Fitch Places Navistar and NFC on Positive Watch on Announcing Strategic Alliance with Volkswagen
The strategic alliance includes an equity investment by VW T&B equal to 16.6% of NAV's common shares on a pro forma basis that will result in $256 million of cash proceeds to NAV, agreements to collaborate on powertrain and other technologies, a procurement joint venture (JV), and the addition of two VW T&B representatives to NAV's board of directors. A joint alliance board will oversee alliance arrangements. Closing of the share purchase agreement and implementation of the alliance will be subject to regulatory approvals and certain closing conditions.
The Positive Watch reflects Fitch's expectation that the equity investment and strategic alliance will create benefits for NAV including a moderate increase in near-term liquidity and financial flexibility, $200 million of annual synergies by the end of five years ($500 million cumulative by year five), and opportunities to leverage technology with VW T&B. An expansion of NAV's technological capabilities could involve engines sourced internally or from within the alliance for use in NAV trucks, a larger parts business, and opportunities to share technology development costs for trucks, engines, and digital technology related to data and analytics. NAV's dealer base would improve VW T&B's access to the North America (NA) market where VW T&B has a limited presence.
Fitch expects to resolve the rating watch after it has an opportunity to review additional details of the transaction and assess the impact on NAV's credit profile. The ratings could be upgraded by one notch depending on the pace of operating improvements from the alliance, Fitch's estimate of near-term free cash flow (FCF) and liquidity, and the impact on customer confidence and NAV's future market share. Fitch notes that some aspects of the alliance will become effective gradually, including the use of VW T&B power train components in NAV trucks which could occur beginning in 2019, realizing benefits from common sourcing, and product introductions associated with collaboration on technology. NAV still faces near-term challenges including the cyclical downturn in the NA heavy-duty truck market and a slow recovery in market share. However, concerns about liquidity are reduced by the planned equity investment by VW T&B, and Fitch believes a more extensive alliance is possible which could further strengthen NAV's credit profile.
KEY RATING DRIVERS
Fitch's 'CCC' Issuer Default Rating (IDR) for NAV incorporates NAV's low liquidity and negative FCF which Fitch expects will improve more slowly than originally expected, largely due to the cyclical downturn in the heavy duty truck market in the U. S. and Canada. The downturn is making it more difficult for NAV to rebuild market share, and weak industry conditions are contributing to high used-truck inventory and competitive pricing. The negative impact of these trends is partly offset by the improvement in core EBITDA margins due to restructuring and NAV's strategy of focusing on its core product markets.
Liquidity is adequate in the near term but continues to be a key rating concern before considering the pending alliance with VW T&B. Fitch believes NAV should be able to meet its projected manufacturing cash and marketable securities balance of approximately $800 million at the end of fiscal 2016. Fitch estimates this would be adequate to fund seasonally negative FCF that would be expected in the first quarter of fiscal 2017 (1Q17)) but it will be sensitive to working capital requirements. Fitch believes there is a risk that negative FCF in 1Q17 could be lower compared to 1Q16 due to pressure on earnings from lower sales volumes and the impact of high used-truck inventory.
Anticipated cash balances at the end of fiscal 2016 would be lower than the past two years, reducing NAV's capacity to adjust to negative developments such as further deterioration of the truck market, loss of market share, or adverse litigation resulting in a large payment by NAV. The next significant scheduled debt maturity is $200 million in October 2018. In recent years, NAV has received modest funding from NFC, but Fitch expects this funding to decline or reverse.
The company's EBITDA margin as calculated by Fitch was 3.9% at April 30, 2016 on a last-12-months (LTM) basis, an improvement compared to 1.4% in 2015 and low levels during the past several years while NAV implemented its revised engine strategy. In 2Q16, NAV reported its first quarterly profit since 2012, but a full-year profit for fiscal 2016 could be difficult to achieve because of weak industry conditions. The outlook for heavy duty truck demand in NA has weakened since late 2015, and demand could be below long-term replacement levels in 2016 and possibly decline again in 2017. Benefits from restructuring together with solid results in the parts business are mitigating the negative impact of lower volumes and low market share.
NAV's operating results are also being affected by high inventories of used trucks, competitive pricing, and charges for pre-existing warranties. Regular warranty costs remain below 3% of sales compared to a peak level above 7% several years ago, although NAV recognized $51 million of charges for pre-existing warranties in 1H16. The cash impact will be spread out over future periods, and the warranty charge appears to be contained. NAV's use of third-party engines and emissions equipment reduces research and development costs, as well as warranty costs, but also limits margins.
