Fitch Upgrades Allison Transmission (ALSN) to 'BB'; Notes Steadily Improving Credit Profile

Fitch Ratings has upgraded the Issuer Default Ratings (IDRs) for Allison Transmission (NYSE: ALSN) and its Allison Transmission, Inc. (ATI) subsidiary to 'BB' from 'BB-'. In addition, Fitch has upgraded the ratings on ATI's secured term loans and secured revolving credit facility to 'BB+' from 'BB' and assigned a Recovery Rating of 'RR1'. A full list of the rating actions follows at the end of this release.

The ratings apply to $2.4 billion in secured term loans and a $465 million secured revolving credit facility. The Rating Outlooks for ALSN and ATI are Stable.

KEY RATING DRIVERS

The upgrade of the ratings of ALSN and ATI is driven by the improvement in the company's credit profile as it has steadily reduced debt over the past several years while producing high margins and strong free cash flow (FCF). The company continues to lead the global market for fully automatic transmissions for commercial vehicles, industrial machinery and military equipment. ALSN has a very strong market position in North America, with 95% of all school buses and nearly three-quarters of medium-duty commercial trucks manufactured with the company's transmissions in 2014. In addition, over half of the Class 8 straight trucks and nearly half of the Class A motorhomes sold in North America in 2014 were manufactured with the company's transmissions, and unlike most Tier 1 suppliers, ALSN's brand name commands a price premium from end users. Fitch expects the market for on-highway automatic transmissions to continue growing in North America as operators seek to improve fuel economy and as they look to grow the pool of available drivers. Automatic transmissions help in this regard as they do not require the skills needed to shift a manual transmission.

ALSN's market position outside North America is significantly smaller, as commercial vehicles in most global markets continue to be produced with manual transmissions. Nonetheless, global acceptance of fully automatic transmissions is growing, particularly for certain vocations, such as buses and emergency vehicles. This has been particularly true in emerging markets like China and India, where ALSN is well positioned for future growth opportunities. Over time, Fitch expects developing markets to follow the lead of North America in embracing the benefits of automatic transmissions as well.

Fitch's concerns continue to include the heavy cyclicality of the global commercial vehicle and industrial equipment markets, volatile raw material costs, the lack of global diversification in ALSN's current business, moderately high leverage and a concentrated debt maturity schedule. However, credit facility amendments over the past three years have shifted nearly 90% of ALSN's term loan maturity obligations to 2019, removing the company's near-term refinancing risk, and the company's strong profitability and FCF generating capability provide it with meaningful financial flexibility to weather economic cycles. It is also notable that ALSN's transmissions are currently used primarily in the vocational truck market, which tends to be less cyclical than the manual transmission-dominated Class 8 linehaul market. Nevertheless, a broad-based global downturn in commercial vehicle and industrial equipment production would likely pressure ASLN's profitability and FCF.

Although ALSN's leverage is somewhat high for the rating category, the company has consistently used FCF over the past several years to reduce debt, including a $255 million decline in the 12 months ended June 30, 2015. However, Fitch does not expect further debt reduction to be a significant priority going forward as the company's net leverage has declined to slightly below its targeted range (net debt/adjusted EBITDA, as calculated by the company) of 3x to 3.5x. A strong liquidity position, modest pension obligations, and manageable near-term debt service requirements are other credit positives. In April 2015, ATI increased its term loan B-3 by $470 million and used the proceeds to fully redeem its $471 million in 7.125% senior unsecured notes due 2019. Following the redemption, all of the company's remaining debt is comprised of secured term loans.

ALSN's credit profile is characterized by relatively high margins, strong FCF and moderate leverage. Fitch-calculated leverage (debt/Fitch-calculated EBITDA) at June 30, 2015, was 3.2x, with $2.4 billion in debt and last 12 months (LTM) Fitch-calculated EBITDA of $762 million. The Fitch-calculated EBITDA margin, at 36.1%, remained very strong for a capital goods manufacturer and was up from 34.5% in the LTM ended June 30, 2014. However, Fitch expects leverage may trend up slightly to the mid-3x range by year-end of 2015 as EBITDA declines on lower sales volumes. Funds flow from operations (FFO) adjusted leverage was 3.5x at June 30, 2015, down from 4x at June 30, 2014.

With consistently strong FCF and all of its debt in the form of term loans, ALSN has the financial flexibility to reduce leverage further in the intermediate term if it chooses to do so, although, as noted earlier, the company's net leverage has declined slightly below its targeted range. As such, Fitch expects the company will prioritize cash returns to shareholders over further discretionary debt reduction. That being said, the company's strong liquidity position at June 30, 2015 was more than sufficient to meet its near-term cash obligations and included $217 million in cash and cash equivalents, augmented by $456 million in availability on its $465 million secured revolving credit facility (after accounting for $9.2 million in letters of credit).

