S&P Raises Allison Transmission (ALSN) to 'BB-'; Sees Strong FCF Generation

Standard & Poor's Ratings Services said that it raised its corporate credit rating on Allison Transmission (NYSE: ALSN) to 'BB-' from 'B+'. The outlook is stable.

At the same time, we raised our issue-level rating on the company's senior secured debt to 'BB' (one notch above the corporate credit rating) from 'BB-'. The debt comprises a $465 million revolver, a $474 million term B-2 loan, and a $1.795 billion term B-3 loan. The '2' recovery rating on the debt indicates our expectation for substantial recovery (70%-90%) in the event of a payment default. The outstanding term debt was $1.781 billion on the term B-3 loan and $424 million on the term B-2 loan as of March 31, 2014.

We also raised our issue-level rating on the company's 7.125% senior unsecured notes due 2019 to 'B' from 'B-'. The '6' recovery rating on the notes indicates our expectation for negligible recovery (0%-10%) in the event of a payment default.

Allison participates in the highly cyclical global commercial vehicle market as a designer and manufacturer of fully automatic transmissions for medium- and heavy-duty commercial vehicles. Allison holds strong shares in its markets, which we believe it can retain, and the company has a track record of good profitability, with one of the highest EBITDA margins among auto and commercial vehicle suppliers.

Allison's business risks include concentrated sales by region (with 70% of sales generated in North America) and fair customer diversity (with Daimler AG, Navistar Inc., and Oshkosh Corp. representing 35% of sales in 2013). Another key risk is Allison's exposure to a concentrated manufacturing footprint. The company has multiple facilities in Speedway, Ind., where it maintains 90% of its production capacity. We believe that any disruption in a large portion of Allison's manufacturing facilities in Indiana would substantially hinder the company's ability to produce and deliver products in the short term.

The stable outlook reflects our expectation that Allison will generate positive free operating cash flow (FOCF) of more than $300 million annually, and maintain FOCF to debt of 5% or more and leverage of 4x or less in 2014 and 2015. "We believe the company's tightly controlled cost structure will enable it to generate positive FOCF, even if certain key end markets begin to weaken," said Standard & Poor's credit analyst Nancy Messer.

We could raise the rating one notch to 'BB' during the next 12 months if we believe Allison's existing financial and business policies will continue. We would expect the company to continue generating positive FOCF of more than $300 million annually, and maintain FOCF to debt of at least 10% and leverage in the 3x-4x range. We would also need to believe that the company could maintain these metrics despite the industry's inherent cyclicality.

Though unlikely over the next 12 months, we could lower the rating if commercial vehicle production in the company's end markets decline, if margin deterioration leads to FOCF generation that is significantly below our expectations for multiple quarters, or if we believe debt to EBITDA, including our adjustments, would exceed 5x on a sustained basis, stemming from lower profitability and weak demand.

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