DBRS Confirms AB Volvo at BBB (high), Trend Changed to Negative

DBRS has today confirmed the long- and short-term ratings of AB Volvo (Volvo or the Company) at BBB (high) and R-2 (high), respectively. The ratings reflect the Company’s solid business profile, with Volvo being firmly entrenched among the world’s largest truck manufacturers and the third global player in construction equipment. The trend on the ratings has been changed to Negative from Stable. DBRS acknowledges that the Company’s earnings performance has improved over the twelve-month period ending June 30, 2014; however, the improvement has been of a degree somewhat less than anticipated by DBRS, primarily due to ongoing weakness across several major construction equipment markets. The lacklustre earnings recovery has also been exacerbated by substantial working capital absorption, which has resulted in negative free cash flow generation through the first half of this year. Moreover, while earnings of the Truck segment have recently rebounded, they nonetheless remain considerably below historical norms, with challenges expected to persist in South America and conditions remaining uncertain in Europe (following pre-buy activity in late 2013 and amid ongoing economic headwinds). In the event that negative free cash persists over the near term, this would likely result in a downgrade of the ratings.

Volvo’s 2013 annual earnings were considerably lower relative to 2012, with weaker performance in each of the core Truck and Construction Equipment segments. In the Truck segment, the reduced profitability was a function of lower volumes exacerbated by higher manufacturing costs, in addition to increased research and development (R&D) expenses associated with Volvo’s extensive product renewal. In the Construction Equipment segment, the softer earnings were also a function of lower volumes, with product mix also being weaker, reflecting significantly reduced global mining activity (in both segments, earnings were further adversely affected by foreign exchange headwinds). However, DBRS nonetheless notes that the Company’s financial performance in H2 2013 was significantly improved vis-à-vis the first six months of the year, given the strong performance of the Truck segment, which benefited from solid demand in major markets such as North America, Brazil and Europe (the latter benefiting from pre-buying activity in advance of the Euro 6 emissions regulation that came into effect as of January 2014).

Through H1 2014, the Company’s earnings on a sequential basis were essentially consistent with H2 2013. The performance of the Truck business remained solid; however, this was meaningfully offset by continued weak results of the Construction Equipment segment that incorporated declines in the Chinese market with ongoing foreign exchange headwinds, further undermining earnings.

DBRS notes that Volvo’s credit metrics remain commensurate with the ratings; in particular, the Company’s coverage measures are well within the BBB (high) to A (low) range. However, this is partly offset by the leverage (i.e., gross debt-to-total capitalization) of the industrial operations, which is somewhat aggressive for the ratings (calculated by DBRS at a level of 44% as of June 30, 2014, on a pro forma basis, to incorporate the completion of the forthcoming joint venture (JV) with Dongfeng Motor Group Company Limited (Dongfeng)). Moreover, DBRS notes that the negative free cash flow in H1 2014 would have increased Volvo’s industrial leverage further were it not for the meaningful associated reduction in the Company’s cash balances.

Notwithstanding the above, Volvo’s competitive position in the Truck segment appears to have been well-defended by its recent and extensive product renewal. In 2013, the Company achieved market share gains across all major market regions with the exception of Europe, where its share experienced a slight adverse impact with the transition to the new product range. However, in Q2 2014, Volvo’s total heavy duty truck market share in Europe increased to 26.1% (vis-à-vis 24.3% over the similar prior-year period), with further gains likely, given that the renewal of the Renault product line is still in its initial stages. Furthermore, in addition to the achieved gains in share, the Company is also enjoying firmer pricing in response to the new models.

With its extensive product renewal having been significantly completed, this year the Company is primarily focused on improving its efficiency and cost position going forward, and has undertaken various restructuring measures. Most significantly, in Q3 2013 and Q1 2014, Volvo announced planned staff cuts of a total targeted amount of 4,400 employees (primarily consisting of white-collar staff and consultants), with the significant majority of such reductions expected to be completed by the end of this year. Other restructuring initiatives include a revamping of the manufacturing footprint in Europe and the sales and service organizations for Trucks in Europe, as well as a reorganization of Volvo’s global parts distribution. In total, these initiatives are expected to result in incurred charges of approximately SEK 5 billion in 2014.

Regarding the Dongfeng JV, while the alliance received approval early this year from the Chinese National Development and Reform Commission, other requisite approvals remain pending, with Volvo expecting the transaction to formally close in the second half of this year. Additionally, in January the Company announced the acquisition of the rigid and articulated hauler business from Terex Corporation (Terex). DBRS notes that the outlays associated with such acquisitions (approximately SEK 6 billion and SEK 1 billion for the Dongfeng JV and Terex, respectively) are essentially offset by recent divestitures, notably including the sale of the Volvo Rents Business in Q1 2014 (generating proceeds of SEK 7 billion), as well as the sale of commercial real estate assets for approximately SEK 0.8 billion.

Going forward, DBRS projects moderately firmer earnings and cash flow generation from the Company. While the results of the Construction Equipment will likely remain undermined by ongoing challenging conditions, primarily across emerging markets (mainly China), this is expected to be more than offset by the Truck segment’s anticipated profits, which are assumed to benefit from higher volumes and firmer pricing. Moreover, with the Company’s investments associated with its extensive product renewal having essentially peaked, R&D expenses and capital expenditures are projected to moderate over the near to medium term, thereby further supporting earnings and free cash flow generation. The Company is still in the relatively early stages of its current transformation plan, scheduled to extend through 2015, with Volvo targeting to become among the leaders in terms of profitability (i.e., operating margin) across the key segments of its industrial operations. In Trucks, the Company is aiming to substantially increase its long-term sales in the Asian market, while in Construction Equipment, Volvo is hoping to increase the global presence of the value SDLG brand while also further developing Volvo-branded products in emerging markets.

In line with the above, Volvo’s industrial earnings are assumed by DBRS to be likely subject to moderate improvement, although headwinds in the Construction Equipment business may continue to significantly offset ongoing progress in Trucks. DBRS notes that working capital usage through H1 2014 significantly exceeded that of last year. Therefore, while working capital development may likely be positive in the second half of this year, it is uncertain as to whether this will be sufficient to effectively reverse the substantial usage earlier in the year. In the event that the Company’s earnings continue to improve and Volvo reverts to free cash flow generation, the trend on the ratings could be changed to Stable. However, in the event that the Company’s negative free cash flow persists, this would likely result in a downgrade of the ratings.

Notes:
All amounts are in SEK unless otherwise specified.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

Ratings on Volvo Treasury Canada Inc. are based on the parent and guarantor, AB Volvo.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

The applicable methodology is Rating Companies in the Automotive Industry, which can be found on our website under Methodologies.