Over the past two years, Carlyle and Onex fully exited their collective equity stake in ALSN. Although Fitch did not previously view the concentrated ownership structure as a significant credit risk, it is nonetheless a mild credit positive that the company's ownership base has become more diversified. However, the company has recently begun to focus more heavily on returning cash to shareholders through dividends and share repurchases now that its shareholder composition is less concentrated and as it has reached its net leverage target range of 3.0x to 3.5x. The company currently has board authorization to repurchase up to $500 million in shares, which it plans to complete by year-end 2016. Through July 28, 2015, the company had repurchased $208 million in shares in 2015.

Although ALSN's shareholder composition is now less concentrated, ValueAct Capital has accumulated an equity stake in the company of nearly 11%, making it ALSN's largest shareholder. In December 2014, ALSN and ValueAct entered into a cooperation agreement pursuant to which the company gave ValueAct the option of having their representative join ALSN's Board of Directors, and in return, ValueAct agreed to several stipulations regarding its trading in the company's stock and limiting its ability to influence the company's corporate governance. ValueAct's representative joined ALSN's Board of Directors in May 2015. Fitch views the cooperation agreement favorably and does not believe ValueAct's ownership stake or Board representation poses a meaningful risk to creditors.

Fitch expects FCF to remain solid over the intermediate term and FCF margins to remain strong by industry standards. LTM FCF was $390 million at June 30, 2015, leading to a strong 18.5% FCF margin. FFO was $579 million in the LTM period, with working capital using a modest $31 million in cash. LTM capital spending was $56 million, equal to only 2.7% of revenue. The company has guided to full-year 2015 capital spending in the range $60 million to $70 million, and with no significant plant construction activity expected over the intermediate term, capital spending needs are likely to remain relatively low over the next several years. ALSN instituted a common stock dividend in 2012 and spent $102 million on dividends in the LTM period ended June 30, 2015, which is included in Fitch's FCF calculation.

ALSN's pension obligations are modest, with an overfunded status of $1.8 million as of year-end 2014. The company's salaried pension plan was closed to new entrants in 2007, and its hourly plan was closed to new entrants in 2008. Benefits for hourly employees who retired prior to Oct. 2, 2011, are covered under General Motors Company's (GM) hourly plan. Fitch does not view ALSN's pension obligations as a meaningful credit risk.

The secured revolver and term loans that comprise ATI's credit facility are rated at 'BB+/ RR1', one notch above ATI's IDR, due to their collateral coverage, which includes virtually all of ATI's assets. Fitch notes that property, plant, and equipment and intangible assets (including intellectual property) comprised $1.9 billion of the $4.7 billion in assets on ALSN's consolidated balance sheet at June 30, 2015. In April and May 2015, ATI fully redeemed its senior unsecured notes with proceeds from its upsized term loan B-3.

KEY ASSUMPTIONS

--Overall demand remains mixed in 2015, with continued weakness in the global off-highway and defense end markets, flat to slightly better demand in the on-highway market outside the U.S. and relatively strong demand in the North American on-highway market;
--Global demand strengthens modestly after 2015;
--ALSN continues to make progress in penetrating the global on-highway markets, especially in emerging markets;
--Margins are forecast to be relatively steady through the forecast period, with EBITDA margins in the mid-30% range;
--Capital spending equals about 3.5% of annual revenue for the next several years;
--The company produces over $300 million in free cash flow annually, equating to free cash flow margins in the 15% to 17% range;
--The company completes its current $500 million share repurchase program in 2016 and continues to use share repurchases to regulate its cash position going forward.

RATING SENSITIVITIES

Positive: With the company having achieved its net leverage target, Fitch does not expect to upgrade the ratings of ALSN or ATI in the intermediate term. However, future developments that may, individually or collectively, lead to a positive rating action include:

--A decline in Fitch-calculated EBITDA leverage to below 3.0x;
--An increase in the global diversification of its revenue base;
--Maintaining EBITDA and FCF margins at or above current levels;
--Continued positive FCF generation in a weakened demand environment.

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

--A sustained significant decline in EBITDA margins or an extended period of negative FCF;
--A competitive entry into the market that results in a significant market share loss;
--An increase in leverage to above 4.0x for a prolonged period;
--A merger or acquisition that results in higher leverage or lower margins over an extended period.

Fitch has upgraded the ratings of ALSN and ATI as follows:

ALSN
--IDR to 'BB' from 'BB-'.

ATI
--IDR to 'BB' from 'BB-';
--Senior secured revolving credit facility to 'BB+/RR1' from 'BB';
--Senior secured term loan B-2 to 'BB+/RR1' from 'BB';
--Senior secured term loan B-3 to 'BB+/RR1' from 'BB'.

The Rating Outlook for both ALSN and ATI is Stable.

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