Fitch Affirms Tenneco's IDR at 'BB '; Outlook Stable
KEY RATING DRIVERS
TEN's ratings continue to be supported by the company's market position as a top global supplier of emission control and vehicle suspension components, with a strong presence in both the original equipment and aftermarket segments. In addition, tightening regulations governing commercial truck and off-highway vehicle emissions in a number of global jurisdictions have led to increased growth opportunities and higher profitability for the company. TEN's credit profile is characterized by slowly declining, but somewhat variable, leverage and adequate liquidity. However, free cash flow margins are relatively low.
Primary risks to the company's credit profile include industry cyclicality, volatile raw material costs and variability in fuel prices. Cyclical risk is mitigated somewhat by the increasing diversification of the company's customer base and improving cost structure, as well as ever-tightening global emissions regulations, which will drive growth in the market for emission control products independent of global economic conditions. Also mitigating risk and supporting near-term liquidity is a lack of material debt maturities until 2019. Volatile fuel prices present a risk because TEN's equipment on smaller and more fuel efficient vehicles tends to be less profitable. As with other auto suppliers, TEN seeks to minimize the effect of volatility in raw material prices by passing along a substantial portion of the change in its material costs to its original equipment customers.
Another meaningful risk is the potential for an adverse outcome in the ongoing antitrust investigation of TEN being conducted by the European Commission (EC) and the U.S. Department of Justice (DOJ). Details of the investigation, the potential timing of any resolution and the ultimate exposure to TEN are currently unknown, but the DOJ's willingness to grant the company conditional leniency through the Antitrust Division's Corporate Leniency Policy is encouraging. The Leniency Policy limits TEN's exposure as long as the company self- reports matters to the DOJ and continues to cooperate with the DOJ's investigation. Nonetheless, a particularly adverse outcome from the investigation by either the EC or the DOJ could lead to a negative rating action.
TEN's secured revolver and secured Term Loan A both have a recovery rating of 'RR1' and are rated one-notch above the company's IDR, reflecting their substantial collateral coverage, which includes virtually all of the company's U.S. assets and up to 66% of the stock of its first-tier foreign subsidiaries. Based on Fitch's recovery rating criteria, 'BBB-' is the highest issue rating that may be assigned to an issuer with an IDR of 'BB+' or lower. Fitch has assigned a recovery rating of 'RR4' to TEN's senior unsecured notes, reflecting Fitch's revised expectations for an average recovery in a distressed scenario. The assignment of an 'RR4' recovery rating has led to an upgrade of the rating on TEN's senior unsecured notes to 'BB+'.
Fitch expects demand for TEN's Clean Air products to remain relatively strong over the intermediate term as global emissions requirements continue to tighten. In particular, increasingly strict regulations for commercial trucks and off-road equipment, as well as for locomotives and water-borne vessels, will contribute to revenue growth that outpaces the growth of global light vehicle production. Fitch also expects TEN's revenue stream to become increasingly diversified over the next several years as the company's product penetration in non-traditional segments increases. New technologies in the company's Ride Performance division, including active and semi-active suspension systems, will also contribute to growth in revenue and profitability, although Fitch continues to expect emissions control products to be the larger contributor to TEN's sales growth over the intermediate term. Despite these improvements, in the near term, sales are likely to be negatively affected by foreign exchange translation as a result of the strong U.S. dollar, which will mask much of the growth associated with higher business levels.
Fitch expects the higher margins generated by TEN's commercial and off-highway business to combine with improvements in the company's cost structure to support further margin growth over the intermediate term. Fitch's calculated EBITDA margin was 8.6% in 2014, but excluding substrate sales (which are largely passed through to the company's customers with little markup), the EBITDA margin would have been a relatively strong 11.1% for the year. In 2014, substrate pass-through revenue totaled \\$1.9 billion, or 23%, of the company's \\$8.4 billion in total revenue. Since larger engines require more substrates in their emissions control systems, substrate pass-through revenue is likely to increase as a percentage of the company's overall revenue over the intermediate term. This could result in some overall margin dilution that could offset a portion of the higher profitability associated with emissions control products for larger engines.
Fitch expects TEN's credit profile to strengthen modestly over the intermediate term on a combination of higher business levels and continued discipline on controllable costs. EBITDA gross leverage will likely decline modestly during 2015, potentially to below 1.5x by year end, and it is likely to decline further over the next couple of years. However, Fitch expects leverage to fluctuate through the year as the company uses its revolver and other short-term borrowings to offset typical seasonal swings in its cash flows. Debt levels will decline somewhat as the company makes normal amortization payments on its Term Loan A, but with net leverage near the company's target at year-end 2014, further debt reduction is likely to be a low priority. TEN ended 2014 with net leverage, according to its own calculation, of 1.1x, versus its target of 1.0x. This suggests that the company will deploy free cash flow primarily toward shareholder-friendly activities going forward, such as the \\$350 million share repurchase program announced in February 2015.
