OREANDA-NEWS. Fitch Ratings has upgraded Meritor, Inc.'s (MTOR) Issuer Default Rating (IDR) to 'B+' from 'B'. Fitch has also upgraded MTOR's senior secured credit facility rating to 'BB+/RR1' from 'BB/RR1' and its senior unsecured notes rating to 'B+/RR4' from 'B/RR4'. A full list of rating actions is included at the end of this release.

MTOR's ratings apply to a $499 million secured revolving credit facility and $1.1 billion in senior unsecured notes. The Rating Outlook is Stable.

KEY RATING DRIVERS

The upgrade of MTOR's ratings reflects the fundamental improvement in the company's credit profile that has resulted from its work to strengthen its balance sheet, improve the flexibility of its cost structure and grow its customer base. The ratings also incorporate MTOR's continued strong market position as a supplier of axles and brakes in the highly cyclical commercial and off-road vehicle sectors. Although the company's top line has been pressured over several years by persistently weak commercial vehicle market conditions outside the U.S., its profitability and credit protection metrics have improved as the company has made progress on the various initiatives packaged in its M2016 plan. As a result of its improved margin performance, MTOR has begun producing positive annual free cash flow (FCF) on a consistent basis, which it has used, along with proceeds from stake sales and a legal settlement, to reduce debt and significantly improve the funded status of its pension plans. Going forward, Fitch expects the increased flexibility of the company's cost structure to improve its ability to manage the potentially extreme demand swings often seen in the global commercial vehicle sector.

Despite the fundamental improvement in MTOR's operations and financial profile, Fitch continues to have several significant rating concerns. Chief among these is the heavy cyclicality of the global commercial and off-road vehicle markets. The North American commercial truck market was near its cyclical peak in fiscal year (FY) 2015 and is likely to cool a bit in FY2016. Meanwhile, Fitch expects the South American and Asian markets to remain relatively weak over the intermediate term, while demand conditions in Western Europe are better but remain tenuous. Defense-related demand is likely to remain weak until the Joint Light Tactical Vehicle (JLTV) program hits its regular run rate, which may be several years away. Even then, MTOR's content on the JLTV will be significantly less than on the Family of Medium Tactical Vehicles (FMTV) program, which is winding down. These conditions will likely constrain MTOR's revenue growth over the next couple of years, and, although MTOR's more-flexible cost structure is better equipped to manage market cycles, tepid global demand could make further credit profile improvement over the intermediate term more challenging.

Along with weaker demand, competition in the industry remains high, which could make new business wins more difficult and put increased pressure on pricing. That being said, MTOR successfully entered into a new multi-year supply agreement with PACCAR Inc. in FY2015, cementing its position as a significant supplier to all four major North American Class 8 truck manufacturers.

REVENUE PERFORMANCE

After growing modestly in FY2014, MTOR's revenue declined $261 million, or 6.9%, in FY2015 to $3.5 billion from $3.8 in the previous year. Negative foreign exchange translation of $226 million was the driver of most of the decline, with weaker South American, Chinese and defense-related volumes making up much of the remainder. The overall decline masked the positive effect of very strong demand in the North American commercial truck and trailer segments, as well as solid demand in Western Europe and India. Looking ahead, Fitch expects revenue in FY2016 to remain under pressure and likely down in the low-single digit range compared to FY2015, as North American demand softens a bit from the very strong level seen in FY2015. However, Fitch expects North American truck production to remain relatively strong by historical standards. Outside North America, Fitch expects many of the trends seen in FY2015 to carry over, with stronger conditions in Western Europe and India, offset by weakness in South America, China and defense sales.

LIQUIDTIY AND FCF

MTOR's liquidity position remained substantial at year-end FY2015 and included $193 million in cash and marketable securities, augmented by full access to its $499 million secured revolver. In addition, MTOR had $94 million available on its $100 million committed U.S. accounts receivable securitization facility. Intermediate-term debt maturities are light, with only $31 million in debt maturities over the next three years. However, Fitch expects the company will redeem its remaining $55 million in 4.625% convertible notes due 2021 when they become callable in FY2016.

MTOR produced positive FCF in FY2015 and FY2014 following three years of negative FCF. In FY2015, FCF totaled $18 million, or $122 million excluding $94 million in voluntary pension-related expenditures and $10 million of cash usage related to discontinued operations. This compared to FCF of $138 million in FY2014, which included $209 million in cash proceeds received from a settlement with Eaton Corporation plc (Eaton), offset by $134 million of discretionary pension contributions and $12 million of cash outflows related to discontinued operations. Adjusting for those unusual items, FCF in FY2014 would have been $75 million. FCF in both years included cash restructuring payments, which totaled $16 million in FY2015 and $10 million in FY2014. Fitch expects FCF to improve over the intermediate term, following the substantial amount of voluntary pension-related payments made over the past two years. Fitch expects MTOR's FCF margin to rise to the low-3% range in FY2016 and potentially rise to the mid-3% range in FY2017.

DEBT AND LEVERAGE

At year-end FY2015, the principal value of MTOR's balance sheet debt stood at $1.1 billion, up from $1 billion at year-end FY2014. During FY2015, MTOR issued $225 million in 6.25% notes due 2024 as an add-on to its existing $225 million in 6.25% notes. Partially offsetting this increase, the company repurchased a total of $129 million in principal amount of its outstanding convertible debt and also reduced its capital leases and export financing debt outstanding by a total of $22 million. The net $74 million increase in debt was primarily used to fund payments to the company's Canadian and German pension plans in connection with shifting the plans to an annuity structure. As noted above, Fitch expects MTOR to call its remaining $55 million in 4.625% convertible notes when they become callable in FY2016. Similar to many U.S. industrial companies with global operations, most of MTOR's debt has been issued in the U.S., while 51% of its FY2015 revenue was derived outside the U.S. While this creates some risk, MTOR has had no meaningful issues repatriating cash when necessary to cover its U.S. obligations.

