Moody's is materially overstating the credit risk of Meritor, Inc. (NYSE:MTOR) with its B1 rating. However, Valens' fundamental analysis highlights a much safer credit profile for MTOR. The company's cash flows cover all their obligations through the next seven years, except for their 2021 debt headwall that their cash build can easily cover. Valens therefore rates MTOR five notches higher at an IG4 credit rating or a Baa2 using Moody's ratings scale. (To register for free access to our corporate credit ratings, please click here.)
In addition, cash bond markets are grossly overstating MTOR's credit risk, with a cash bond YTW of 9.789% relative to an Intrinsic YTW of only 6.679%. CDS markets are likewise overstating credit risk, with a CDS of 648bps versus an Intrinsic CDS of 519bps.
Cash Flow Profile
Valens Credit produces a Credit Cash Flow Prime™ chart for Meritor, Inc., as it does for every company it evaluates. 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 Credit's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.
The colored, stacked bars show the cash obligations of the firm in each year forecast. 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?
MTOR's annual cash flows are more than sufficient to service all of their obligations, except for their $270mn 2021 debt maturity. That said, given the company's projected cash build of $1bn by 2021, their combined cash flows and cash on hand would cover the said debt headwall.
Like most people, senior executives and board members do what they are paid to do. This is why MTOR's Form DEF 14A is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Valens' Incentives Dictate Behavior™ analysis focuses on MTOR's senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, how aligned a management team may be with shareholder interests, and the potential consequences of a management compensation framework to the business.
MTOR's management compensation framework shows positive signals for debt holders. Their short-term compensation is based on their adjusted EBITDA and cash flows, while their cash performance plans are based on their EBITDA margin.
The focus on cash flows should drive management to efficiently manage working capital and capex, while the EBITDA metrics both incentivize margin improvement and revenue growth. Thus, this compensation framework should result in an ROA' improvement.
Valens provides analyses of companies' 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, stability, strategies, their ability to manage business risks, and especially, their liquidity and solvency.
In the case of MTOR, the analysis of their Q4 2015 earnings call highlighted mixed markers from management. Management appears concerned about the off-highway sector and their commercial truck and industrial segment EBITDA. They also appear to be exaggerating their ability to win business over their competitors.
However, management did generate highly confident markers regarding margin improvement given their focus on cost reduction and other operational improvements. They also generated highly confident markers over margins for the after-market and trailer segment looking ahead to 2016. (More about Valens' innovative research tools is available here.)
Ultimately, a company's credit risk (or lack thereof) is driven by cash available against cash obligations. MTOR's credit risk is being grossly overstated by cash bond markets, materially overstated by Moody's, and overstated by CDS markets. Given MTOR's strong cash profile, however, ratings are expected to improve and credit market spreads are expected to tighten once the company's fundamentals are recognized.
Valens Credit Ratings are those made by the Valens Credit organization, determined by a ratings committee in a systematic process, and not the opinion of any single person.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Credit ratings committee. Litman served as final editor of this Seeking Alpha article and the related reports supporting the findings published herein.
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.