Fitch Affirms Navistar at 'CCC'
KEY RATING DRIVERS
The 'CCC' IDR for NAV considers ongoing concerns about NAV's negative free cash flow (FCF), liquidity, litigation risks, a slow recovery in the company's market share, and the prospect for lower demand in NAV's key North America heavy duty truck market which appears to be near peak levels in 2015 and could begin to moderate in 2016. EBITDA margins are low but NAV's actions to focus on its key product markets and streamline its operations are contributing to steady improvement.
NAV's liquidity improved in August 2015 when it increased its secured term loan by $342 million, to $1,040 million, and extended the maturity date from 2017 to 2020. Fitch believes NAV has adequate liquidity to fund the company's operations in the near term, but annual FCF remains negative and NAV has used funding from NFC to maintain excess cash balances. Until NAV increases and maintains margins at consistently higher levels and begins to generate positive FCF, NAV will be sensitive to adverse developments in its end markets and ongoing litigation.
Manufacturing cash balances and marketable securities in 2015 have remained above $700 million at the end of each quarter ($775 million at July 31, 2015). Fitch expects cash will increase by the end of fiscal 2015 ahead of the first quarter in 2016 when seasonal FCF typically is at its weakest level. The next significant scheduled debt maturity is in October 2018 for $200 million.
Fitch estimates manufacturing FCF in fiscal 2015 will be approximately negative $200 million compared to negative $447 million in 2014. FCF as calculated by Fitch excludes dividends from Financial Services and changes in intercompany used truck financing. Although EBITDA margins are improving, FCF and operating results are reduced by higher capital expenditures compared to 2014, cash warranty spending in excess of expense, weak end markets in NAV's Global Operations business, and low residual values on sales of NAV's used truck inventory related to legacy EGR engines.
Fitch expects FCF in 2016 could become slightly positive, but results will depend on industry demand for heavy duty trucks and NAV's ability to build market share. Fitch expects NAV's FCF to benefit from higher operating margins, lower warranty spending, and a decline in used truck inventories from levels NAV believes may have peaked in Q2 2015. Also, NAV has tax losses that reduce cash tax payments. Fitch's calculation of FCF excludes the impact of changes in the intercompany used truck loan from NFC.
NAV's net pension obligations were $1.4 billion at FYE Oct. 31, 2014, unchanged compared to the prior year. The company expects to contribute $113 million in 2015, including $73 million in the first nine months of the year, and expects required annual contributions from 2016 to 2018 will be at least $100 million.
At July 31, 2015 debt/EBITDA was over 7x which represented an improvement compared to the past three years, and funds from operations as calculated by Fitch turned slightly positive in the second and third fiscal quarters of 2015. Fitch does not include intercompany loans from NFC in manufacturing debt, and leverage would be higher when including these liabilities. NAV's use of intercompany funds from NFC includes loans and dividends. The net amount of loans and dividends provided to NAV in the first nine months of 2015 totaled $73 million. 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 reduce liquidity and slow an improvement in NAV's credit measures. Other litigation includes the SEC's investigation into NAV's accounting and disclosure practices, class action lawsuits concerning NAV's discontinued advanced EGR engines, and shareholder lawsuits.
The company's EBITDA margin as calculated by Fitch increased to 3.8% at July 31, 2015 on a last-12-months basis and could improve to mid-single digits or higher by the end of 2016. Annual EBITDA margins had not been materially higher than around 1% since 2011 while NAV implemented its revised engine strategy. The increase in margins reflects lower costs for materials, engineering, and SG&A including the elimination of non-core manufacturing facilities. Warranty costs declined to 3% of sales in the third quarter of 2015 compared to a level above 7% as recently as 2013 although cash expenditures remain elevated.
NAV's operating performance has benefited from cyclical strength in the North America heavy and medium duty truck markets where NAV's business is concentrated. However, other regions are weak, particularly Brazil and Mexico, and NAV's market share for heavy duty trucks remains low compared to the company's historical levels due to the impact from NAV's legacy EGR engines. In the third fiscal quarter of 2015, NAV's market shares for combined Class 8 heavy and severe service trucks was 13% compared to 28% in 2010, and NAV's share of Class 6 and 7 medium trucks was 24% compared to 38% in 2010. If industry demand in North America begins to slow in 2016 as widely anticipated, it could be more difficult for NAV to regain market share. The current cycle has been less pronounced than past cycles, however, which could dampen the impact of a slowdown.
Orders in NAV's traditional markets (Class 6-8 trucks and school buses) were roughly flat through the first nine months of NAV's fiscal 2015 while the backlog at July 31, 2015 was slightly higher than one year earlier. Customer acceptance of NAV's trucks may improve as trucks with SCR engines demonstrate a record of performance but near term demand continues to be negatively affected by substantial used truck inventory and low residual values which also affect sales of new trucks.
