prospects at the low end of the 30%-50% range for the senior secured notes.
The negative outlook reflects our opinion of the possibility that Heckler & Koch's very tight liquidity will not improve in the fourth quarter of 2012 and first quarter of 2013, which could potentially put its interest payments of EUR14 million in May and November 2013 at risk. Liquidity is strongly dependent on the timing of order delivery, which has shown some volatility and is to some degree not predictable. In the absence of timely order delivery and working capital management, liquidity would be insufficient, and we would therefore consider a downgrade.
Under our base case, we believe that the company will have sufficient cash on the back of the completion of delayed orders and the order book as of Sept. 30, 2012, which is about 11 months for the cash interest payment in May. We note, however, that despite satisfactory profitability, Heckler & Koch's cash generation is weak, and, as a result, limited downward diversions from our base-case assumptions could create significant liquidity stress. These downward diversions could, for example, come from a weaker order book or further delays in export license approvals.
An outlook revision to stable would in our view depend on the group's ability to significantly improve its liquidity position for the next 12 months. Given the high biannual interest payments and high leverage, weak cash flow and ongoing tight liquidity and variability of order delivery, the outlook could stay negative beyond our outlook horizon of one year.