Overview -- Albany, N.Y.-based silicone and quartz producer Momentive Performance Materials Inc. (MPM) has completed a first-priority notes offering and related refinancing of certain debt. -- We are affirming our 'CCC' corporate credit rating on MPM. -- We are lowering our rating on the company's 1.5 lien notes to 'CC' from 'CCC' and removing them from CreditWatch. We are also revising the recovery rating on these notes to '6' from '4'. -- We are affirming all our other issue ratings. -- The negative outlook reflects our view that the company's debt load is unsustainable at the current earnings level. We will likely lower the ratings in the next several quarters unless earnings improve significantly. Rating Action On Dec. 10, 2012, Standard & Poor's Ratings Services affirmed its 'CCC' corporate credit rating on MPM. At the same time, we lowered our rating on the company's 1.5 lien notes to 'CC' (two notches below the corporate credit rating) from 'CCC' and removed them from CreditWatch, where we had placed them with negative implications on Oct. 11, 2012, upon announcement of the refinancing and based on our updated recovery analysis. We are revising the recovery rating on these notes to '6' from '4', indicating our expectation of negligible (0%-10%) recovery in the event of a payment default. We are affirming all our other issue ratings. The outlook remains negative. Rationale These rating actions follow MPM's successful placement of $1.1 billion of first-priority senior secured notes due 2020 and its use of the proceeds to repay revolving and term loan borrowings and its $200 million 12.5% second-lien notes due 2014. After satisfaction of the escrow conditions, these first-priority notes, originally issued by escrow subsidiaries, became obligations of MPM. In addition, following repayment of the second-lien notes, the company's existing second-priority springing lien notes became secured, but the 'CC' issue rating and '6' recovery rating on these notes did not change. We assume the company will execute its plan to enter into a new five-year $300 million revolving asset-based loan (ABL) facility to replace its existing revolving credit facility maturing in December 2014 and $35 million synthetic letter of credit facility maturing in December 2013. In our view, leverage is unsustainably high, with total adjusted debt of about $4.1 billion and debt-to-EBITDA above 20x. Our debt adjustment totals about $1 billion and includes pay-in-kind (PIK) seller notes at MPM's direct parent company, Momentive Performance Materials Holdings Inc. (unrated), tax-adjusted unfunded postretirement obligations, and capitalized operating leases. The ratings on MPM reflect the company's "highly leveraged" financial profile and what we deem to be a "fair" business risk profile. Our assessment of the company's management and governance is "fair". MPM's debt and leverage have been high ever since controlling shareholder Apollo Global Management L.P. acquired the company from General Electric Co. in 2006. But, beginning in the second half of 2011, earnings and cash flow weakness have caused leverage to reach very aggressive levels. Earnings challenges stem from: -- Overcapacity in silicones, which has resulted in very competitive pricing; -- A slowdown in the semiconductor industry, leading to lower demand for quartz; -- Customer inventory reductions in late 2011; and -- Weaker economic conditions in Europe and China. We estimate that during the first three quarters of 2012, pro forma for costs associated with the recent refinancing, the company used about $200 million of cash. Our base case assumes that, despite steps to lower operating costs and working capital, free operating cash flow will continue to be negative for at least the next several quarters. Key assumptions for full-year 2012 include: -- $100 million of capital spending; -- Pension funding of $19 million; -- A total of about $65 million for financing costs and restructuring outlays to achieve synergies with Momentive Specialty Chemicals Inc. (MSC; B-/Stable/--), which is owned by the same parent holding company; and -- Working capital becoming a slight source of cash for the full-year 2012. However, this could change if raw material costs spike. We expect debt to continue to increase both to fund the shortfall in free operating cash flow and as a function of the PIK feature of the seller note at the parent holding company. Consequently, we believe debt leverage will remain unsustainably high during the next several quarters, increasing the likelihood of a default or debt restructuring in the absence of a meaningful reversal of business trends. Moreover, MPM has considerably more debt than its primary competitors, which could erode its competitiveness over time if it impedes sufficient business reinvestment. MPM is a large producer of silicones (representing more than 90% of sales and about 75% of EBITDA in 2011), which are used in a wide variety of applications. MPM also produces quartz, which is used primarily in semiconductors. Construction, transportation, personal care, electronics, and agriculture utilize silicones. They are generally used as an additive, providing or enhancing attributes, such as resistance (to heat, ultraviolet light, or chemicals), lubrication, adhesion, or viscosity. Positive industry factors include significant consolidation and historically above-average growth rates. MPM benefits from good diversification by end market and region, as