CORPORATES CREDIT OPINION 15 July 2016 Heraeus Holding GmbH Update to Key Credit Considerations Update Summary Rating Rationale Heraeus’ Baa1 is supported by its broad product offering and leading market positions within many of its business units. These market positions are to some degree protected by barriers to entry given the company's extensive know-how in precious metal processing, long standing relationships with industrial customers and mining companies as well as numerous patents. RATINGS Heraeus Holding GmbH Domicile Germany Long Term Rating Baa1 Type LT Issuer Rating - Fgn Curr Outlook Stable Please see the ratings section at the end of this report for more information.The ratings and outlook shown reflect information as of the publication date. Analyst Contacts Jeanine Arnold 49-69-70730-789 VP-Senior Analyst jeanine.arnold@moodys.com Moritz Melsbach 49-69-70730-784 Associate Analyst moritz.melsbach@moodys.com The company is, however, weakly positioned at the current rating level. This is because operating and cash flow performance has gradually weakened over the last two to three years and been consistently lower relative to both our and the company's expectations. We believe the company's weaker operating performance and the lower degree of earnings visibility stem from the fact that over time the company has developed a less focused product portfolio, which has made the company less apt in addressing more challenging economic conditions. In particular profitability measured as adjusted EBITA from nonprecious metal sales has declined to €204 million (EBITA margin: 10.6%) in 2015 from around €393 million (EBITA margin: 20%) in 2012. This weaker operating performance has driven a marked increase in Heraeus’ leverage to around 3.4x debt/EBITDA as at 2015 from around 2.5x in 2012. We expect improvements in profitability, free cash flow and leverage in 2016 with further improvements expected in 2017. This is because we believe challenging operating conditions for some of its product lines are easing, and management appears much more intent on restructuring and refocusing its product portfolio than it has done in the past. We believe Heraeus' cash flow generation, its substantial cash balance of around €1.0 billion and commitment to a conservative financial profile provide the company with the financial means and time for restructuring measures to take effect and establish a more sustainable operating model. Heraeus’ adjusted net debt/EBITDA was around 0.3x as at December 2015. Credit Strengths » Leading global market positions » Technological know-how creates barriers to entry » Strong balance sheet and liquidity sufficient to absorb earning pressures and undertake restructuring CORPORATES MOODY'S INVESTORS SERVICE Credit Challenges » Diversified end market exposure has not fully mitigated profit and FCF volatility » Limited earnings visibility as evidenced by underperformance relative to expectations » High gross leverage Rating Outlook Heraeus is weakly positioned at the Baa1 rating level given its weak earnings and cash flow generation as well as its persistent underperformance relative to expectations. However, the stable outlook reflects our expectation that Heraeus' operating performance will begin to improve as of 2016 and that the company will continue to maintain a disciplined conservative financial policy, including a solid liquidity profile. We expect that improved earnings should also allow Heraeus to sustainably reduce leverage towards 2.5x in the next 12 to 18 months. Factors that Could Lead to an Upgrade Owing to Heraeus' weak positioning at the Baa1 rating level, an upgrade is currently unlikely. An upgrade of Heraeus’ rating would require a sustainable improvement in EBITA margins on a non-pm sales basis to the high teens as well as greater earnings visibility and predictability. In addition, a rating upgrade would require a track record of consistently generating positive FCF in excess of 10% FCF/ Debt as well as maintaining debt/EBITDA below 2.0x and a strong liquidity profile. Factors that Could Lead to a Downgrade Negative rating action is likely if the company fails to expand its EBITA margin on non-pm sales towards the mid-teens in the next 12-18 months. In our view this would evidence more persistent structural weaknesses in the company’s business profile and markets, and the need for further restructuring. Likewise debt/EBITDA remaining in excess of 2.5x beyond 2017 and a failure to improve (RCFCapex)/debt to around 10% (2.3% in 2015) on a sustainable basis could also lead to negative rating action, a material deterioration of Heraeus’ liquidity profile could also result in negative pressure on the rating. Key Indicators Exhibit 1 This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history. 