September 18, 2017 / 7:55 PM / a year ago

Fitch Rates Meritor's Proposed Convertible Notes 'B+/RR4'

(The following statement was released by the rating agency) CHICAGO, September 18 (Fitch) Fitch Ratings has assigned a rating of 'B+/RR4' to Meritor, Inc.'s (MTOR) proposed private placement of $300 million in senior unsecured convertible notes due 2037. MTOR's Long-Term Issuer Default Rating (IDR) is 'B+' and its Rating Outlook is Stable. A full list of MTOR's ratings is included at the end of this release. The proposed notes will be guaranteed by each of MTOR's subsidiaries who also guarantee its secured revolving credit facility. The company intends to use the net proceeds from the proposed notes to refinance existing debt. MTOR's senior unsecured notes, including the proposed notes, are rated 'B+/RR4', reflecting Fitch's expectations of average recovery prospects in the 31% to 50% range in a distressed scenario. MTOR expects to grant the initial purchasers of the notes an option to purchase up to an additional $25 million in principal amount of the notes, potentially taking the total amount issued to $325 million. KEY RATING DRIVERS MTOR's ratings reflect the fundamental improvement seen in the company's credit profile over the past several years resulting from its work to strengthen its balance sheet, improve its cost structure and grow its customer base. The ratings also incorporate the company's strong market position as a supplier of axles and brakes in the highly cyclical commercial truck and off-highway vehicle sectors. The improvement in the company's credit profile has been particularly evident in its ability to produce positive FCF for each of the past several years, even while the North American commercial truck market went through a particularly steep downturn. Over the longer term, MTOR is well-positioned for the nascent turnaround in its key end markets, which could provide it with opportunities to further strengthen its credit profile. Despite the improvements, Fitch has several significant rating concerns. Chief among these is the relatively extreme cyclicality of the global commercial truck and off-highway vehicle markets. This heavy volatility can make credit profile improvement challenging and heightens the importance of maintaining relatively conservative mid-cycle credit metrics. Other concerns include heavy competition in the commercial truck driveline sector, particularly in North America, as well as volatile raw material costs, which can pressure margins despite pass-through mechanisms in many customer contracts. MTOR's heightened interest in potential acquisitions and ongoing share repurchase activity are also concerns, although Fitch does not expect these activities to drive a material increase in long-term leverage. As of June 30, 2017, MTOR's debt (including off-balance-sheet factored receivables) totaled $1.3 billion and LTM Fitch-calculated EBITDA at the time was $317 million (including dividends received from minority joint ventures), leading to Fitch-calculated EBITDA leverage of 4.1x. FFO adjusted leverage was 3.6x. MTOR's EBITDA margin was 9.0% in the LTM ended June 30, 2017 (excluding the effect of minority joint venture dividends). Fitch-calculated FCF in the LTM ended June 30, 2017 was $56 million, leading to a FCF margin of 1.8%. MTOR remains focused on debt reduction, and in August 2017, the company called for redemption of $100 million of its existing 6.75% convertible notes due 2021. In September 2017, MTOR announced that it agreed to sell its 50% stake in its Meritor WABCO Vehicle Control Systems (Meritor WABCO) joint venture to its partner for $250 million and use a portion of the proceeds to redeem the remaining $175 million in 6.75% convertible notes. Fitch expects debt to decline as a result of these transactions, although the effect on EBITDA leverage will be partially offset by the loss of dividends from the Meritor WABCO joint venture. In early September 2017, following a decision by the U.S. Court of Appeals for the Sixth Circuit, MTOR modified benefits that will be paid to certain former United Auto Workers (UAW) represented employees. As a result of the benefits modification, MTOR's benefit liability is expected to be reduced by $315 million. The associated reduction in cash benefit payments is expected to improve FCF by about $17 million in fiscals 2018 and 2019 versus $32 million in payments in fiscal 2017. Likewise, EBITDA is expected to improve by about $40 million annually in fiscals 2018 