Our view of the company's financial risk profile as intermediate somewhat constrains the ratings. We factor in the sensitivity of Akzo's sizable postretirement obligations to actuarial assumptions. Lower discount rates have led to an increased pension deficit in 2012, notwithstanding sizable top-up payments made, weakening Akzo's Standard & Poor's adjusted credit metrics. The company's financial risk profile is supported, however, by our view that Akzo's generation of funds from operations (FFO) is recurring and free cash flow potential before dividends is strong. We also view the company's recently announced disposal of its North American Decorative Paints business to PPG Industries Inc. (BBB+/Stable/A-2) as a stabilizing factor for the rating. The assets to be sold had generated negative cash flows in the past few years and reached break-even only in recent quarters. Akzo has announced it intends to use the cash proceeds of $875 million for investments in its continuing operations and deleveraging.
S&P base-case operating scenario
In our base-case assessment, we anticipate that Akzo will report revenues of about EUR16.5 billion in 2012 (this includes North American Decorative Paints, which Akzo will report separately as "held for sale"), up from EUR15.7 billion in 2011 (of which EUR1.1 billion related to the North American Decorative Paints business), based on strong pricing trends and supported by a weaker euro, but also integrating softer volumes across its three divisions.
We believe Akzo will report more than EUR1.9 billion in 2012 EBITDA (before special charges and benefits, according to the company), compared with EUR1.8 billion in 2011. After satisfactory first-nine-month 2012 EBITDA of EUR1.5 billion, we expect a weaker fourth quarter, owing to the uncertain macroeconomic environment, including further softening in demand in the decorative paints segment.
Furthermore, Akzo expects the targeted benefits of EUR500 million EBITDA from its recently announced performance improvement program to be realized only in 2014 (EUR200 million in benefits expected for full-year 2012). Related incremental costs will likely amount to EUR425 million over 2012-2014.
S&P base-case cash flow and capital-structure scenario
While pressure on Akzo's cash flow based credit metrics started to build during 2012 due to adverse movements in actuarial pension-related assumptions, we think credit ratios will quickly be restored in second-quarter 2013, with an inflow of $875 million cash disposal proceeds and the transfer of $175 million of pension obligations (of which about $100 million will reduce Akzo's pension deficit under IFRS according to the group), both related to Akzo's disposal of its North American Decorative Paints business.
Adverse movements in actuarial pension-related assumptions this year mean that we now forecast Akzo's adjusted debt to rise by a hefty EUR1 billion year-on-year to EUR4.6 billion at year-end 2012. We have therefore revised down our base-line forecast for Akzo's 2012 Standard & Poor's-adjusted FFO to net debt to around 28%, from 35% in our summary analysis published Oct. 10, 2012, and down from 32% achieved at year-end 2011.
Following the disposal, we assume the ratio will improve to at least 35% and further increase in 2014, depending on the final allocation of the disposal proceeds to investments or debt reduction, and factoring in the increased profit upside from the above-mentioned cost improvement program.
For 2012, we anticipate adjusted FFO of about EUR1.2 billion--after adding back sizable pension-related top-up payments--to cover adjusted capital spending of about EUR0.8 billion and EUR0.3 billion in dividends (including to minority shareholders).
Despite ongoing large top-up payments, the company's pension deficit increased to about EUR0.9 billion as of the end of September 2012, compared with EUR0.5 billion at year-end 2011 and EUR1 billion at year-end 2010, as a result of the very low discount rates that increased the net present value of its long-ended (notably U.K.) pension obligations. Akzo had gross pension obligations of as much as EUR15.5 billion at year-end 2011, offset by EUR14.6 billion in low-risk pension assets (with only 15% invested in equities).
The 'A-2' short-term rating reflects our view of the company's "strong" liquidity as per our criteria. We forecast liquidity sources exceeding liquidity needs by more than 1.5x over the 12 months started Sept. 30, 2012.
Liquidity sources as of Sept. 30, 2012, over the following 12 months comprise:
-- Reported cash of EUR1.5 billion. We treat EUR0.4 billion of this as tied to operations, given the company's seasonality and restricted cash.
-- EUR1.8 billion availability under credit facilities, which are not subject to any financial covenants. Akzo completed an extension in September of EUR1.7 billion to 2017, with the remainder of about EUR65 million (which has not been extended) maturing in 2016.
-- Positive free cash flow of about EUR0.2 billion, before dividends and discretionary pension-top-up payments of EUR0.3 billion per year.
Our estimate of sources does not include the expected cash proceeds of $875 million (EUR665 million) from the disposal of Akzo's North American Decorative Paints business announced in December 2012, which it expects to complete in second-quarter 2012.
Liquidity uses for the same period may include:
-- Short-term debt of about EUR347 million as of Sept. 30, 2012. A $500 million bond comes due in December 2013.
-- Dividend payments (including to minority shareholders) of about EUR0.3 billion.
We also note that in January 2014 a EUR825 million bond comes due.
The stable outlook reflects our view that despite weakening demand and the substantial increase in Akzo's pension deficit and adjusted debt, Akzo's adjusted FFO-to-debt ratio should quickly recover in 2013 to above 35%. We would consider this level to be commensurate with the current ratings. This factors in the proceeds from the recently announced sale of the North American Decorative Paints business and the related transfer of pension obligations, as well as management's supportive financial policies and commitment to improve credit metrics.
Downside ratings pressure could arise if Akzo's adjusted FFO to debt fell below 30% without near-term prospects of recovery or if it generated substantial negative free operating cash flow (FOCF), for example due to a combination of a difficult macroeconomic environment, sizable capital spending, and an ongoing squeeze on margins owing to raw materials prices. In addition, we do not factor in unanticipated significant acquisitions into the ratings.
We do not exclude ratings upside over the medium term, provided we were confident that Akzo would generate healthy sustainable positive FOCF, notably if the challenging economic climate were to persist. In addition, ratings upside would depend on sufficiently supportive financial policies, and management's commitment to higher credit metrics.
Related Criteria And Research
All articles listed below are available on RatingsDirect on the Global Credit Portal, unless otherwise stated.
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
-- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, September 18, 2012
-- Methodology and Assumptions: Liquidity Descriptors for Global Corporate Issuers, Sept. 28, 2011
-- Key Credit Factors: Business and Financial Risks In The Commodity And Specialty Chemical Industry, Nov. 20, 2008