2 15 July 2016 Heraeus Holding GmbH: Update to Key Credit Considerations CORPORATES MOODY'S INVESTORS SERVICE Detailed Rating Considerations LEADING GLOBAL MARKET POSITIONS WITH BARRIERS TO ENTRY DUE TO TECHNOLOGICAL KNOW-HOW Heraeus ranks among the top three players in the majority of its globally-diversified markets, which are considered relatively consolidated and profitable. In particular, Heraeus is active in melting and processing precious metals for recycling purposes, industrial products based on precious metals such as catalysts for the chemical industry and solder pastes for integrated circuits. Heraeus is also a leading player in the manufacture of sensors for the steel industry, bone cements for endoprosthetics, quartz glass and specialty light products . In addition, Heraeus is one of the biggest industrial precious metal traders worldwide, which includes the sourcing, handling and management of precious metals and the control of market risks on behalf of its industry customers. These activities also safeguard the supply of precious metals for Heraeus' own manufacturing activities. Heraeus' technological expertise in the precious metal processing, numerous patents, its good relationships with industry customers as well as mining companies represent sound entry barriers. DIVERSIFIED END MARKET EXPOSURE HAS NOT MITIGATED EARNINGS AND FCF VOLATILITY, BUT RESTRUCTURING MEASURES SHOULD BEGIN TO ADDRESS THIS Heraeus benefits from a diversified industry and product portfolio, as well as good geographical diversification. It operates in different industries including energy, chemicals, healthcare, mobility, communication and steel. Heraeus' revenues are also well spread by customer and economic regions. This diversified product portfolio allows the company to reduce top-line and earnings volatility to some degree. For example, Heraeus’ Health segment has continued to generate relatively strong earnings and this has enabled the company to offset declines in its Industrial Applications business. At the same time, we believe the company’s broad product and geographic portfolio has also developed a less focused product portfolio and critical mass, which we believe has exacerbated losses in some of the company's business units and contributed to the company’s earnings and FCF volatility. Adjusted EBITA has fallen consecutively, and contrary to Moody's and the company’s expectations over the last few years. In 2015 Moody's adjusted EBITA was €204 million, compared with €393 million in 2012 and around €510 million in 2011 when photovoltaic fundamentals were exceptionally strong. In addition, between 2009 and 2015 adjusted FCF has fluctuated between €-32 million in €126 million (2015 and 2012). These fluctuations represent a high level of volatility when compared to other investment grade rated manufacturing peers. In contrast to many other peers rated under the global manufacturing methodology Heraeus’ does not have a sizeable order backlog or a sizeable service business providing the company with strong revenue visibility. This, in combination with a number of highly cyclical businesses exposed to different demand drivers, makes it extremely difficult to forecast revenue development and profitability. In order to address operational challenges and increase efficiencies Heraeus has initiated various restructuring programs over the last few years, but we believe that “Heraeus FIT”, which was introduced in 2015, is much more comprehensive. It addresses the company’s overall fixed cost structure as well as undertaking a more thorough re-organization of production and phasing out/ substitution of existing products. Restructuring costs related to this plan have negatively impacted profitability in 2015, but our base case assumes that these will improve the company’s profitability and margins in the coming years. We expect the cash costs of these restructuring measures to be spread over the next few years and be more than manageable in the context of Heraeus' FCF generation and substantial cash balance. CHALLENGING ECONOMIC CONDITIONS TO PERSIST, BUT SOME EASING EXPECTED TO SUPPORT IMPROVED EARNINGS AS OF 2016 In addition to the company's less focused product and geographical portfolio, the company’s weak profitability has also been driven by weaker cyclical demand in some of the company's product segments. For example, the company has witnessed a structural decline in its steel sensor business, increased substitution of gold bonding wire through copper palladium bonding wire (and where its competitors have better market positions), which has negatively impacted the company's Electronics segment, but also sluggish demand for sputtering targets used for hard disk drives in its industrial activities. However, the company's photovoltaics is witnessing some improvement after several years of depressed demand and we expect continued demand growth in the company's medical components as well in its quartz glass business, given the high levels of investments in fiber optic networks. A more favorable product mix should also allow the company to moderately expand adjusted EBITA as of 2016. We forecast adjusted EBITA should improve to around €263 million in 2016 and around €300 million in 2017. 