In addition to its balance sheet debt, MTOR utilizes several off-balance sheet factoring programs in Europe. As of year-end FY2015, MTOR had factored $255 million of its receivables in off-balance sheet programs. Of this amount, $204 million was related to a committed factoring program involving only receivables from AB Volvo. The remaining $51 million of factored receivables was through various uncommitted European factoring programs. Fitch includes MTOR's factored receivables in its calculation of lease-adjusted leverage.

As calculated by Fitch, MTOR's EBITDA declined to $299 million in FY2015 from $304 million in FY2014, mostly due to the decline in revenue. However, improvement in the company's cost structure resulted in an increase in its EBITDA margin to 8.5% from 8.1%. Fitch-calculated leverage (balance sheet debt/Fitch-calculated EBITDA) rose to 3.7x at year-end FY2015 from 3.3x at FY2014, but it was well below the 5.7x level seen at year-end FY2013. Lease-adjusted leverage, including MTOR's off-balance sheet factoring, was 4.6x at year-end FY2016, up from 4.2x at year-end FY2014 but down substantially from 7.2x at year-end FY2013. FFO adjusted leverage was 6.1x at year-end FY2015, but this figure was skewed higher due to the $94 million in aforementioned voluntary pension-related payments that depressed the company's FFO in the fiscal year. Fitch expects MTOR's credit protection metrics to strengthen a bit over the intermediate term as EBITDA and FCF grow on continued improvement in the company's operational performance and as it looks for further opportunities to reduce debt.

EQUITY-LINKED REPURCHASE PROGRAM

In FY2014, in conjunction with the Eaton settlement, MTOR's Board of Directors authorized the repurchase of up to $210 million in equity or equity-linked securities once its M2016 debt reduction target was met. Although Fitch has some concerns regarding the repurchase program, particularly given MTOR's current rating level, Fitch expects the company to be judicious in administering the program, and it appears to remain committed to reducing leverage and maintaining a strong liquidity position. Through Nov. 10, 2015, the company had repurchased $94 million worth of securities under the program, including $19 million of its 4% convertible notes. The repurchase of the remaining 4.625% convertible notes in FY2016 could be accomplished within the $116 million in authorization remaining under the program.

PENSION FUNDING

The funded status of MTOR's global pension plans improved in FY2015 as the company settled its German pension plan by purchasing an annuity and settled three Canadian plans via lump sum payments and the purchase of another annuity. Improvement in the funded status also reflected the company's de-risking initiatives. As of year-end FY2015, the company's global plans were 93% funded on a projected benefit obligation basis, with a shortfall of $109 million, down from a funded status of 88% and a $219 million shortfall at year-end FY2014. However, at year-end FY2015, the company's key U.S. plans were only 80% funded, with a $212 million net liability. MTOR expects to contribute $5 million to its pension plans in FY2016, down from $12 million in FY2015, and roughly $60 million to $65 million less than its typical contributions several years ago. The decline in required pension contributions has been a significant factor in the improvement in MTOR's FCF generating capability.

RECOVERY RATINGS

The rating of 'BB+/RR1' on MTOR's secured revolver reflects its substantial collateral coverage and outstanding recovery prospects in a distressed scenario, which Fitch estimates in the 90% to 100% range. Collateral includes hard assets, accounts receivable, intellectual property, and investments in certain subsidiaries, which MTOR valued at $636 million as of Sept. 30, 2015. The rating of 'B+/RR4'on the company's senior unsecured notes reflects Fitch's expectations of average recovery in the 30% to 50% range in a distressed scenario.

KEY ASSUMPTIONS

--The global truck and industrial equipment markets remain relatively steady in FY2016, although the North American commercial truck market declines by about 11% from the very strong level seen in FY2015.
--Beyond FY2016, global truck and industrial production increases modestly.
--MTOR picks up additional revenue over the next several years as recent business wins begin to gain traction.
--The company calls its remaining $55 million in 4.265% convertible notes in FY2016.
--Capital expenditures are about $90 million in FY2016 and run at a rate equal to about 2.5% of revenue in later years.
--Free cash flow is in the 3% to 4% range over the intermediate term.
--The company maintains around $150 million to $200 million in cash on its balance sheet, with any excess used for strategic opportunities or share repurchases.

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to a positive rating action include:

--Maintaining EBITDA leverage below 3.5x and lease-adjusted leverage (lease-adjusted debt, including off-balance sheet debt/EBITDAR) below 4.0x through the cycle;
--Producing a 3.5% FCF margin on a consistent basis;
--Maintaining an EBITDA margin above 9% through the cycle.

Negative: Future developments that may, individually or collectively, lead to a negative rating action include:

--A material deterioration in the global commercial truck or industrial equipment markets for a prolonged period;
--An increase in EBITDA leverage to above 4.0x and lease-adjusted leverage above 4.5x through the cycle;
--A decline in the EBITDA margin to below 8% through the cycle.

Fitch has upgraded MTOR's ratings as follows:

--IDR to 'B+' from 'B';
--Secured revolving credit facility rating to 'BB+/RR1' from 'BB/RR1';
--Senior unsecured notes rating to 'B+/RR4' from 'B/RR4'.