Fitch Affirms Allison Transmission's IDR at 'BB'; Outlook Stable
KEY RATING DRIVERS
The ratings of ALSN and ATI continue to be supported by the company's high margins and strong free cash flow (FCF), set against a backdrop of elevated leverage. ALSN continues to lead the global market for fully automatic transmissions for commercial vehicles, off-road machinery and military equipment.
ALSN's market position in North America remains very strong, with 98% of the school buses and 77% of the medium-duty commercial trucks manufactured in the region delivered with the company's transmissions in 2015. In addition, 61% of the Class 8 straight trucks and 40% of the Class A motorhomes produced in North America in 2015 were manufactured with the company's transmissions. Unlike most Tier 1 suppliers, ALSN has a brand name that is recognized by end users, and its transmissions command a price premium in the market. Over time, Fitch expects the market for commercial vehicle automatic transmissions to grow in North America as truck operators increasingly choose automatic transmissions for increased fuel efficiency. Automatic transmissions also increase the pool of available drivers for end users, which is becoming increasingly important as driver turnover in the trucking industry remains high.
Outside North America, ALSN's market position is significantly smaller, as the penetration of automatic transmissions in commercial vehicles remains relatively low. However, outside North America, acceptance of fully automatic transmissions is growing, particularly for certain types of vocational vehicles, such as buses and fire engines. This has been especially true in certain emerging markets like China and India, where ALSN is well positioned for future growth opportunities. Over the longer term, Fitch expects automatic transmissions to gain in popularity among commercial vehicle end users for many of the same reasons that automatic transmissions are increasingly used in North America.
Fitch's concerns continue to include the heavy cyclicality of the global commercial vehicle and off-highway equipment markets, volatile raw material costs, the relative lack of global diversification in ALSN's current business mix, moderately high leverage and a concentrated debt maturity schedule. However, it is notable that the company's transmissions are tend to be used primarily in the vocational truck market, which is generally less cyclical than the Class 8 linehaul tractor market, as Class 8 linehaul tractors continue to be primarily delivered with manual transmissions. Nevertheless, a broad-based global downturn in commercial vehicle and off-road equipment production, more severe than the current depressed market, would put increased pressure ASLN's profitability and FCF. In addition, although the proposed refinancing transactions will spread ALSN's maturity schedule, it will still remain relatively concentrated over a couple of years.
The refinancing of a portion of the term loan with proceeds from the proposed senior unsecured notes will help to diversify ALSN's capital structure, while pushing is significant maturities further into the future. Following several refinancings and credit facility amendments over the past four years, all of ALSN's debt has become concentrated in its single Term Loan B-3. As of June 30, 2016, a total of $2.4 billion principal remained outstanding on the loan. Amortization payments on the loan have only amounted to about $25 million per year, but the highly concentrated maturity schedule, with the majority of the loan coming due in 2019, has been a concern. The refinancing will reduce the amount of the final loan maturity, and the credit facility amendment will move it out to 2022, but it will remain a concern. However, the company will have the opportunity to prepay portions of the loan early, which could provide it with some flexibility in managing the final maturity.
Fitch expects ALSN's EBITDA to remain in the mid-3x range over the intermediate term, while FFO adjusted leverage will likely rise to the high-3x range, both of which are somewhat elevated for the rating category. Both metrics will be pressured in the near term by lower earnings and cash flow resulting from relatively weak conditions in many of ALSN's global end markets. As of June 30, 2016, ALSN's EBITDA leverage, (debt/Fitch-calculated EBITDA), was 3.6x, while FFO adjusted leverage was 3.5x. However, despite the weakened end-market demand, ALSN's profitability has remained very strong by industry standards, with an EBITDA margin of 35.2% in the last 12 months (LTM) ended June 30, 2016.
Although ALSN's leverage is high for its rating category, this is mitigated by the company's very strong profitability and FCF generation, which provides it with significant financial flexibility. Fitch expects ALSN to continue producing strong FCF over the intermediate term, with post-dividend FCF margins generally running in the high teens, which is strong for a capital goods-related supplier. ALSN's capital spending needs are relatively low, and Fitch expects its capital intensity (capital spending/revenue) to run in the 3% to 4% range over the intermediate term, which is roughly consistent with its actual range over the past several years. Fitch expects the company will deploy much of its post-dividend FCF toward share repurchases, with the potential for some further debt reduction as well. FCF after dividends in the LTM ended June 30, 2016 was $466 million, equal to a very strong 24.4% FCF margin, although, as noted, Fitch expects FCF margins to moderate somewhat going forward.
