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Standard & Poor’s (S&P), a division of The McGraw-Hill Companies Inc. , recently upgraded the corporate credit rating of Harman International Industries, Inc. (HAR - Snapshot Report) to BB+ from BB with a positive outlook.

Harman also announced that S&P has raised the issue rating on the company's senior unsecured notes to BB from BB- and Harman’s corporate credit rating is expected to be upgraded to investment grade by next year.

S&P cited the company’s strong backlog as the primary reason for the upgrade. The rating agency also noted robust margins (expects double-digit growth) and strong free cash flow generation ability to be the growth drivers of the company going forward. The agency also believes that Harman has sufficient liquidity to repay its debt balance of $400.0 million in 2012.

We believe that the upgrade reflects Harman’s strong first quarter 2012 performance and improving liquidity. As of September 30, 2011, total available cash was $1.2 billion, including $543.0 million available under its credit facility. The upgrade will further increase Harman’s debt raising capabilities, which in turn will boost its capacity expansion plans in our view.

Harman has been realigning its manufacturing facilities by closing down factories in high-cost zones and shifting production to low cost areas such as Hungary, Ukraine, Brazil and China. The company has also been expanding its manufacturing capacity in these regions over the last 12 months.

Recently, Harman opened a new manufacturing facility in the Dandong region in China. The launch of the new facility highlights the company’s additional $100.0 million investment plan to strengthen manufacturing and research capabilities in China.

Harman’s decision to increase investment in China makes sense as a large chunk of global auto production has now shifted to the country. Further, demand for audio systems from Chinese automakers is also on the rise. Premium automakers, such as Geely Motors, BYD and Dongfeng Passenger Vehicle are already using Harman’s superior sound systems.

We believe that the strong automobile backlog will drive top-line growth going forward. At the end of first quarter of 2012, infotainment awarded business backlog amounted to $11.4 billion, while automotive backlog was $3.1 billion. Given increasing adoption rates in the emerging markets of Brazil, Russia, India and China, Harman expects to outperform the overall automotive sector going forward.

Harman boasts a solid product pipeline that is supported by more than 3500 patents, and the company intends to roll out new infotainment products in order to further drive sales. The company expects to deliver impressive margins for the next two years on the back of robust demand for the infotainment business.

We believe that a further increase in Harman’s rating to investment grade will attract new investors intending to partake of the growth story attached to the emerging markets and BRIC countries where Harman is expected to gain significant market share going forward.

Although year-to-date, Harman shares have underperformed the broader S&P 500 by 13.38%, we expect further decline due to volatile macro economic conditions prevailing in Harman’s major market (Europe). Moreover, higher level of investments related to capacity expansion can hurt profitability going forward.

We maintain our Neutral recommendation on a long-term basis (6-12 months). A stellar first quarter 2012 performance with earnings growing 97.0% year over year makes us optimistic on the stock. Currently, Harman has a Zacks #1 Rank, which implies a Strong Buy rating on a short-term basis (1-3 months).

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