well as an increasing contribution from specialty products. However, sluggish demand and significant capacity additions in 2011 have resulted in oversupply and very competitive pricing. As a result, MPM's EBITDA margins have dropped sharply from a peak of about 19% to below 10%. Liquidity The recent refinancing increased the absolute amount of liquidity slightly and considerably extended debt maturities, and the planned ABL facility would eliminate maintenance financial covenants. We nevertheless continue to regard liquidity as "weak" as defined in our criteria. This is because at the current earnings level, we expect the company's free operating cash flow to be negative for at least the next several quarters and for liquidity to therefore contract. In our base-case forecast, EBITDA is just below $200 million in 2012 (somewhat higher as calculated under the financial covenant in MPM's existing credit facilities). If EBITDA is flat or increases only slightly in 2013, we believe sources of liquidity will be insufficient to cover projected uses by the end of 2013. MPM intends to enter into a new $300 million ABL revolving credit facility maturing in 2017 to replace its existing $300 million revolver and $35 million synthetic letter of credit (L/C) facility ($33 million of L/Cs outstanding). It has obtained $270 million in commitments from financial institutions and expects to obtain an additional $30 million. Pro forma for all the elements of the refinancing, including entry into the new revolver, we estimate liquidity as of Sept. 30, 2012, at about $330 million. This included $146 million of cash and $184 million of borrowing capacity (after deducting $78 million of L/C's issued plus borrowing base restrictions of $37.5 million or 12.5% of the facility amount). If the credit facility refinancing is completed as currently structured, MPM would have no significant debt maturities until 2016. Recovery analysis If the company enters into the new $300 million ABL facility as planned, the ratings on its existing rated debt will remain unchanged. Its first-priority senior secured notes are rated 'CCC+' (one notch above the corporate credit rating) with a recovery rating of '2', indicating prospects for substantial (70% to 90%) recovery in the event of a payment default. All its other debt, including its 1.5 lien notes, second-priority notes, and subordinated notes, is rated 'CC' (two notches below the corporate credit rating), with a recovery rating of '6', denoting prospects for negligible (0% to 10%) recovery in the event of a payment default. The senior secured revolver and synthetic bank loan are rated 'B-', with '1' recovery ratings; we expect these facilities to be replaced by the ABL revolver. For the full recovery analysis, please see our recovery report on MPM published on The Global Credit Portal on Oct. 16, 2012. Outlook The negative outlook reflects our expectation that silicone overcapacity and a tepid global economy will cause MPM's free operating cash flow to be negative for at least the next several quarters, causing liquidity to contract. We are likely to lower the ratings during the next several quarters if industry conditions fail to improve sufficiently to enable MPM to achieve cash flow neutrality and stabilize liquidity, heightening the probability of a payment default. We could also lower the ratings sooner if the proposed $300 million ABL and notes financing is not completed as currently structured, or if the company voluntarily restructures or repurchases its debt in such a way that results in anything less than full and timely repayment. On the other hand, we could revise the outlook to stable if earnings and cash flow strengthen, leverage declines, and liquidity stabilizes at a level we consider adequate. Related Criteria And Research -- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Key Credit Factors: Business And Financial Risks In The Commodity And Specialty Chemical Industry, Nov. 20, 2008 -- General Criteria: Criteria For Assigning 'CCC+', 'CCC', 'CCC-', And 'CC' Ratings, Oct. 1, 2012 -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 Ratings List Ratings Affirmed Momentive Performance Materials Inc. Corporate Credit Rating CCC/Negative/-- Momentive Performance Materials Inc. Senior Secured US$1.161 bil second priority CC springing lien nts due 01/15/2021 Recovery Rating 6 EUR150 mil 9.50% second priority CC springing lien nts due 01/15/2021 Recovery Rating 6 Subordinated Local Currency CC Recovery Rating 6 6 Momentive Performance Materials Inc. Senior Secured (First-priority notes) Local Currency CCC+ CCC+ Recovery Rating 2 2 Momentive Performance Materials GmbH Momentive Performance Materials USA Inc. Senior Secured US$300 mil revolv credit fac bank B- B- ln due 12/03/2014 Recovery Rating 1 1 US$35 mil synthetic ltr or credit B- B- bank ln due 12/04/2013 Recovery Rating 1 1 Rating Lowered; CreditWatch/Outlook Action To From Momentive Performance Materials Inc. Senior Secured (1.5-lien notes) Local Currency CC CCC /Watch Neg Recovery Rating 6 4 Ratings Withdrawn To From Momentive Performance Materials Inc. Momentive Performance Materials GmbH Senior Secured US$436.41 mil term bank ln due NR B- 05/05/2015 Recovery Rating NR 1 EUR294.38 mil term bank ln due NR B- 05/05/2015 Recovery Rating NR 1 US$200 mil 12.50% 2nd lien nts due NR CC 06/15/2014 Recovery Rating NR 6 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. 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