TEN's free cash flow was (\\$17) million in 2014, primarily due to increased capital spending to support the company's growth initiatives. However, in 2013 the company produced positive free cash flow of \\$220 million, the strongest level of free cash flow in years. In 2015, Fitch expects free cash flow to turn positive again, but it is likely to remain under pressure from relatively high capital spending. The company also has fully utilized it U.S. tax NOLs, which led to higher cash tax payments in 2014 and will continue to pressure free cash flow going forward. Over the past several years (with the exception of 2014), TEN's free cash flow margins have generally been in the low-single digit range, even after adjusting for substrate revenue, and Fitch expects the company to continue producing low-single-digit free cash flow margins over the intermediate term. These low free cash flow margins are a significant factor weighing on TEN's IDR and are well below those of higher-rated auto suppliers.
Despite the negative free cash flow, TEN's overall liquidity position remained adequate at year-end 2014. The company ended the year with \\$282 million in cash and cash equivalents, augmented by nearly full availability on its \\$1.2 billion secured revolver. (The company had \\$34 million in letters of credit backed by the revolver at year-end 2014.) However, most of TEN's cash was located outside the U.S. at year-end 2014. Going forward, Fitch expects cash liquidity to remain near the current level, with any excess cash targeted toward the company's recently announced \\$350 million three-year share repurchase program. Although TEN is likely to maintain only modest cash balances in the U.S., the company does repatriate cash when needed to fund certain U.S. activities. TEN has not been an acquisitive company in recent times, but Fitch expects the company would dial back on share repurchases to support its liquidity position in the event that it undertook an acquisition.
TEN's credit profile strengthened modestly in 2014 on continued improvements in the company's operating performance, which offset a slight increase in debt. Revenue increased 5.7% to \\$8.4 billion as the effect of higher business levels was partially offset by negative foreign exchange translation. Fitch's calculated EBITDA margin was 8.6% in 2014, up from 8.1% in 2013. As of year-end 2014, TEN's EBITDA leverage (debt/Fitch-calculated EBITDA) was 1.6x, down from 1.7x at year-end 2013, while debt rose to \\$1.13 billion from \\$1.10 billion. Lease-adjusted leverage (lease-adjusted debt/ EBITDAR) was 2.3x at year-end 2014. Fitch's calculation of lease adjusted leverage includes the impact of operating leases as well as \\$153 million in off-balance sheet borrowings on the company's European accounts receivable securitization facilities. FFO adjusted leverage at year-end 2014 rose slightly to 3.3x from 3.1x at year-end 2013, while FFO fixed charge coverage declined to 3.4x from 3.8x.
The funded status of TEN's global pension plans declined in 2014, falling to 78% at year-end 2014 from 84% a year earlier. In the U.S., the funded status declined to 75% from 82% at the end of 2013. As with many corporate plans, the year-over-year decline in the funded status was primarily due to a combination of lower long-term interest rates and revised mortality assumptions. TEN used a 4.1% discount rate to value its U.S. projected benefit obligation in 2014, down from 4.8% in 2013. On a dollar basis, TEN's global plans were underfunded by only \\$205 million (\\$115 million in the U.S.), which Fitch views as manageable given the company's liquidity position and free cash flow prospects. TEN has estimated that required cash contributions to its global pension plans will be \\$31 million in 2015, down from actual contributions of \\$46 million in 2014.
KEY ASSUMPTIONS
--Global economic conditions continue to improve at a modest pace, leading to low-single digit growth in global auto production.
--In addition to increased auto production, TEN's revenue benefits from higher commercial vehicle and off-road equipment demand as emissions regulations in these segments continue to tighten many global markets.
--With the improving vehicle production volumes and increased penetration, TEN's revenue and profitability grow, but negative foreign exchange masks much of the near-term revenue improvement.
--Capital spending remains elevated by historical standards over the intermediate term to support new product wins and growth in the company's manufacturing footprint.
--Debt maturities are refinanced through over the next several years.
--Share repurchases total of \\$350 million over the next three years, and the company continues with share buybacks following the expiration of the current program.
--The company's cash remains near the year-end 2014 level though the intermediate term.
RATING SENSITIVITIES
Positive: Further developments that may, individually or collectively, lead to a positive rating action include:
--An Increase in TEN's value-added free cash flow margin to about 3% on a consistent basis;
--A decline in FFO adjusted leverage to 2.5x or lower;
--An increase in FFO fixed charge coverage to 5x or higher.
Negative: Further developments that may, individually or collectively, lead to a negative rating action include:
--A severe decline in global vehicle production that leads to reduced demand for TEN's products;
--A decline in TEN's value-added free cash flow margin to below 1% for an extended period;
--An increase in FFO adjusted leverage to 4x or higher;
--A decline in FFO fixed charge coverage to 3x or lower;
--An adverse outcome from the antitrust investigation that lead to a significant decline in liquidity or an increase in leverage.
Fitch has taken the following rating actions on TEN with a Stable Rating Outlook:
--IDR affirmed at 'BB+';
--Secured revolving credit facility rating affirmed at 'BBB-' and assigned a recovery rating of 'RR1';
--Secured Term Loan A rating affirmed at 'BBB-' and assigned a recovery rating of 'RR1';
--Senior unsecured notes rating upgraded to 'BB+/RR4' from 'BB'.
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