TEXT-S&P cuts Ferro Corp rating to 'B+'
Overview -- Operating results for Ohio-based chemicals producer Ferro Corp. have deteriorated in recent quarters, and the company has significantly lowered its earnings guidance for 2012. -- We lowered our corporate credit rating on Ferro to 'B+' from 'BB-' and lowered all our issue-level ratings by one notch. -- The stable outlook reflects our expectation that, despite a significant reduction in 2012 EBITDA, the company will be able to maintain adequate liquidity and a financial profile consistent with the ratings. Rating Action On July 30, 2012, Standard & Poor's Ratings Services lowered its corporate credit rating on Ferro Corp. to 'B+' from 'BB-'. We also lowered the issue-level ratings on the company's senior unsecured debt to 'B-' from 'B'. The '6' recovery rating, which remains unchanged, reflects our expectation for negligible (0% to 10%) recovery in the event of a payment default. The outlook is stable. Rationale The downgrade follows the company's announcement that it has significantly lowered its earnings guidance for 2012. The reduction in earnings expectations reflect the continued weakness in Europe (which represents roughly one-third of the company's revenues), subdued demand in the electronic materials segment, particularly for the company's conductive pastes used in solar panels, and increased pension expense. We modified our initial expectation that earnings would moderately grow in the second half of the year, to now being in line with first-half levels. Given the continued economic uncertainty and reduced earnings expectations, we now believe that the key ratio of funds from operations (FFO) to total adjusted debt will fail to meet our previous expectations of 20%, a level we had considered appropriate for the 'BB-' rating. Based on our scenario forecasts for moderately lower cash flows in 2012, we expect this ratio will decline to about 15%, which we consider in line with an "aggressive" financial risk profile and appropriate for the current rating. Accordingly, we revised our assessment of the financial risk profile to "aggressive" from "significant". The ratings on Ohio-based Ferro Corp. reflect our assessment of the company's business risk profile as "weak" and financial risk profile as "aggressive." With annual sales of $1.9 billion, the company produces a variety of performance materials and chemicals for use, primarily in the electronics, construction, appliances, automotive, and household furnishings end markets. Ferro operates in six business segments: electronic materials, color and glass performance materials (which include high-quality glazes, enamels, pigments, and dinnerware decoration colors), performance coatings (which include tile coatings and porcelain enamel for appliances and cookware), polymer additives, specialty plastics, and pharmaceuticals. Ferro remains vulnerable to cost fluctuations for its raw materials and has significant exposure to residential and commercial construction and electronics end markets. Many of the company's products are discretionary purchases, which renders their demand highly sensitive to extended cyclical downturns. In addition, profitability in some business segments (such as polymer additives, which make up about 15% of sales) is suffering because of commodity-like and highly competitive markets. Partially offsetting these weaknesses are the company's leading market positions in some of its segments, a diverse portfolio of performance materials and chemicals, geographic and customer diversification, and an improved cost structure. Its top 10 customers account for about 20% of sales, and it generates more than 50% of revenues outside of the U.S. (although a significant portion of that is derived from the weak European market). Over the last year, the company has been affected by a reduced amount of paste now being used in solar cells (thrifting). In addition, the solar industry has also felt the effects of reductions in government subsidies for solar use in parts of Europe, and increased solar panel competition, which led to production overcapacities, excess inventories of solar panels and rapid price declines. Additionally, recent tariffs imposed on Chinese solar manufacturers add further uncertainty to near-term demand. Given the expectation that this segment will remain weak over at least the near term, the company's efforts to secure additional product qualifications and increase share with Asian Tier 1 customers will remain key to improving earnings in the electronic materials segment. At its peak, solar represented a sizeable portion of the company's EBITDA and had significantly higher margins than the other segments. The company's margins have deteriorated with the solar decline; the last-12-month EBITDA margins were 7.4% as of June 30, 2012, down from 12.7% for the same period ended June 2011. Debt reduction in 2009 and 2010 (in part with proceeds from a 2009 equity issuance), the recovery of cash collateral relating to the company's precious metal leases, and the resulting significant reduction in interest