S&P Upgraded Stoneridge (SRI) to 'BB'; Sees 'Substantial' Leverage, Net Cash Flow Improvement in FY15

Standard & Poor's Ratings Services raised its corporate credit rating on Warren, Ohio-based auto supplier Stoneridge (NYSE: SRI) to 'BB' from 'BB-'. The outlook is stable.

At the same time, we revised our recovery rating on the company's senior secured notes to '3', indicating our expectation for meaningful (50%-70%) recovery in the case of default, from '4' (30%-50% recovery expectation). We subsequently raised our issue-level rating on this debt to 'BB' from 'BB-'.

The upgrade reflects our view that Stoneridge Inc.'s debt leverage and cash flow will begin to show substantial improvement in 2015 because of its reduced debt and cost structure. Stoneridge recently sold its wiring business to Motherson Sumi Systems Ltd. for $71.4 million in cash. The company will use a portion of the proceeds to redeem 10% ($17.5 million) of its 9.5% senior secured notes. The company has indicated that it will look into refinancing the remaining senior secured notes and cut its interest expense substantially. We also believe the divestiture will bring greater strategic focus to the company.

We consider Stoneridge's business risk profile to be "weak," reflecting the company's highly competitive and cyclical light and commercial vehicle end markets. We believe these factors together limit the company's ability to mitigate adverse business, financial, or economic conditions.

The company operates in three product segments: electronics (28.7% of 2013 pro forma revenue), control devices (44.3%), and PST (27%). In both the control devices and electronics businesses, the company faces larger and better-capitalized competitors (Sensata, Delphi, and Bosch in control devices and Delphi, Continental, and Bosch in cockpit electronics). Still, we believe the company is positioned to compete with its low-cost production and focus on those higher-margin products that enhance vehicle performance such as shift-by-wire actuators and help reduce emissions such as soot sensors.

The wiring business, on the other hand, is a low-margin business that requires scale to compete successfully. Therefore, the divestiture of the business makes strategic sense in that it allows management to focus on other businesses with greater room for product differentiation and growth. In addition, geographic and customer concentration becomes more balanced relative to global end markets. Sales to North America will represent 46.5% of pro forma 2013 revenue as opposed to 62.8% of actual revenue, South America 27% versus 18.8%, and Europe/other 26.5% versus 18.4%. Also, the top three customers will make up about 24% of pro forma revenue versus about 34% of actual 2013 revenue.

In its Brazilian business, PST, as a result of economic weakness, Stoneridge is restructuring the business through headcount reductions and improved components sourcing. PST's underlying aftermarket businesses (vehicle security, tracking, and infotainment devices) have higher gross margins than its control devices or electronics segments, and we expect it to contribute again significantly to overall margins as economic conditions normalize.

About 37.1% of Stoneridge's sales come from the light-vehicle market and 37.7% from the commercial vehicle market, based on second-quarter results. We expect commercial vehicle production to rise almost 11% in North America in 2014, after falling more than 3% in 2013, and decreasing almost 5% in Europe in 2014. We expect light-vehicle production to increase about 3% in North America and 2% in Europe.

We are revising the company's financial risk profile to "intermediate" from "significant." The company's adjusted debt to EBITDA was 2.5x as of Dec. 31, 2013, and we see leverage falling below 2x during 2014 because of higher overall margins arising from the divestiture of the wiring business and anticipated debt reduction. FOCF to debt was 11% as of Dec. 31, 2013, and we expect this ratio to be in the low-single digits in 2014 but rise above 25% in 2015.

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