and 2019 as a result of the changes. Pro forma for the benefit modifications, LTM EBITDA leverage at June 30, 2017 would have been 3.7x and the FCF margin would have been 2.3%. DERIVATION SUMMARY MTOR is among the smaller public capital goods suppliers, with product lines focused on driveline components and brakes for commercial vehicles, off-highway equipment and trailers. Compared with its primary competitor, Dana Incorporated, MTOR is smaller and fully focused on the capital goods industry, without any meaningful light vehicle exposure. That said, MTOR generally retains a top-three market position in most of the product segments where it competes. Compared with other industrials rated below investment grade, such as Tenneco Inc., The Goodyear Tire and Rubber Company or Allison Transmission Holdings, Inc., MTOR's leverage is relatively high and margins are lower. MTOR's EBITDA leverage has generally fluctuated in the high-3x to low-4x range over the past several years, which is roughly 1x to 1.5x higher than most issuers in the 'BB' category. That said, EBITDA margins recently have been in the high-single-digit range and annual FCF has been consistently positive over the past several years, which could lead to further credit profile improvement over the longer term. KEY ASSUMPTIONS Fitch's key assumptions within its rating case for the issuer include: --In North America, the commercial truck cycle reaches a trough in mid-fiscal 2017 and begins to grow thereafter; --Revenue grows slightly in fiscal 2017 on modestly improving end-market demand, but grows more solidly in the following years on improved market conditions and new business wins; --FCF remains positive over the next several years, with FCF margins in the low-single-digit range; --Capital expenditures run at about 2.5% to 3% of revenue over the next several years, in-line with recent capital spending levels; --The company generally maintains cash balances in the $150 million to $170 million range, with excess cash used for share repurchases or modest acquisitions. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action --Maintaining EBITDA leverage below 3.5x and through the cycle; --Maintaining FFO adjusted leverage below 4.5x through the cycle; --Maintaining a FCF margin of 1.5% or higher through the cycle; --Maintaining an EBITDA margin above 9% through the cycle. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action --A material deterioration in the global commercial truck or industrial equipment markets for a prolonged period; --An increase in EBITDA leverage to above 4.5x through the cycle; --An increase in FFO adjusted leverage to above 5.5x through the cycle; --A decline in the FCF margin to below 0.5% through the cycle; --A decline in the EBITDA margin to below 8% through the cycle. LIQUIDITY Fitch expects MTOR's liquidity to remain adequate over the intermediate term. At June 30, 2017, the company had $231 million in cash and cash equivalents, which was higher than normal. Typically, the company has carried between $150 million and $200 million in cash on its balance sheet. In addition to its cash, MTOR has access to a $525 million secured ABL revolving credit facility that was fully available at June 30, 2017. Based on its criteria, Fitch treats non-U.S. cash, as well as cash needed to cover seasonal changes in working capital and other obligations, as "not readily available" for purposes of calculating net metrics. Therefore, Fitch has treated $129 million of MTOR's consolidated cash as "not readily available" in its calculations. FULL LIST OF RATINGS Fitch currently rates MTOR as follows: --Long-Term IDR 'B+'; --Secured revolving credit facility rating 'BB+/RR1'; --Senior unsecured notes rating 'B+/RR4'. The Rating Outlook is Stable. Contact: Primary Analyst Stephen Brown Senior Director +1-312-368-3139 Fitch Ratings, Inc. 70 West Madison Street Chicago, IL 60602 Secondary Analyst Craig D. Fraser Managing Director +1-212-908-0310 Committee Chairperson Eric Ause Senior Director +1-312-606-2302 Relevant Committee Date: Jan. 30, 2017 Summary of Financial Statement Adjustments - Fitch has adjusted MTOR's debt to include off-balance-sheet factored receivables. Also, for purposes of calculating EBITDA-based metrics, Fitch has included dividends received from equity method investments in its calculation of EBITDA. However, Fitch has not included these dividends in its standalone calculations of EBITDA or the EBITDA margin. 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