- Bill Feingold and Jeffrey Alton, CFA
Navistar is not your father’s Triple-C (or, as one former colleague used to annoy me by saying, “Triple Hooks”) credit. Both the company’s straight bonds and convertibles imply a spread in the 450-500 basis point range, which once upon a time was the province of meaningfully stronger ratings.
No matter. Navistar is an improving credit and, even if the price implies a tighter spread than one might have associated with the ugly rating, the reality is that there could be room for even more tightening—especially as the company continues to work its way back from its near-death experience of two years ago.
We’ll put aside the 3% convertibles due later this year, which have been effectively defeased by the issuances of the 4.50% and 4.75% convertibles over the last nine months. (We certainly wouldn’t blame anyone for hanging onto the 3% through October as a cash substitute with a tiny sliver of optionality). Both the 4.50% and 4.75% offer healthy coupons that surely attract managers with yield bogeys. Meanwhile, the conversion premiums in the high 50’s and low 60’s—again, not your father’s premiums for above-par paper—at least leave room for upside participation somewhere between modest and respectable.
Trading around 102 ½ (on the 4.50% of 2018) and 107 (on the 4.75% of 2019), the convertibles offer generally favorable risk/reward profiles in the absence of a significant reversal of Navistar’s current turnaround. That said, the bonds are not a no-brainer for Navistar bulls. They figure to participate in less than 40% of the shares’ upside for moderate stock moves. Investors who like the Navistar story and want income but also seek more aggressive participation might consider blending either the convertibles or the 8.25% senior notes due 2021 with some common stock. But given the market’s relative lack of high (ish) coupon convertibles with reasonable upside participation, and the moderate size of the two issues, we think these bonds are likely to stay well bid for some time.
Navistar International Corporation (NAV) is a manufacturer and distributor of Class 4 through 8 trucks, parts and engines, with a focus on Class 6 through 8 heavy duty trucks built to tow over 19,500 lbs. Their products include semi-trailer trucks, commercial and school buses, military vehicles and cement mixers. The company operates a financial services arm to support truck and engine sales.
The company divides itself into four operating segments:
Revenue & Income by Segment (in millions) 2013 vs. 2012 ended 10/31/14
The North American medium and heavy duty truck markets are competitive with a number of well-known companies participating in the market. Differentiators include price, fuel-mileage and styling as per individual driver preferences. Major North American manufacturers include Daimler Freightliner, AB Volvo Mack, PACCAR Kenworth and Peterbilt as well as Navistar. Manufacturers both produce their own engines and use outside vendors such as Cummins. Freightliner holds the largest market share with over 40% for medium duty trucks and just under 40% for heavy duty trucks, a market share level that Navistar once held. Paccar brands hold close to a 25% share in the heavy duty market, and Navistar and AB Volvo Mack have the balance.
A Recent History of Quality Problems Jeopardize Navistar
Navistar’s well publicized quality problems began in the beginning of this century when it made the decision to chart its own course in developing an EGR (Exhaust Gas Recirculation) engine to meet new EPA exhaust guidelines set to start in 2010. The rest of the industry chose to add an SCR (Selective Catalytic Reduction) module to existing engines to meet the standards. Navistar’s decision proved to be disastrous as the engine not only failed to meet EPA standards but also was plagued by quality problems, leading to a wave of warranty expenses and market share loss. This colossal wreck of strategy and execution put the company’s very existence in jeopardy.
The Company Proceeds with a Rebuilding Strategy
Navistar is halfway through a three-year rebuilding process to address these issues and right the ship with a goal of reaching 8% to 10% EBITDA margin by the end of 2015. The strategy has focused on:
- Increasing the quality of its engines by improving the EGR engine and introducing Cummins engines on select models to win back market share.
- Introducing SCR engine modules across its product line to meet EPA standards.
- An aggressive cost reduction strategy to offset the large warranty expenses and the increased cost of adding the SCR module to its engines.
Anecdotally, the quality turnaround has begun with Navistar winning the 2014 Heavy-Duty Commercial Truck of the Year and the 2014 Medium-Duty Commercial Truck of the Year awards at the American Truck Dealers Convention in January.
