Fitch Ratings has affirmed German-based manufacturer KME SE's Long-Term Issuer Default Rating (IDR) at 'B-' and senior secured rating at 'BB-'/'RR1'.

The Outlook on the IDR is Stable.

The ratings affirmation and Stable Outlook reflect the company's improving leverage and profitability metrics. Fitch expects KME's EBITDA leverage ratio to be within rating sensitivities, despite the expected economic slowdown in Europe in 2023 and KME's high exposure to the German market, which is vulnerable to the energy crisis. The leverage profile will be supported by price increases and a timely debt service based on a new capital structure, which, however, will be offset by the weakening economic environment in 2023. The refinancing of the remaining EUR110 million of KME's EUR300 million senior secured notes (SSN) due in February 2023 is progressing, and Fitch expects the process to be finalised in the next few weeks.

KME's IDR is constrained by the volatility of copper product manufacturing, and, in effect, by KME's dependence on copper prices, its weak profitability and cash flow generation relative to peers, reflecting KME's position in the value chain.

Key Rating Drivers

Improving Leverage Profile: We forecast EBITDA leverage at about 4.1x in 2022 and 3.4x in 2023 compared with 8x-12x reported in the past, driven by the expected lower debt quantum by nearly EUR100 million by end-2022 (vs 2021) and profitability improvement. We expect the divested EBITDA of special and wire businesses will be compensated for by price increases, above the inflation rate and with full effect in 2023, and the acquisition of part of Aurubis AG flat-rolled products in July 2022. However, this will be slightly offset by the expected weak economic environment in Europe.

Deleveraging Under New Capital Structure: After redemption of the remaining EUR110 million SSN, a new capital structure will be composed of bank loans and working capital facilities. We believe the deleveraging path to about 3.0x in 2024 will be driven by loan amortisations and the economy stabilisation. However, this path is likely to extend beyond 2024 in case of a deeper economic slowdown with an energy rationing scenario likely to be relevant for non-critical product manufacturers. KME with its over 60% of net added value generation (revenue less metal costs) in Germany, albeit mitigated by a limited gas usage, is likely to be affected directly or indirectly through lower activity of its customers due to the energy crisis.

Deviations from the expected deleveraging path due to the energy crisis will affect liquidity and the debt service capacity and will likely result in a negative rating action.

Refinancing Process in Progress: We no longer view the refinancing risk for KME's remaining EUR110 million SSN due in February 2023 as high. The company has entered into a new EUR110 million amortising loan and is finalising a new EUR90 million sale and leaseback to manage the refinancing risk. In parallel, the borrowing base facility maturity is being extended by two years. Fitch believes the refinancing process will be completed in next few weeks.

In the future, the refinancing risk will refer to working capital facilities on which KME heavily depends in daily operations. We view the ongoing access to borrowing base and factoring facilities as critical for the liquidity management.

Improving but Still Low Profitability: KME's Fitch-adjusted EBITDA margin (IFRS-based figure) of 4%-5% over the rating horizon is weak compared with similarly rated peers. Despite a current structural change in margins from the previous 2%-4% on the recent price increases, KME's profitability remains vulnerable to growing energy prices as well as other costs compared with peers, despite its moderate energy expenses (2.8% of sales in June 2022 or 1.9% in June 2021).

In the absence of the special division with historically better margins than copper and copper alloy products, KME's profitability profile maps a 'b-' midpoint, according to our Diversified Industrials and Capital Goods Ratings Navigator.

Thin FCF Margin: We expect the free cash flow (FCF) margin to turn negative in 2022 due to high working-capital outflows, mainly related to high copper prices and divested businesses. Thereafter, we forecast a recovery to nearly 3% in 2023-2024 as working capital changes stabilize, interest costs decrease on debt amortization and non-recurring costs are limited. We view thin FCF margins as a long-term sustainable characteristic based on KME's low-margin operating environment for a producer of copper and copper alloy products.

Less Diversified Offering: We view KME's product range and geographic diversification as weaker than before the divestments. KME is now focused on rolled copper products and its alloys, following the divestment of special and wire businesses. Revenue will, therefore, be lower in 2022, although it will be partly offset by the accretive revenue on acquisition of Aurubis' flat-rolled product plant in The Netherlands, high copper prices and KME's realised price increases.

Constrained Business Profile: KME's business profile is constrained by its fairly small scale, concentration on Europe and a limited product range after the disposal of the special division. This is also related to low entry barriers, which are a result of the highly commoditised processing of most copper products. In addition, we see risks related to KME's uncertain M&A strategy.