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 RR '6' 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, and the IDR of the finance subsidiary is directly linked to that of its ultimate parent due to the close operating relationship and importance to NIC, 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 NIC 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 NIC's ratings. The company's performance has not changed materially compared to Fitch's expectations, but its financial profile remains tied to NIC's operating and financial performance. Total financing revenue increased for the nine months of 2015 (9M15) ended July 31, 2015, resulting from the continued growth in the average size of the wholesale portfolio partially offset by the expected decline of the retail portfolio balance. The average finance receivables balance increased to $1.6 billion for the nine months ending July 31, 2015 compared to $1.3 billion for the year-earlier prior.
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 relative to the retail portfolio.
NFC's leverage remains relatively low compared to its captive peers but has risen 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). Balance sheet leverage, as measured by total debt to equity, was 3.9x as of July 31, 2015. Fitch believes NFC's leverage is appropriate and consistent with other captive finance companies. NIC 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 NIC and NFC.
The equalization of the bank credit facility at 'CCC/RR4' (reflecting average recovery prospects) with the IDR indicates that given current balance sheet encumbrances, the creditors under the facility are effectively in an equal position with unsecured note-holders. This incorporates Fitch's expectation that NFC will continue to utilize the securitization markets to fund its operations, which could consequently lead to the level of unencumbered assets falling to such an extent that they may only be sufficient to support repayment of the senior secured credit facility. Fitch would view positively, a greater proportion of unsecured debt in the funding profile, as it would enhance the company's financial flexibility in a stressed scenario.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for NAV's manufacturing business include:
--Revenue is lower in 2015 than 2014 due to the termination of NAV's Blue Diamond Truck joint venture with Ford in the third fiscal quarter of 2015, a decline in exports, pricing pressure and product mix;
--Industry demand for heavy and medium duty trucks reaches a cyclical peak in 2015 and declines in 2016. Impact on NAV's sales will be mitigated by a slow recovery in NAV's market share;
--FCF improves but remains negative in 2015. Fitch expects FCF to become slightly positive by mid-to-late 2016 on an annualized basis, subject to industry conditions;
--EBITDA margins increase further from low levels;
--Warranty cash costs continue to decline.
RATING SENSITIVITIES
Navistar International Corporation
Future developments that may, individually or collectively, lead to a positive rating action include:
--Consistently higher EBITDA margins lead to positive FCF and lower leverage;
--NAV's market share recovers toward a level near 20% for combined Class 8 heavy and severe service trucks (13% in Q3 2015) and 30% for medium duty trucks (24% in Q3 2015);
--Liquidity improves sufficiently to reduce reliance on funding from NFC.
Future developments that may, individually or collectively, lead to a negative rating action include:
--Manufacturing cash and marketable securities balances decline to a level near NAV's estimated minimum required operating cash level of approximately $500 million;
--Manufacturing EBITDA margins as calculated by Fitch fail to improve materially from approximately 3.8% on an LTM basis at July 31, 2015;
--FCF does not become positive on an LTM basis within 12-18 months;
--There is a material adverse outcome from litigation.
Navistar Financial Corporation
NFC's ratings are linked to those of 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 of 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.
LIQUIDITY
Liquidity at NAV's manufacturing business as of July 31, 2015 included cash and marketable securities totaling $760 million (net of BDP joint venture cash and restricted cash). NAV also has an undrawn $175 million ABL facility. Liquidity was offset by current maturities of manufacturing long term debt of $100 million. In addition to the ABL, NAV uses an Intercompany Used Truck Loan from NFC under which $209 million was outstanding at July 31, 2015. NAV also had an outstanding intercompany loan of $190 million from NFC at July 31, 2015.
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. As of July 31, 2015 NFC had $23.3 million of unrestricted cash and approximately $316 million of availability under its various borrowing facilities. During 9M15, NFC issued $250 million in two-year dealer floorplan notes, renewed a $100 million trade receivables securitization and extended the maturity date of the revolving note of a wholesale receivables transaction. 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 July 31, 2015 debt at NAV's manufacturing business totaled $3 billion, including unamortized discount, and $2.4 billion at the Financial Services segment, the majority of which is at NFC.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the ratings for NAV and its affiliates as follows:
Navistar International Corporation
--Long-term IDR at 'CCC';
--Senior unsecured notes at 'CCC'/'RR4';
--Senior subordinated notes at 'CC'/'RR6'.
Navistar, Inc.
--Long-term IDR at 'CCC';
--Senior secured term loan at 'B'/'RR1'.
Cook County, Illinois
--Recovery zone revenue facility bonds (Navistar International Corporation Project) series 2010 at 'CCC'.
Illinois Finance Authority (IFA)
--Recovery zone revenue facility bonds (Navistar International Corporation Project) series 2010 at 'CCC'.
Navistar Financial Corporation
--Long-term IDR at 'CCC';
--Senior secured bank credit facility at 'CCC'/'RR4'.
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