With its strong FCF generating capability, Fitch expects ALSN's liquidity to remain adequate over the intermediate term. At June 30, 2016, ALSN had $364 million in cash and cash equivalents, with about 88% located in the U. S. This level of cash was higher than what the company usually carries, and Fitch expects the company's cash balance will likely decline toward a more typical level closer to $200 million over the intermediate term. In addition to its cash, ALSN's liquidity is bolstered by access to its $465 million secured revolver, which had $462 million available at June 30, 2016, after deducting $2.6 million for letters of credit backed by the facility. As part of the proposed refinancing transaction, the company plans to reduce the size of the revolver to $400 million, which will still provide the company with a significant liquidity buffer.
Over the last couple of years, ALSN has begun returning more cash to shareholders through dividends and share repurchases. In the LTM ended June 30, 2016, the company paid a total of $103 million in common dividends and spent a net $280 million on share repurchases. The current share repurchase authorization was put in place in October 2014, allowing up to $500 million in repurchases through year-end 2016. Through June 30, 2016, ALSN had repurchased $398 million in shares under the repurchase authorization. Fitch expects that ALSN will continue to target most of its excess cash toward share repurchases, although Fitch also expects the company would pull back on repurchases if it needed to conserve liquidity.
ALSN has drawn interest from several activist investors over the past two years, including ValueAct Capital, Longview Asset Management and Ashe Capital Management. According to ALSN's most recent proxy statement, ValueAct holds an 11% equity stake in the company, while Ashe and Longview hold stakes of 5.9% and 5.1%, respectively. ValueAct and Longview both have representatives on ALSN's Board of Directors, while earlier in 2016, Ashe nominated a director and put forward some governance proposals that it subsequently withdrew after ALSN made changes to its corporate bylaws. Although the influence of activists is a concern, Fitch does not believe the changes in governance that have resulted from the activists' involvement have been detrimental to the company's creditors. It is also mildly positive that ALSN was able to placate the activists' concerns without a drawn-out proxy fight.
ALSN's pension obligations are modest, with an underfunded status of only $0.3 million as of year-end 2015. The company's salaried pension plan was closed to new entrants in 2007, and its hourly plan was closed to new entrants in 2008. Benefits for hourly employees who retired prior to Oct. 2, 2011, are covered under General Motors Company's hourly plan. Fitch does not view ALSN's pension obligations as a meaningful credit risk.
The secured revolver and term loans that comprise ATI's credit facility are rated 'BB+/ RR1', one notch above ATI's IDR, due to their collateral coverage, which includes virtually all of ATI's assets. Fitch notes that property, plant, and equipment and intangible assets (including intellectual property) comprised $1.7 billion of the $4.5 billion in assets on ALSN's consolidated balance sheet at June 30, 2016. The proposed senior unsecured notes are rated 'BB(EXP)/RR4' reflecting Fitch's expectations of average recovery prospects in a distressed scenario.
--Global end-market demand remains relatively weak through 2016, with some improvement in demand beginning in 2017 and further demand improvement in 2018 and 2019;
--Margins improve slightly over the intermediate term on improved production volumes, price increases and further cost efficiencies;
--The company's refinancing plans are completed as contemplated;
--Capital spending in 2016 is forecast at the midpoint of the company's guidance, and then runs at about 4% of revenue in following years;
--The company keeps roughly $150 million to $250 million in cash on its balance sheet, with excess cash used for share repurchases;
--The cash flow effects of any dividend rate increases are largely offset by a lower share count.
Positive: Future developments that may, individually or collectively, lead to a positive rating action include:
--A decline in Fitch-calculated EBITDA leverage to below 3.0x;
--An increase in the global diversification of its revenue base;
--Maintaining EBITDA and FCF margins at or above current levels;
--Continued positive FCF generation in a weakened demand environment.
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
--A sustained significant decline in EBITDA margins or an extended period of negative FCF;
--A competitive entry into the market that results in a significant market share loss;
--An increase in leverage to above 4.0x for a prolonged period;
--A merger or acquisition that results in higher leverage or lower margins over an extended period.
Fitch has taken the following actions:
--Long-Term IDR affirmed at 'BB'.
--Long-Term IDR affirmed at 'BB';
--Secured revolving credit facility rating affirmed at 'BB+/RR1';
--Secured Term Loan B-3 rating affirmed at 'BB+/RR1';
--Senior unsecured notes rating assigned at 'BB(EXP)/RR4'.
The Rating Outlook for both ALSN and ATI is Stable.