Constellium: Operational Sustainability To Forge Safer Ratings And Lower Yields

| About: Constellium Holdco (CSTM)

Summary

Cash bond markets are grossly overstating CSTM’s credit risk with a cash bond YTW of 7.602% relative to our iYTW of 4.112% and iCDS of 398bps.

Moreover, Moody’s is overstating CSTM’s fundamental credit risk, treating it as a high-yield B3 credit, four notches lower than our HY1 (Ba2) credit rating.

Bond markets and Moody’s are not accurately assessing CSTM’s operational sustainability and sizeable cash-on-hand levels, leading to these mispricings.

Cash bond markets are grossly overstating Constellium N.V. (NYSE:CSTM) credit risk with a cash bond YTW of 7.602%. Moreover, Moody's is overstating CSTM's fundamental credit risk, treating it as a high-yield B3 credit. Our fundamental analysis highlights a much safer credit profile for CSTM, whose cash flows would exceed the firm's operating obligations in each year going forward. While the firm would lack sufficient liquidity to navigate their sizeable 2021 debt maturity headwall, they could reduce maintenance capex by 50% to free up enough liquidity to service all obligations through 2022, if they choose not to refinance their debt. Given the firm's sizable cash on hand levels, they have several years to improve their profitability and credit position, which, combined with the firm's operational sustainability, drive our safer Intrinsic YTW of 4.112%, Intrinsic CDS of 398bps, and HY1 (Ba2) rating.

Cash Flow Profile

Click to enlarge

We produced a Credit Cash Flow Prime™ chart for Constellium N.V., as we do for every company we evaluate. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. It shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (Valens' scrubbed cash flow number) expected to be generated based on consensus analyst estimates and Valens Research's own in-house research team. The blue dots above that line indicate the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit. For the numbers behind this chart, please click here.

The colored, stacked bars show the forecasted cash obligations of the firm in each year. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.

If the company generates and has cash levels that are above their obligations, the risk of default is extremely low. Even if the cash generated yearly is close to the levels of the stacked bars, a company generally has the flexibility to defer payments of various kinds. For example, they can allow assets to age a little longer, or they can cut certain maintenance costs such as maintenance capex. While decisions such as those can create other business concerns, the issue in credit risk is simply this: Does the company have enough cash to service their credit obligations?

CSTM's cash flows would consistently exceed operating obligations in each year going forward by $16mn-$82mn. In addition, the firm has sizeable cash liquidity, which should allow them to service all obligations until their 2021 debt headwall, offering them several years to improve operations and their capital structure. That said, their multi-year runway is important, as their combined cash flows and cash on hand would fall short in the face of the firm's material $676mn 2021 debt headwall. CSTM does have a relatively young asset base, which may help enable them to reduce their maintenance capex by 50%, freeing up enough liquidity to service all obligations through 2022. Alternatively, the firm may be forced to refinance their obligations instead to avoid a cash crunch. However, the firm's weak 40% recovery rate on unsecured debt, driven by low working capital levels and minimal PP&E backing, may inhibit their ability to cheaply access credit markets to refinance.

Management Incentives

Like most people, senior executives and board members do what they are paid to do. This is why CSTM's Form 20-F , specifically pp. 87-89, is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Our Incentives Dictate Behavior™ analysis focuses on CSTM's senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, management team alignment with shareholder interests, and the potential consequences of a management compensation framework to the business.

CSTM's long term compensation management is based on unspecified financial metrics, environmental, health and safety (EHS) performance objectives, as well as individual and team objectives. Meanwhile, long-term compensation is awarded in the form of RSUs and PRSUs.

The EHS performance metric should incentivize management to improve EHS compliance thereby limiting facility downtime, minimizing costs associated with EHS incidents, and promoting efficient utilization of assets. However, the lack of clarity around the company's financial metrics, which make up the bulk of the company's short-term and long-term compensation, may not guarantee a focus on ROA' expansion and increased cash flows going forward.

Management Representations

We also provide analyses of managements' statements on earnings calls, termed Earnings Call Forensics™. This analysis is meant to help assess a management team's confidence in their conference calls when discussing certain areas of the business such as operations, strategies, their ability to manage business risks, and especially, their liquidity and solvency.

In the case of CSTM, our qualitative analysis of their Q2 2016 earnings call highlights that management is confident about the sustainability of Adjusted EBITDA growth in their Muscle Shoals division. However, they appear concerned about their ability to drive further volume growth and cost reductions in Muscle Shoals. They may also lack confidence in their ability to refinance with cheaper debt.

Conclusion

As Earnings Call Forensics™ highlights, CSTM may face some near-term operational headwinds. However, this does not necessarily warrant weaker fundamental credit ratings. Ultimately, a company's credit risk (or lack thereof) is driven by cash and cash flows available against cash obligations. Given CSTM's operational sustainability and sizeable cash-on-hand levels, cash bond market spreads and ratings are expected to improve once the company's fundamentals are recognized.

To find out more about Constellium N.V. and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Melvin Yubal. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.