Fitch Ratings has upgraded Fiat Chrysler Automobiles N.V. 's (FCA) (NYSE: FCAU) ratings, including the Long-Term Issuer Default Rating (IDR) to 'BBB-' from 'BB'. The Outlook on the Long-Term IDR is Stable.

The upgrade reflects the continuous strengthening of FCA's financial profile and our expectation that this improvement is sustainable despite a potential cyclical weakening of new vehicle sales in some of the key markets where FCA is active. In particular, we expect free cash flow (FCF) to remain on average above 1.5% in the foreseeable future and funds from operations (FFO) adjusted net leverage to decline further to around breakeven by end-2020.

FCA's credit profile has also been supported by the disposal of Magneti Marelli, FCA's main components business, which is expected to be completed in 2019. This will further lower the group's net indebtedness and improve financial flexibility. The upgrade also reflects FCA's solid business profile, consistent with a low investment-grade rating.

KEY RATING DRIVERS

Stronger FCF: We project a further improvement of FCF to around 1.5% on average in the coming two to three years as cash generation will benefit from better underlying profitability and lower cash interest paid from a continuous reduction in gross debt. This should offset the cash tax increase from higher income and the resumption of ordinary dividends payment as the group announced a payout ratio of up to 20% from 2019 onwards. Weak FCF, below 0.5%, has been a rating constraint in past years, especially considering the lack of dividends and a declining capex ratio, which we believe the group has now overcome.

Improving Financial Structure: Proceeds from the Magneti Marelli disposal, FCA's main components business, for approximately EUR6 billion will enable the group to distribute an extraordinary dividend of about EUR2 billion in 2019 and has allowed the group to pre-contribute about EUR0.6 billion to its US pension plans in 3Q18. The rest should be allocated to net debt reduction and greater financial flexibility. Combined with improving underlying FFO and positive FCF, this sale will lead to a decrease of the FFO adjusted gross and net leverage to below 1.5x and 0.5x, respectively, at end-2019 according to our projections, from 1.6x and 0.8x at end-2017.

Robust US Earnings: Fitch expects a further strengthening of adjusted group operating margin to more than 6.5% in 2019 and around 7% by 2021, from 6.4% in 2017, 5.5% in 2016 and 4.3% in 2015. FCA's product portfolio has strengthened and decreasing investments in recent years are having a positive impact on the depreciation rate. Performance has been particularly robust in North America, FCA's primary market, and is putting FCA on track to outperform its US peers in profitability. This should compensate for a potential weakening of profitability coming from the upcoming cyclical weakness in the US and for possible margin erosion in Europe and Asia and at Maserati.

Investment-Grade Business Profile: The business profile of FCA reflects its positive track record since the group's merger with Chrysler, its broad product and geographic diversification, and its diversified portfolio of well-recognised global brands. FCA is working on moving its product positioning upscale but its portfolio of vehicle remains biased towards the mass-market segment. The group still lacks a significant presence in Asia but has solid penetration in Latin America and the profitable North American market.

Disruptive Sector Trends: FCA has limited investments in major fundamental trends reshaping the industry such as powertrain electrification, autonomous driving and new mobility services including car-sharing and ride-hailing. This has safeguarded its cash generation but could result in the group falling behind in a rapidly changing sector. However, we expect further investments in these fields and the signing of new alliances.

Short-term Asset Sale Unlikely: We expect a pause in corporate reorganisation in the next 12-18 months following the recent sale of the components business and change in CEO. We believe that a complete or partial disposal of the premium brands, including Alfa Romeo and/or Maserati, remains a long-term option but this is not included in our base case in the foreseeable future. We expect the group to focus first on rejuvenating these brands' profitability before considering a disposal. Other smaller businesses, however, such as Teksid and Comau could be put up for sale.

DERIVATION SUMMARY

FCA is more indebted than most of its mass-market global peers, including Peugeot SA (PSA, BBB-/Stable), General Motors Company (GM, BBB/Stable) and Ford Motor Company (BBB/Stable) but its continuous deleveraging since 2014 makes it comparable to Renault SA (Renault, BBB/Stable). Its leverage is now lower than Jaguar Land Rover Ltd.'s (JLR, BB/Negative).

Strong earnings generated in North America and improving results in other regions lead to operating margins comparing favourably with higher-rated Renault, GM and Ford. The improvement of FCF also positions the group in line with its main global 'BBB-'/'BBB' competitors.

FCA's business profile is supported by the group's large scale, solid brands and broad end-market diversification versus other mass-markets carmakers rated in the 'BB' and 'BBB' categories such as Renault and PSA. However, FCA is less advanced than most of its close peers in the field of alternative powertrains, such as hybrid and electric vehicles, autonomous driving and new mobility services and car ownership options. No parent/subsidiary, no country-ceiling or operating environment aspects impact the ratings.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
-Group revenue to increase by around 4% in 2018 and in low single-digits thereafter, excluding the effect of asset sales and M&A;
-Adjusted group EBIT margin to increase gradually to just above 7% by 2021, supported by still robust profitability in the NAFTA region, a gradual recovery in Latin America and Asia and at Maserati and modest improvement in Europe;
-Capex declining below EUR7.5 billion in 2018 before increasing to EUR9.5 billion-EUR10 billion in 2020-2021;
-Resumption of ordinary dividend payment in 2019, with a payout ratio of around 20%, and a special dividend of around EUR2 billion in 2019; and
-EUR6 billion cash inflow in 2019 from the sale of Magneti Marelli but no other large asset sale and specific M&A are incorporated in our rating case as this will be treated on a case-by-case basis when announced.

RATING SENSITIVITIES

Future Developments That May, Individually or Collectively, Lead to Positive Rating Action
-FCF sustainably around 2% (2017: 1%)
-FFO adjusted net leverage sustainably around 0.5x (2017: 0.8x)
-Greater share of profits coming from premium brands and outside current core regions

Future Developments That May, Individually or Collectively, Lead to Negative Rating Action
-FCF sustainably below 1%
-FFO adjusted net leverage sustainably above 1.5x
-Cash flow from operations/lease adjusted debt sustainably below 40% (2017: 49%)
-Increasingly lagging behind developing fundamental industry trends

LIQUIDITY AND DEBT STRUCTURE

Healthy Liquidity: At end-September 2018 FCA reported EUR8.8 billion in cash and cash equivalents and current debt securities, excluding Fitch's EUR3.2 billion adjustments for minimum operational cash and other adjustments, including derivatives. Liquidity is also supported by EUR7.7 billion of undrawn revolving credit facility at end-September 2018. This largely covers debt of EUR6.4 billion maturing over the next 15 months. The group also follows a conservative financial strategy aimed at maintaining a robust gross cash position as protection against the next cyclical downturn.

SUMMARY OF FINANCIAL ADJUSTMENTS

Fitch's operating EBIT differs from FCA's adjusted EBIT, notably because impairment expense (EUR229 million in 2017) and currency devaluations (none in 2017) are viewed as operating items and result from investments (EUR220 million) is viewed as a non-operating item.