Fitch expects manufacturing FCF in fiscal 2016 will remain negative rather than become slightly positive as originally anticipated. Funds from operations have improved steadily but are being offset by working capital requirements partly associated with high used-truck inventory, contributing to the recent deterioration in FCF. While a return to positive FCF is possible in 2017, weak demand for heavy duty trucks and NAV's low market share could pressure near-term results including FCF and constrain the company's financial flexibility. NAV has tax losses that can be used to reduce future cash tax payments. FCF as calculated by Fitch excludes dividends from Financial Services and changes in intercompany used-truck financing.
Other factors that negatively affect NAV's FCF include cash costs for warranties and pension contributions. NAV's net pension obligation was just under $1.6 billion (61% funded) at fiscal year-end (FYE) Oct. 31, 2015. The company expects to contribute nearly $100 million in 2016, including $40 million during the first six months, and expects required annual contributions from 2017 to 2019 will be $100 million-$200 million.
NAV's market share of Class 8 trucks in the U. S and Canada was 11% in 1H16, down from 12% in 2015 and 20% or higher prior to 2012, and its share is behind the three other dominant commercial truck makers. Orders in NAV's traditional markets (Class 6-8 trucks and school buses) were down 21% in 1H16, with the decline most pronounced in Class 8 trucks. NAV's global truck business is also down significantly due to economic weakness in Brazil, although the business represented only 5% of NAV's consolidated revenue in 2015 as estimated by Fitch. The medium-duty market is more stable and NAV's share, while well below historical levels, is holding up better. NAV continues to invest in product development, which could provide opportunities to regain market share over the long term.
At April 30, 2016, debt/EBITDA was over 9x, reflecting low but improved earnings. Fitch does not include intercompany loans from Financial Services in manufacturing debt, and leverage would be higher when including these liabilities. NAV's use of intercompany funds from Financial Services includes loans and dividends. The net amount of loans and dividends provided to NAV in 1H16 was $97 million, some of which Fitch expects will be reversed in the second half. NAV made a small amount of repayments in 2015, net of dividends from NFC. Loans include used-truck inventory financing utilized by NAV to facilitate new truck sales.
Litigation risks include a lawsuit by the U. S. Department of Justice which is seeking penalties of up to $291 million on behalf of the U. S. Environmental Protection Agency related to NAV's use of engines during 2010 that did not meet emissions standards. In the event of an adverse outcome, a large payment would exacerbate concerns about liquidity, although Fitch expects the timing of any payments could be delayed in a lengthy litigation process. Other litigation includes class action lawsuits concerning NAV's discontinued advanced EGR engines, and shareholder lawsuits. In March 2016, NAV reached a settlement with the SEC regarding its investigation into NAV's accounting and disclosure practices, resulting in a cease-and-desist order and, among other things, NAV's payment of a $7.5 million penalty.
The Recovery Rating (RR) of '1' for Navistar, Inc.'s senior secured term loan facility supports a rating of 'B', three levels above NAV's IDR, as Fitch expects the loan would recover more than 90% in a distressed scenario based on a strong collateral position. The 'RR4' for senior unsecured debt reflects average recovery prospects in a distressed scenario. The 'RR6' for senior subordinated convertible notes reflects a low priority position relative to NAV's other debt.
NAVISTAR FINANCIAL CORPORATION
Fitch believes NFC is core to NAV's overall franchise. Thus the IDR of the finance subsidiary is directly linked to that of its ultimate parent due to the close operating relationship and importance to NAV, as substantially all of NFC's business is connected to the financing of dealer inventory and trucks sold by NAV's dealers. The relationship is formally governed by the Master Intercompany Agreement, as well as a provision referenced under NFC's credit agreement requiring NAV or Navistar, Inc. to own 100% of NFC's equity at all times.
NFC's operating performance and overall credit metrics are viewed by Fitch to be neutral to NAV's ratings. The company's performance has not changed materially compared to Fitch's expectations, but its financial profile remains tied to NAV's operating and financial performance. Total financing revenue decreased slightly for the first six months of 2016 (6M16) ended April 30, 2016, resulting from a decline in the average size of the wholesale and retail portfolio partially offset by higher accounts revenue. The average finance receivables balance decreased to $1.4 billion for 6M16, compared to $1.6 billion in the year-earlier period.
Asset quality of the underlying receivables portfolio remains stable, reflecting the mature retail portfolio, which continues to run off. Charge-offs and provisioning has also been stable as NFC continues to focus on its wholesale portfolio, which historically has experienced lower loss rates versus the retail portfolio.
NFC's leverage remains relatively low compared to its captive peers but has risen slightly in recent quarters due primarily to the upstreaming of $125 million in dividends to the parent (partially financed by an $80 million loan repayment to NFC) in 2015 and an additional $30 million in dividends in 2Q16. Balance sheet leverage, as measured by total debt to equity, was 3.2x as of April 30, 2016. Fitch believes NFC's leverage is appropriate and consistent with other captive finance companies. NAV continues to utilize the strength of NFC's balance sheet to enhance liquidity at the parent company, including re-establishing dividends and intercompany borrowing between NAV and NFC.
