SGL Carbon Downgraded To 'CCC+' On Continued Weak Market Conditions; Outlook Stable

  • Economic activity in Europe and the U.S. is expected to weaken in 2020, which is likely to erode profitability at German carbon and graphite manufacturer SGL Carbon SE further.
  • We project another year for SGL with a negative free cash flow and elevated credit metrics, leading us to assess its capital structure as unsustainable.
  • We are therefore lowering to 'CCC+' from 'B-' our long-term issuer credit rating on SGL Carbon SE and to 'B-' from 'B' our issue rating on its senior secured notes.
  • The stable outlook is supported by the company's supportive liquidity position and limited downside to the rating in the next 12 months.
PARIS (S&P Global Ratings) March 24, 2020--S&P Global Ratings today took the rating actions listed above.
We downgraded SGL because its capital structure, in our view, is becoming unsustainable, explained by elevated credit metrics and a negative free cash flow. At the same time, its adequate liquidity position remains supportive, and will enable the company to hold on for the next 12 months. As a result, at this stage, there is limited downside to the rating.
Given the current adverse economic conditions in Europe and the U.S., results for 2020 will likely remain weak, delaying our previous expectations of a reduction in the company's absolute debt level. Even excluding the effect of the COVID-19 epidemic, we now expect the company to report an S&P Global Ratings-adjusted EBITDA of up to €100 million in 2020, as well as our adjusted debt to EBITDA above 7.0x in 2020 without an obvious improvement in 2021. Moreover, under our base case, we expect the company to generate negative free operating cash flow (FOCF) of up to €20 million in 2020. We note the company has recently guided the market for recurring EBIT at 10%-15% below the prior year's level (equivalent to EBITDA of about €115 million) with a breakeven free cash flow.
Based on its liquidity sources as of Dec. 31, 2019, SGL could comfortably absorb this amount, mainly through its cash position. The company also has a comfortable maturity profile; its first sizable (€159 million) repayment is only in 2023.

SGL was already struggling to rebuild momentum--COVID-19 won't help

After the sound results in 2018 and the expectation of further positive momentum in 2019, SGL reported disappointing results, with reported EBITDA of €120 million (in line with our projection of €100 million-€120 million from September 2019, when we revised the outlook to negative). While its graphite materials and systems (GMS) division had a record year, the company's carbon fiber materials (CFM) division stumbled in 2019. The company considered that the drop stemmed from its textile fiber business--which remained loss making--and mixed effects in its wind energy business.
Earlier this year, and before factoring in the consequences of the COVID-19 outbreak, we projected EBITDA of €100 million-€120 million in 2020. This projection anticipated SGL's need to address its cost structure in certain parts of its business (for example, the textile segment). SGL also needs to tackle softer demand for some applications and to fill the capacity of its current carbon fiber facilities, because its agreement with BMW is coming to an end in 2022 (we understand that the agreement could be extended). According to the company, some important milestones have already been achieved.

What if the current crisis turned into a longer recession?

Governments across Europe are taking unprecedented steps to contain the COVID-19 outbreak and, as a result, we now project a deep recession on the continent in 2020. We assume that GDP will contract by 0.5%-1.0% under our base case and alternative case. As a result, we have revised down our EBITDA projection for 2020, to €80 million-€100 million. This projection incorporates SGL's current order backlog and other supportive factors--these may fade out if the unfavorable economic conditions last for longer.
Given the high level of uncertainty, we tested the company's sensitivity to several scenarios that go well beyond our base case, including a severe drop in the company's EBITDA in 2020 to about €40 million. This reference point is equivalent to the EBITDA reported by its two divisions during the financial crisis of 2009, although the business perimeters of the divisions are not fully comparable. Under this scenario, the company would have a cash burn of about €60 million-€80 million if it made no change to its capital expenditure (capex) program, had flat working capital, and didn't take other counteraction measures. In our view, even though the company's €175 million revolving credit facility (RCF) would effectively be unavailable because SGL would have breached its financial covenants, it would have sufficient liquidity to accommodate such a scenario. However, if the scenario were to persist for more than 12 months, we foresee a different outcome.

Weak market developments present a risk to the company's growth potential and its financial policies

In our view, the company will need to make a difficult decision about how to balance cash preservation and future growth.
On one hand, the company's core markets--energy, mobility, and digitalization--are still attractive, with annual projected growth rates of 5%-10%. In our view, SGL's ability to address future trends through new and existing products should support its growth and improved earnings over time. We understand that tapping into future demand requires ongoing spending above the maintenance capex. On the other hand, the company aims to generate a positive free cash flow and reduce its gross debt.
Facing weaker market demand, the company took the decision to cut its capex budget to €75 million in 2020 from a previous guidance of €95 million. In addition, the company is working on additional initiatives to further bolster its liquidity. This would have eliminated a higher negative FOCF, and it announced its intention to cut capex further if needed. We view the company's proactive measures positively. At the same time, we cannot ignore the medium- and longer-term implications if further cuts were made later this year and in 2021.
The stable outlook is supported by the company's supportive liquidity position and limited downside for the rating in the next 12 months.
We project that the company will generate adjusted EBITDA of about €80 million-€100 million and negative FOCF of up to €20 million in 2020, resulting in adjusted debt to EBITDA of more than 7x in 2020.
We do not expect to lower the rating in the coming six to 12 months unless we see a material deterioration in the company's liquidity position. If the company were to see a material decline in its EBITDA, leading to higher cash burn and breach of covenants under its RCF, it could push it into executing a distressed exchange offer.
We don't expect to raise the rating in the next six months.
We could do so if we considered SGL was likely to maintain leverage below 6.5x, improving rapidly to 5.0x, while generating neutral or positive FOCF.

We would also look for clarity regarding the company's long-term strategy as a new CEO will join the company later this year. In addition, SGL will need to build a track record of predictability in EBITDA and FOCF generation, especially in the CFM division.
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