S&P: Polymer Film Manufacturer Innovia Group (Holding 3) Outlook Revised To Positive On Debt Reduction; 'B' Ratings Affirmed
The outlook revision follows Innovia's announcement that it is redeeming €80 million of its senior secured notes, which is expected to be completed on Aug. 26, 2016. The redemption was triggered by the sale of its cellophane business for €75 million. We view the decision to use the proceeds to repay debt as positive with regards to financial policy, given the limited take-up of the mandatory notes offer. We also view the sale of the cellophane business as broadly positive for business risk because, following the sale, we forecast that fully S&P Global Ratings-adjusted EBITDA margins will markedly improve to about 19% from 12% in 2015 and, to a more limited extent, improved cash flow generation.
Further supporting our rating is the very strong performance the group recorded in the first half of 2016. While we forecast slightly lower earnings in the second half of the year as seasonality and raw material pass-through mechanisms have an impact, we have nevertheless revised upward our earnings forecasts. Looking further forward, we expect the utilization of recent new capacity additions, as well as new banknote contracts to provide further incremental earnings, while reduced one-off costs and capital expenditure (capex) should contribute to a steady improvement in credit metrics. As a result, we now forecast S&P Global Ratings-adjusted leverage to drop toward 4.4x over the next 12-24 months from 6.7x in 2015, with further improvements thereafter.
We see the evolution of both financial policy and operating performance as important contributing factors to the potential for an upgrade over the next few quarters. We view the decision to pre-emptively pay down debt as positive with regards to financial policy, and recent comments made during the company's second quarter results about targeting further deleveraging provide us with some testament that the risk of releveraging over 5x could be low. Nevertheless, in the absence of a clearly communicated financial policy target, we would look toward some track record of maintaining lower leverage in order to raise the ratings.
Any potential upgrade would also require evidence that recent improvements in operating performance and credit metrics can be sustained. Innovia's earnings profile to date has been characterized by a relatively high degree of volatility due to the group's small absolute size, the lumpy nature of banknote contracts, volatile input costs, and lags in being able to pass these costs onto customers. That said, management argues that a healthy order book and operational improvements should result in a reduced level of volatility going forward, of which there is some evidence in recent quarters.
Innovia's fair business risk profile continues to reflect the group's relatively volatile profitability in polymer film products, and limited size compared to its rated peers--with revenues of about €400 million following the sale of its cellophane business. Innovia's strong competitive positions in niche, fragmented markets, and relatively stable end markets, partly mitigate these weaknesses. A high proportion of the group's contracts with its end users include clauses that enable it to pass through any increase in the cost of raw materials, providing it with some protection from volatile input costs. We also recognize Innovia's relatively strong product and geographic diversity as the group is present in over 100 countries.
In our base case, we assume: Revenues reducing by 10%-13% in 2016 and 2017, due predominantly to the sale of the cellophane business on June 30, 2016 and lower raw material costs that are expected to be passed through via reduced prices. We forecast underlying organic volume growth in low-single digits until significant new security contracts ramp up in 2018.Significant improvements in margins as a result of operating improvements, fewer one-off costs, and the sale of the low margin (4.6%) cellophane division. We forecast adjusted EBITDA margins to be sustained at about 19% going forward. Capex reducing to €15 million-€20 million per year from €42 million in 2015 following the completion of capacity expansion projects. Based on these assumptions, we arrive at the following credit measures: Adjusted leverage to drop to about 4.4x over the next 12-24 months from 6.7x in 2015.Funds from operations (FFO) to debt improving to about 16% in 2016 and 2017, up from 7.1% in 2015.
The positive outlook reflects our view that we could raise the ratings by one notch over the next 6-12 months if we believe that Innovia will maintain permanently reduced leverage, and that the risk of releveraging is low.
We could upgrade Innovia to 'B+' if the company is able to demonstrate sustainably reduced leverage at comfortably less than 5x, and an FFO-to-debt ratio of above 12%--through improved operating performance and reduced earnings volatility--while supported by less aggressive financial policies that target further deleveraging.
We could revise the outlook to stable if we are no longer convinced that Innovia's shareholders are targeting a less aggressive capital structure, or if weaker or more volatile earnings resulted in credit metrics returning to those consistent with a highly leveraged financial risk profile.