The 'B-' rating assigned to the existing senior secured bank credit facility reflects Fitch's view that the addition of a 1.35x collateral coverage covenant in the amended bank credit facility agreement on May 27, 2016 is a credit positive for lenders. The addition of this covenant helps support recovery ratings of 'RR3' and mitigates Fitch's earlier concerns that NFC could securitize all its remaining unencumbered assets, thereby leaving other senior secured lenders in a subordinate collateral position to the company's securitizations.
KEY ASSUMPTIONS
Fitch's key assumptions within the current rating case for NAV's manufacturing business, before considering the alliance with VW T&B, include:
--Manufacturing revenue in 2016 declines 15%-20% due to the industry downturn for heavy-duty trucks; termination of NAV's Blue Diamond Truck JV with Ford in 2015, a decline in exports, and pricing pressure;
--Industry demand for heavy-duty trucks declines in 2016 and possibly in 2017;
--NAV experiences no further significant declines in market share;
--FCF remains negative in 2016 and becomes slightly positive in 2017;
--EBITDA margins continue to improve slightly;
--Warranty expense, excluding adjustments to pre-existing warranties, remains below 3%.
RATING SENSITIVITIES
Navistar International Corporation
Fitch believes that the most likely resolution of the positive rating watch is an upgrade to the IDR by one notch and that this could occur if Fitch expects:
--Minimal risk that the strategic alliance will not receive regulatory approval;
--NAV will be able to realize the planned $200 million of annual synergies by the end of five years and $500 million cumulative by year five;
--Opportunities to leverage technology with VW T&B will result in the ability to source engines internally or from within the alliance and that this would boost margins;
--FCF becomes consistently positive.
Fitch could affirm the ratings if it expects benefits from the alliance will be substantially less than estimated.
Navistar Financial Corporation
NFC's ratings are expected to move in tandem with its parent. Therefore, positive rating momentum will be limited by Fitch's view of NIC's credit profile. However, negative rating action could be driven by a change in the perceived relationship between NFC and its parent. Additionally, a change in profitability leading to operating losses, a material change in leverage and/or deterioration in the company's liquidity profile could also yield negative rating actions.
The rating on the senior secured bank credit facility is sensitive to changes in NFC's IDR, as well as the level of unencumbered balance sheet assets in a stress scenario, relative to outstanding debt.
Fitch cannot envision a scenario where NFC would be rated higher than the parent.
LIQUIDITY
Navistar International Corporation
Liquidity at NAV's manufacturing business as of April 30, 2016 included cash and marketable securities totaling $730 million (net of the Blue Diamond Parts joint venture cash and restricted cash). NAV had limited availability under a $175 million ABL facility. Liquidity was offset by current maturities of manufacturing long-term debt of $83 million. In addition to the ABL, NAV uses an Intercompany Used Truck Loan from NFC under which $151 million was outstanding at April 30, 2016. NAV also had an outstanding intercompany loan of $190 million from NFC.
Navistar Financial Corporation
Fitch deems NFC's current liquidity to be adequate given available resources and the company's continued success in securitizing originated assets but notes that liquidity may become constrained if the parent materially increases its reliance on NFC to fund operations or if NFC is unable to refinance a sufficient amount of debt on economical terms.
As of April 30, 2016, NFC had $25.1 million of unrestricted cash and approximately $462.8 million of availability under its various borrowing facilities (subject to collateral requirements). Fitch views favorably NFC's ability to refinance a portion of its borrowing facilities and access the capital markets at reasonable terms, which should mitigate some potential near-term liquidity concerns.
As of April 30, 2016, debt at NAV's manufacturing business totaled $3.2 billion, including unamortized discount, and $2.1 billion at the Financial Services segment, the majority of which is at NFC.
FULL LIST OF RATING ACTIONS
Fitch places the following ratings on Rating Watch Positive:
Navistar International Corporation
--Long-Term IDR 'CCC';
--Senior unsecured notes 'CCC/RR4';
--Senior subordinated notes 'CC/RR6'.
Navistar, Inc.
--Long-Term IDR 'CCC';
--Senior secured term loan 'B/RR1'.
Cook County, Illinois
--Recovery zone revenue facility bonds (Navistar International Corporation Project) series 2010 'CCC'.
Illinois Finance Authority (IFA)
--Recovery zone revenue facility bonds (Navistar International Corporation Project) series 2010 'CCC'.
Navistar Financial Corporation
--Long-Term IDR 'CCC';
--Senior secured bank credit facility 'B-/RR3'.
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