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Icahn to Rachesky Circle Navistar With Bonds Below Par

Navistar Chief Executive Officer Daniel Ustian
Chief Executive Officer Daniel Ustian has revamped management as Navistar, which operated as International Harvester through most of the 20th century, struggles to meet 2010 federal emission standards for one of its truck engines. Photographer: Andrew Harrer/Bloomberg

Navistar International Corp. has gone from being more creditworthy than its peers to less in the past 3 weeks as a drop in earnings signal troubles beyond its bet on a new engine that has yet to win regulatory approval.

Relative yields on the third-biggest U.S. and Canadian truck-engine maker’s bonds have widened 192 basis points to 774 basis points this month, while those of all high-yield automotive products makers remained unchanged at 622 basis points, Bank of America Merrill Lynch data show. Lisle, Illinois-based Navistar cut its 2012 profit forecast to a range of break-even to $2 a share from as much as $5.25 three months ago, citing rising warranty costs, slowing overseas sales and growing inventories.

Navistar’s bonds have fallen below face value, a sign investors question its ability to service the debt, said Vicki Bryan, a debt analyst at Gimme Credit LLC who rates the notes “sell.” Hedge fund manager Mark Rachesky has revealed a 13.6 percent stake in Navistar’s shares, more than that of his former mentor, Carl Icahn, who owns 11.9 percent.

“I don’t see a quick fix here,” Bryan said in a telephone interview. “There are hints of systemic problems in its product line in addition to its exhaust gas recirculation troubles. Over the last two quarters the company’s reported a spike in repair costs, its warranty reserve, and a sizable recall of its buses.”

Swaps Rise

The cost to protect against losses on the debt of Navistar has increased about 55 basis points to a mid-price of 550.6 basis points this month, Bloomberg prices show. Credit default swaps typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Navistar has enough cash and borrowing ability to pay the penalties through the end of the year, Navistar spokeswoman Karen Denning wrote in an e-mailed statement. She declined to comment on a June 11 FT Deutschland report that Volkswagen was considering taking a stake in the company.

The company, which manufactures products under brand names such as MaxxForce and Workhorse, had $737 million of cash and equivalents on April 30, the least in two years, according to data compiled by Bloomberg.

Engine Certification

Chief Executive Officer Daniel Ustian has revamped management as Navistar, which operated as International Harvester through most of the 20th century, struggles to meet 2010 federal emission standards for one of its truck engines.

Navistar is trying to develop a 13-liter engine that meets EPA certification for nitrogen oxide emissions. A lack of certification cost the company $10 million in penalties in its second 2012 quarter, which ended April 30, and the bill may rise to as much as $40 million if the engine isn’t certified this year, Chief Executive Officer said in a June 7 teleconference to discuss the results with analysts and investors.

“The penalties -- if they are allowed and if they applied for an extended period -- are designed to make sales not profitable, so the company wouldn’t be able to continue operating profitably,” Sol Samson, a New York-based credit analyst at Standard & Poor’s said in a telephone interview.

The U.S. Court of Appeals for the District of Columbia vacated on June 12 an Environmental Protection Agency interim rule that allowed Navistar to pay fines called non-conformance penalties for selling engines that don’t meet environmental standards that took effect in 2010.

‘Limited’ Effect

The judges wrote that their decision was of “limited practical impact” because it dealt with the interim rule on technical ground and that the EPA was “certainly free to make whatever findings it deems appropriate in the pending final rulemaking” subject to the court’s further review.

“They believed they could stall the EPA with lawsuits and have an engine certified faster than they did,” Jeffrey Kauffman, an analyst at Sterne, Agee & Leach Inc., said in a telephone interview. “It doesn’t appear that they have a plan B in place.”

Ustian said during the teleconference that Navistar was “continuing to work with the EPA” on having its engine approved and preferred not to pay the fines.

Management inability to communicate the risks involved are responsible for the problems at Navistar rather than long-term operational issues, Kauffman said.

Bonds Decline

The company’s 8.25 percent $900 million notes maturing in November 2021 have declined 9.37 percent this month to 95 cents on the dollar, while junk bonds in the U.S. have gained an average 0.4 percent, Bank of America Merrill Lynch index data show

The bonds may rise by 5 cents on the dollar if the EPA ultimately approves Navistar’s technology JPMorgan Chase & Co. analyst Eric Selle said in a June 15 research note. They might fall 15 cents if it doesn’t, he said.

Navistar shares fell 1.39 cents at 11:26 a.m. in New York morning, to $28.56. That’s off a year low of $24.11 on June 7.

Weakening demand in overseas markets, which accounted for about 35 percent of the company’s revenue in 2011, has contributed to the constrained earnings. “Our business needs volume to become more cost effective, and our volumes are lower than we anticipated,” Chief Financial Officer Andrew Cederoth said on the conference call. The drop has also led to a buildup of Navistar products in inventory instead of on the roads.

Navistar witnessed an “unanticipated increase” in warranty-related expenses, the company said in its June 7 quarterly filing. Problems in the quality of engines led to higher repair costs than previously expected, the filing showed.

‘Getting Surprised’

The company had forecast $227 million of increased estimates of warranty costs for products sold in previous periods. In the first six months of the company’s previous financial year, it increased warranty estimates by $36 million.

“It seems like the company keeps getting surprised by things,” Kauffman said. “The drop in investor confidence is a result of loss in management credibility.”

Rachesky’s company, MHR Fund Management LLC, said in a June 15 filing that Navistar’s shares are “undervalued” and that it may “seek to engage in discussions with management and others concerning the business and operations of the company.”

Navistar posted an adjusted loss of $137 million, or $1.99 per share, in the three months ended April 30. A survey of 15 analysts by Bloomberg had estimated the company would earn 67 cents. The net loss was $172 million, or $2.50 a share, compared with a profit of $74 million, or 93 cents, a year earlier.

Ratings Cut

The company’s truck business recorded a loss of $89 million for the quarter from a $92 million profit a year earlier. The engine business had a $108 million deficit, compared with a $2 million profit.

S&P lowered Navistar’s rating to B+ from BB- after the earnings announcement and put the company on CreditWatch with “negative” implications. The ratings company said Navistar will “be challenged to avoid a full-year loss.”

Fitch Ratings rates Navistar BB and put the company on watch “negative,” saying margins shrank because of “a higher proportion of heavy duty trucks and sales to large customers that generate lower margins.”

“There are lots of issues surrounding the level of losses that Navistar experienced, including market share, warranty, and efficiency, which are not a function of EPA,” S&P’s Samson said. If the EPA rejects Navistar’s application, “then they will have a much bigger problem,” he said.

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