The company’s second quarter financial results also hint at a turnaround with losses in the truck segment reduced by over 50% quarter over quarter.
Q2 2014 vs Q2 2013 Revenues and Income (in millions)
The improvement in the North American Truck segment was due to a combination of an improving truck market coupled with an increase in Navistar’s market share. Results of the global segment were disappointing because of difficult economic conditions in the company’s Brazil operations.
Navistar has hit market share bottom and is beginning to rebound as quality has improved.
Navistar Market Share by Truck Segment
The company is introducing new engines in its severe service trucks, and similar to customers waiting to purchase before a new iPhone launch, Navistar customers appear to be waiting for the new engine before purchasing. The launch is happening this summer and Navistar expects market share to increase thereafter.
Navistar has also worked to reduce costs, taking out $330 million in 2013 and is projecting savings of $250 million in 2014. The company expects further cost savings of up to $1,200/truck as it redesigns its trucks to incorporate benefits from the SCR modules next year.
Warranty expense is decreasing as well. Warranty expense as a percentage of manufacturing revenue in the second quarter of 2014 was 5.3% versus 7.7% for 2013. The company’s near term goal is to reduce that percentage to 4%.
The combination of an improving economy, increased market share and reduced costs have driven improved top and bottom line performance……
Selected Income Statement Information (in millions)
After years of deterioration……
Total outstanding long-term manufacturing debt is $3.17 billion. The major outstanding debt securities include:
Senior Secured Term Loan Credit Facility, as Amended, due 2017 $694
8.25% Senior Notes, due 2021 $1,179
3.00% Senior Subordinated Convertible Notes, due 2014 $166
4.50% Senior Subordinated Convertible Notes, due 2018 $200
4.75% Senior Subordinated Convertible Notes, due 2019 $411
Current Credit Ratings for Navistar International Inc. debt are:
Senior Unsecured Convertibles
Standard & Poors CCC- CCC-
Moody’s B3 Caa2
Fitch CCC CC
The ratings take into account not only the recent business setbacks that Navistar has endured, but also other factors going forward including:
1. Dissolution of Navistar’s joint venture with Ford Motor called Blue Diamond in early 2015. Sales the Blue Diamond joint venture sold 4,500 units in the first six months of fiscal 2014. Ford will bring the production of the trucks in-house beginning with the 2016 model year.
2. Significant unfunded pension liabilities, Navistar plans to make contributions of $198 million in 2014 and $174 million in years 2015 to 2017 to maintain minimum compliance.
3. The union contract at the company’s Springfield, IL plant expires on October 1, 2014.
Despite these risks, there are opportunities for credit upgrades in the coming years. The story can be likened to the Ford Motor turnaround in the last decade where the security markets began to realize the evolving story before the rating agencies began to upgrade the credit.
Tailwinds to Navistar include prudent cash management maintaining cash and cash equivalents above $1 billion since beginning its turnaround plan 18 months ago. The company reported adjusted EBITDA of $80 million in the last quarter, giving it sufficient liquidity to continue to enact its turnaround plan over the next 18 months.
With no significant refinancing due until 2017, Navistar should have ample time to complete its turnaround assuming no major setbacks in the domestic US economy.
Navistar International stock is currently trading at $37, up from a low of $18 in 2012 as Navistar faced its darkest days. The company has a current market cap of approximately $3 billion. However, with only about 81.3 million shares outstanding and a history of earning over $300 million annually in better days, the stock could continue to appreciate as the turnaround plan unfolds. The company also has an ample supply of net operation loss carryforwards to assist in boosting EPS.
Paccar, a manufacturer of light, medium and heavy duty trucks provides a useful comparison point. The stock trades at $63 with analyst estimates at $3.62 and $4.12. The company trades at an Enterprise Value/EBITDA of 13.4.
As the Navistar story progresses and exits the turnaround phase at the end of 2015, the company still posses the capacity to return to a normalized EPS of $3 per share and EBITDA of $500 million per year. Given the Paccar data points, the stock appears to have room to move higher during the life of the convertible bond.