Outlook On Japan#s Mitsubishi Heavy Industries Ltd. Revised To Negative, #A-# Long-Term Ratings Affirmed

Stocks and Financial Services Press Releases Friday May 19, 2017 17:55
TOKYO--19 May--S&P Global Ratings

TOKYO (S&P Global Ratings) May 19, 2017--S&P Global Ratings today said it has revised to negative from stable the outlook on its long-term corporate credit ratings on Japan-based diversified capital goods company Mitsubishi Heavy Industries Ltd. (MHI). We affirmed the 'A-' long-term corporate credit ratings.

The outlook revision reflects our view that there is more than a one-in-three chance major financial indicators for the company, including profitability measures that worsened in fiscal 2016, will not recover in the next two years.

Amid stagnant order receipts and intense competition in its core energy and environment business, the business' earnings are likely to take a long time to recover. Earnings from commercial aircraft and ships are also unlikely to recover quickly.

In addition, a potential risk of major losses still exists, in our view. However, ratios of the company's cash flow adequacy and leverage have not deteriorated materially, because the company has sold assets to reduce debt. Accordingly, we have affirmed the ratings.

MHI made ¥150.5 billion in operating income in fiscal 2016 (ended March 31, 2017), materially lower than the ¥240 billion it estimated when it revised downward its forecast income in February. The decline is attributable mainly to a fall in revenues from post-sale services for thermal power generation plants in its core energy and environment business.

It also results from an increase in development costs for the Mitsubishi Regional Jet (MRJ) produced in Japan. As a result, we estimate MHI's EBITDA margin (after our adjustments) declined to 8%-9% in fiscal 2016 from about 11% in fiscal 2015.

We believe total sales in fiscal 2017 and thereafter may not grow as much as the company predicts, because of the possibility of a rise in its ratio of long-term contracts to total orders receipts or a further delay in the progress of large-scale deals in its energy and environment business.

Earnings in the commercial aircraft and commercial ship businesses are also likely to take longer to improve than the company predicts, given weak short-term demand for its products in this area.
Accordingly, we see a limited recovery of earnings this fiscal year, and we see a lower possibility its EBITDA margin will recover to our previous forecast of about 11% in fiscal 2018.

MHI has already taken measures to cut risk factors related to large cruise ships, Mitsubishi Motors Corp., and claims related to the San Onofre nuclear power plant in the U.S after fixing its losses for fiscal 2016.

However, higher costs for its commercial ship business and development of the MRJ in its commercial aircraft business may not be a one-off.

Also still remaining is the risk of major losses if MHI and Hitachi Ltd. fail to agree on how to cover costs related to a joint venture's involvement in a thermal power generation plant project in South Africa. Therefore, we think the company's operating performance may weaken in fiscal 2017 and thereafter.

We maintain our assessment of MHI's business risk profile as satisfactory, in accordance with the company's relatively high competitive advantage globally in its thermal power generation system and commercial aviation businesses.

Our assessment also reflects its important role in Japanese government policies in the fields of defense and space, and commercial aviation and transportation systems, as well as its stable customer base.
However, the assessment remains under downward pressure, given the company's profitability, relatively stable until fiscal 2015, is likely to remain weaker than our assumptions over the next one to two years.

MHI's EBITDA declined in fiscal 2016. However, cash flow adequacy and leverage ratios for the company did not deteriorate materially, because the company reduced debt through asset sales and other measures. We estimate debt to EBITDA after our adjustments as of the end of fiscal 2016 deteriorated only to about 2.5x from 2.1x the previous year.

Considering an expected moderate recovery of operating income and free cash flow in fiscal 2017 and thereafter, as well as the company's conservative capital expenditure plans, we expect debt to EBITDA to improve to slightly below 2.0x as of the end of fiscal 2018.

Given all these factors, we evaluate MHI's financial risk profile as modest. In addition, we consider MHI's business diversification--spanning such fields as capital goods, commercial aviation, defense and space, engineering and construction, and automotive products--helps stabilize the company's overall earnings. As a result, we raise the rating a notch to incorporate our positive assessment of diversification/portfolio effect for MHI.

We make the following assumptions in our base-case scenario: Orders receipts in fiscal 2017 will be slightly below the company's ¥4,500 billion forecast,Total sales will grow at a rate slightly below the company's 6% forecast,Annual capital expenditures will be ¥200 billion,Asset sales and cost reductions will mostly cover sizable losses from large-scale deals, if any,Positive free cash flow will lower MHI's debt balance as of March 31, 2018, from a year earlier, and The company has no planned mergers and acquisitions requiring additional debt financing.

Under this base-case scenario, we estimate key financial indicators will be as follows: EBITDA margin will improve moderately to marginally below 9% in fiscal 2017 and over 10% in fiscal 2018, andDebt to EBITDA will improve steadily to below 2x as of the end of March 2019.We assess MHI's liquidity as adequate.

We expect MHI's liquidity sources to exceed 1.2x uses over the next 12 months. We believe MHI has maintained extremely strong relationships with its main banks, including Bank of Tokyo-Mitsubishi UFJ Ltd., and good access to capital markets. We also expect the company will maintain a relatively conservative financial policy.

We expect MHI's liquidity sources to include cash and equivalents of about ¥200 billion, annual funds from operations (FFO) of about ¥300 billion, and asset sales. MHI's liquidity uses are likely to include debt repayment of about ¥150 billion and annual capital expenditures of about ¥200 billion. We may consider lowering the rating if we see a lower likelihood of improvement in MHI's consolidated EBITDA margin to 10% in fiscal 2018.

This could happen if the company's earnings fall further because of lower profitability, despite enhancement of cost control, including project management, in its energy and environment businesses. We may also lower the rating if we see a higher likelihood of MHI's debt to EBITDA remaining above 2.5x for a prolonged period.

Conversely, we may consider revising upward our outlook if MHI's EBITDA margin is highly likely to exceed 10% in fiscal 2017, supported by a reduction in fixed expenses, improved working capital management, and improved management efficiency.

We may also consider revising upward the outlook if debt to EBITDA improves to below 2.0x and stays at that level.

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