Fitch Upgrades Lubrizol to 'BBB+'; Outlook Stable

NEW YORK--(BUSINESS WIRE)--Fitch Ratings has upgraded Lubrizol Corporation's (Lubrizol) Issuer Default Rating (IDR) and related debt ratings to 'BBB+' from 'BBB'. The Rating Outlook is Stable. A full rating list is shown below.

The ratings upgrade reflects Lubrizol's significantly strengthened credit profile that is characterized by high operating margins and profits, a fairly low leverage, increased free cash flow generation and robust liquidity.

The specialty chemicals company has an innovative and value-adding product portfolio, particularly in its key division, lubricant additives, which accounted for 72% of revenues and 82% of segment operating profits in fiscal 2009. Coupled with related research, development and testing services, these products enable high operating margins and profits. Latest 12 months (LTM) operating EBITDA at June 30, 2010 totaled approximately $1.25 billion or 24.1% of revenues compared to a 12.5% to 14.5% range achieved in the fiscal years 2004 to 2008.

Since the $2 billion acquisition of Noveon in 2004, which grew the company's businesses within the Advanced Materials segment, Lubrizol has continuously reduced its financial leverage. Driven by more than $600 million debt reduction and by margin and profit improvements, gross balance sheet debt to LTM operating EBITDA decreased to a fairly low 1.1 times (x). EBITDA interest coverage equally strengthened to 11.9x.

The company's cash flow generation capacity improved in line with the strong operating performance over the past 18 months. LTM cash flow from operations increased to $778 million after $151 million negative change in working capital requirements. Free cash flow was $562 million after $127 million capital expenditures and $88 million dividends.

Lubrizol used most of the generated surplus to bolster its liquidity. As of June 30, 2010 and pro forma the renewal of its U.S. revolver in July 2010, the company had robust liquidity that consisted of $972 million cash and equivalents on-hand, the renewed and undrawn $500 million revolving credit facility, which expires in July 2015, and an equally undrawn EUR 150 million revolver with an expiration date of July 2012. Both facilities are governed by a debt to EBITDA leverage covenant of maximum 3.5x and a EBITDA interest covenant of minimum 3.5x. Fitch expects the company to remain well within covenant compliance over the lifetime of both facilities. In contrast, debt maturities are very manageable. After terminating the $150 million term loan to fund acquisitions of two thermoplastic polyurethane businesses in 2009 and repaying $46 million borrowings under the EUR revolver earlier this year, the company has only approximately $1 million debt coming due until 2013, of which $0.3 million is short-term. The next major maturity is the $450 million 5.5% senior unsecured notes due in 2014. All other remaining debt is long-term with maturities ranging from 2019 to 2034.

The Rating Outlook is Stable. Lubrizol benefits from favorable dynamics in the highly consolidated lubricant additives industry. The company has established long-standing and deep relationships with its key customers. Albeit not immune to volume losses, the Additives segment proved to be somewhat resilient to economic downturns as the segment generates a large share of revenues from vehicle maintenance rather than original equipment manufacturer (OEM) production.

Incumbents enjoy relatively high barriers of entry, given sizeable capital investments required to build a new additives production plant. These investments are difficult to justify for new entrants against the backdrop of a stable but mature industry with annual growth prospects of only 1%-2% annually. Furthermore, the industry has a track record of market and pricing discipline as well as reasonable capacity addition management that makes it likely that the favorable industry environment will continue to support Lubrizol's operating performance and cash flow generation.

These positive dynamics are off-set by the limited size and cyclicality of a large portion of the Advanced Materials segment, increased capital expenditures over the next few years, a recently announced sizeable increase of the company's share repurchase program and event risk in the potential form of a larger, leveraging acquisition.

Despite Lubrizol's strategy to grow Advanced Materials through acquisitions, the segment is still relatively small, which makes it more difficult to absorb fixed and overhead costs and to weather the cyclicality of end-user markets such as construction and industrial markets. In fiscal 2009, revenues of the Advanced Materials segment fell more than 12%. Particularly the engineered polymers and performance coatings divisions will remain exposed to potential set-backs in the economic recovery in the second half of 2010 or beyond.

Lubrizol stated its guidance to increase its capital expenditures to approximately $230 million in fiscal 2010 compared to $140 million in 2009. The increase is primarily driven by the greenfield development of a new lubricant additives plant in China. The facility is scheduled to come on-stream in 2013. Fitch expects that capital expenditures remain higher than in the past until the project is completed. Fitch points out, however, that the current cash flow from operations comfortably supports these elevated capex levels.

In mid-2010, Lubrizol's Board of Directors authorized a sizeable increase of the company's share repurchase program. Under the new authorization, the company can buy back up to 7.2 million or 10% of outstanding shares. Based on the current share price, the value of the share buybacks would be approximately $700 million. The impact on the company's credit profile is mitigated by the absence of a firm deadline for completion of the program. This allows the company to fund the execution of the program with free cash flow generation and cash on-hand rather than debt financing. Lubrizol expects incremental share buybacks of $200 million in the second half of 2010, which would be covered by either cash on-hand or free cash flow generation. The company repurchased shares for $126 million in the first half of 2010.

Historically, Lubrizol has pursued a growth through acquisition strategy, particularly to build-out the Advanced Materials segment. Fitch expects the company to continue the strategy, thus representing event risk for bondholders. The risk is mitigated by the smaller size of completed acquisitions, which were mostly bolt-on and complementary to the company's existing technologies and products. However, Fitch notes that the company is likely to also consider larger acquisitions if an attractive target becomes available as the company did in the case of the Noveon acquisition and the interest in acquiring German specialty chemicals company Cognis GmbH, which did not materialize. As an additional mitigant, Lubrizol may finance a portion of a potential deal with equity as the company did in the Noveon acquisition.

Meaningfully weaker credit metrics as the result of debt-financed acquisitions, share buybacks that are not funded with cash on hand or internally generated free cash flow and significant deteriorations of operating margins, cash flows and liquidity would be catalysts for a downgrade or Negative Outlook.

Catalysts for an upgrade or Positive Outlook would be a sizeable growth of revenues, notably in the Advanced Materials division, while maintaining high margins, significant free cash flow, strong liquidity and improved credit metrics. Fitch notes that an additional upgrade seems unlikely, given the expected incremental capital expenditures for the expansion project in China, ongoing share buybacks and potential acquisitions.

Fitch has taken the following rating actions:

Lubrizol Corp

--IDR to 'BBB+' from 'BBB';

--Senior unsecured bank credit facilities to 'BBB+' from 'BBB';

--Senior unsecured notes and debentures to 'BBB+' from 'BBB'.

The Rating Outlook is Stable.

Additional information is available at 'www.fitchratings.com'

Related Research:

--'Corporate Rating Methodology' (Aug. 16, 2010);

--'Rating Chemical Companies' (May, 13, 2010).

Related Research:

Rating Chemical Companies Sector Credit Factors

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=510626

Corporate Rating Methodology

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=546646

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