expense all contributed to Ferro's improved financial risk profile when compared with 2009. However, as a result of the significant drop in EBITDA over the past year, credit metrics have weakened--a trend we expect to continue this year. The ratio of FFO to total adjusted debt (adjusted for capitalized operating leases, and underfunded pension and other postretirement obligations) was 23% as of June 30, 2012, compared with 30% at the end of 2011. We believe management will remain prudent in its capital spending plans and any potential acquisitions or shareholder rewards, thereby maintaining a financial policy that support our ratings. Liquidity We view Ferro's liquidity as "adequate." As of June 30, 2012, the company had $25 million in cash and about $341 million available under its $350 million revolving credit facility maturing in August 2015. The company also has a $50 million 364-day receivables securitization facility expiring in May 2013. Ferro uses precious metals in the production of some of its products, primarily silver for electronic materials products. It has about $350 million in collateral free lease lines and did not have any cash on deposit as collateral as of June 30, 2012. We base our liquidity assessment on the following factors and expectations: -- Sources of cash will exceed 1.2x of cash usage during the next 12 to 18 months; -- Sources will remain positive even in the event of a 20% EBITDA decline; -- Compliance with financial covenants could survive a 15% drop in EBITDA; and -- Ferro would likely be able to absorb low-probability shocks based on available liquidity. We believe the company's flexibility to lower capital spending or sell assets should supplement liquidity. Debt maturities are limited for the next several years, with the next upcoming maturity consisting of the remaining $34 million of convertible senior notes due Aug. 15, 2013. We expect that the company will repay these notes through a combination of free cash flow and revolver borrowings. In June 2012, the company amended its financial covenants to provide additional flexibility. Financial covenants now include a maximum leverage ratio of 4.25x in 2012 and 3.5x thereafter, as well as a maximum capital expenditure and minimum interest coverage covenant. The minimum interest coverage covenant is 2.5x in the third quarter of 2012, 2.75x in the fourth quarter, and 3.0x thereafter. Ferro eliminated the minimum fixed-charge coverage ratio, which we believe was problematic, as it had deducted capital expenditures from EBITDA in the calculation. Recovery analysis For the complete recovery analysis, see our recovery report on Ferro Corp., Ferro Corp.'s Recovery Rating Profile, published on May 17, 2012, on RatingsDirect. Outlook The outlook is stable. Our base case assumes a significant drop in 2012 EBITDA, resulting from depressed demand for solar pastes, coupled with continuing sluggish demand for residential and commercial building and renovation, particularly in Europe. We expect that earnings will improve modestly in 2013, albeit from very weak levels, as the company should benefit from recent cost cutting initiatives. Based on our scenario forecasts, we believe that 2012 free operating cash flow will be neutral, based on our expectations that reduced capital expenditures and lower working capital needs will offset lower earnings. We could lower the ratings within the next 12 months if industry conditions or the company's operating performance are below our expectations. This could occur if the company is unable to successfully improve its position in the Asian solar market, or if fierce competition continues to keep pricing down. Based on our downside scenario, we could lower the ratings if revenues decline by 15% and EBITDA margins decrease by 100 basis points or more below our expectations. In such a scenario, FFO to total adjusted debt would decrease to below 12%. We could also lower the ratings if free cash flow turns negative, or if EBITDA cushions under the covenants decline to about 10%. We could consider a one-notch upgrade if the macroeconomic outlook strengthens, operating results stabilize, and we gain confidence that EBITDA will moderately improve from weak 2012 levels. Specifically, we could consider a modest upgrade if EBITDA margins improve by 150 basis points or more, coupled with a 5% increase in revenues. In such a scenario, we expect that FFO to total adjusted debt would increase to above 20%. The company's end-market concentration in construction and electronics, which are cyclical and have discretionary demand characteristics, could limit further upgrade potential if the company does not take strategic actions to diversify and strengthen its portfolio. Related Criteria And Research -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- Key Credit Factors: Methodology And Assumptions On Risks In The Packaging Industry, Dec. 4, 2008 Ratings List Ratings Lowered Ferro Corp. To From Corporate credit rating B+/Stable/-- BB-/Stable/-- Senior unsecured B- B Recovery rating 6 6
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