The business profile is supported by KME's leading market positions in Europe within copper products and a diversified customer base with long-term customer relationships (of up to 20 years with some larger clients) and KME's exposure to end-markets with firm growth prospects driven by investments in the green economy.

Derivation Summary

KME's scale is smaller than that of its direct competitor Wieland Group's and Aurubis Group's and aluminum processing peer Constellium's. They all operate in a low-margin environment due to their position in the value chain, though Constellium has higher margins than KME. This is mainly due to lower basic metal prices (aluminum versus copper), given Constellium's higher value-added product portfolio.

KME's leverage has been higher than that of similarly rated peers in the diversified industrials and capital goods sector for the past few years. With cash proceeds from the divestment of the special division deployed to debt reduction, EBITDA leverage is lower than industrial belt manufacturer Ammega Group B.V. (B-/Stable) and reciprocating gas engines manufacturer INNIO Group Holding GmbH (B/Stable). This is balanced by weaker product and geographical diversification, and weaker and more volatile margins and cash flow generation.

Key Assumptions

Fitch's Key Assumptions Within Its Rating Case for the Issuer:

Revenue to decline 5% in 2022 on the disposal of the special and wire businesses supported by the acquisition of Aurubis followed by a 4% decline in 2023 on the weak economic environment in Europe and a low single-digit growth in 2024-2025

EBITDA margin at 4.4% in 2022, increasing to 4.7%-4.9% in 2023-2025

High working capital outflows in 2022, before normalising from 2023

Capex at about 1% for 2022-2025

No dividends paid and received until 2025

Redemption of its EUR110 million outstanding bond in 2022

Extension of KME's borrowing-base facility and factoring lines on a regular basis

RECOVERY ASSUMPTIONS

Fitch's bespoke recovery for KME's senior secured debt is based on a liquidation approach

The approach reflects the security package of the senior secured notes and the borrowing-base facility, which contains separate collateral

The recovery analysis is based on the EUR110 million outstanding amount of the EUR300 million notes and the residual security package value after the disposal of The Special Division

We apply a discounted market value of KME's property and the net book value of the machinery and equipment related to the property securing the notes

A going-concern EBITDA of EUR35 million and a 4.0x distressed enterprise value/EBITDA multiple adjusted with a 10% administrative charge

These assumptions result in a recovery rate for the senior secured rating within the 'RR1' range, which enables a three-notch uplift to the debt rating from the IDR

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

EBITDA gross leverage sustainably below 4.0x

FFO margin sustainably above 4%

FCF margin above 2%

Improving diversification

Factors that could, individually or collectively, lead to negative rating action/downgrade:

FFO gross leverage consistently above 7.0x

EBITDA gross leverage consistently above 6.0x

Negative FCF margin leading to diminishing liquidity sources

Lack of progress to refinance 2023 maturities

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Limited Liquidity: Fitch views KME's liquidity profile as limited but adequate for continued operations in the short term. This is based on EUR70 million of cash on the balance sheet at end-June 2022, after adjusting for not-readily-available cash of EUR5 million, as well as an available EUR30 million shareholder working-capital facility line. KME also has access to a committed EUR320 million borrowing-base facility, which is highly utilised for outstanding letters of credit, leaving no headroom for regular cash funding.

We expect a working-capital outflow in 2022, due to high copper prices and divested businesses, before it normalises in 2023-2024. We forecast an FCF margin of nearly 3% in 2023-2024 with a debt service supported by available liquidity sources. We view ongoing access to borrowing base and factoring facilities as critical for the liquidity management. Fitch assumes that KME will have continued access to working-capital facilities based on its regular extension pattern in the past as well as compliance with financial covenants under its borrowing-base facility agreement and factoring programme.

Debt Structure: We expect the redemption of the remaining EUR 110m Senior Secured Notes maturing in February 2023 to be finalised in the next few weeks. The new capital structure will consist of amortising loans and working capital facilities with the refinancing risk applicable for working capital facilities on which KME heavily depends in daily operations.

Issuer Profile

KME is a producer of semi-finished and finished copper and copper alloy products for use in other products and processes by a wide range of end users and industries. The production facilities are located in Europe, China and the US.

In accordance with Fitch Ratings' policies, the issuer appealed and provided additional information to Fitch Ratings that resulted in a Rating action that is different than the original Rating committee outcome.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

(C) 2022 Electronic News Publishing, source ENP Newswire