3 15 July 2016 Heraeus Holding GmbH: Update to Key Credit Considerations MOODY'S INVESTORS SERVICE CORPORATES Exhibit 2 Adjusted EBITA margin over non-pm revenues has been declining since peak in 2011 Source:Company information, Moody's STRONG BALANCE SHEET AND LIQUIDITY PROFILE SUFFICIENT TO ABSORB EARNING PRESSURES As at 31 December 2015 Heraeus had cash and cash equivalents of around €1.0 billion and adjusted net debt/EBITDA of 0.3x (-0.4x on an unadjusted basis). This strong balance sheet combined with a conservative financial policy continues to support the company’s Baa1 rating and the stable outlook. In particular, it provides the company with the financial means and time to undertake necessary restructuring measures in order to improve the stability and growth of its earnings. In addition, we forecast that improving profitability in 2016, continued focus on working capital management and a lower dividend payout in 2016 will allow the company to generate Moody’s defined FCF in the range of €70 million to €90 million. This will further strengthen the company’s liquidity profile in 2016. Exhibit 3 FCF expected to continue to be volatile, but cumulative FCF contributes to stronger liquidity Source: Company information, Moody's Maintaining a strong cash balance is important, particularly in the context of the company’s earning pressures, as we consider Heraeus' adjusted leverage of 3.4x in 2015 to be high in the context of the Baa1 rating level and compared with similarly-rated peers. We currently forecast that Heraeus’ leverage will improve to around 3.0x in 2016 and at last around 2.5x in 2017, which we consider would be at levels more commensurate for the rating level. Further improvements in earnings post 2016 as well as Heraeus’ outstanding €250 million bond, which falls due in May 2017, provide further scope for deleveraging in 2017 to this level. 4 15 July 2016 Heraeus Holding GmbH: Update to Key Credit Considerations MOODY'S INVESTORS SERVICE CORPORATES We adjust Heraeus' reported debt for pension liabilities, operating leases and precious metal loans. However, precious metal loans in the past have been volatile and add an additional element of uncertainty when forecasting the company's leverage metrics. We believe the company’s commitment to a conservative financial policy is evidenced by the company’s strong liquidity profile, which Heraeus has maintained since the sale of its dental business in 2013. On average the company has maintained a cash balance in excess of €800 million since 2009 and operated a cash balance of around €1.0 billion over the last three years. Heraeus also maintains a prudent dividend policy and a disciplined approach towards acquisitions. Heraeus’ dividend payout has historically been around 25% and there have been no special dividends following the sale of the dental business back in 2013. We also expect the company to remain moderate in terms of its acquisition spending and as in the past, engage in relatively small bolton acquisitions. Larger strategic acquisitions, if accompanied by still material operating underperformance, could place pressure on Heraeus' current rating. METAL TRADING RISKS ARE WELL MANAGED; TRADING OPERATIONS DISTORT FINANCIALS Heraeus has substantial precious metal trading activities. These are used to hedge and physically secure precious metals needed for the group's own manufacturing of its products as well as providing services to industry customers. Trading activities operate as a profit center but risks are controlled given spot pricing, rigid trading limits and the close monitoring of counterparty risk. Risks from volatile precious metal prices are typically borne by customers or hedged back-to-back. The company's trading activities are inherently lower-margin as earning contributions reflect the charging of trading fees only. These distort the company's overall group margins and therefore, in our view, EBITA margins calculated on a non-precious metals basis are a better performance measure. While these continue to include contributions of the company's trading business they provide greater insight into the profitability of the company's manufacturing activities. Revenues excluding precious metal content disregard a substantial portion of the company’s COGS but at the same time allow monitoring of the company’s revenue growth independent from fluctuations of precious metal prices which impact product revenues which the company reported up until 2014. Heraeus also uses precious metal loans (PM loans) as a short-term financing tool. Within the loan transaction, Heraeus receives from lenders (e.g. banks) a fixed quantity of precious metal for a certain period of time and in return pays interest for borrowing the precious metal. We include these off-balance sheet PM loans in our adjusted gross debt figure. Depending on Heraeus' choice to directly use cash to temporarily buy (hedged) precious metal or enter into PM loans, Heraeus faces higher working capital consumption in the first case and higher adjusted debt in the latter case. In addition, volatility of precious metal prices affects group sales inventory level as well as the absolute amount of PM loans. Liquidity Analysis We consider Heraeus' liquidity profile to be solid. As at December 2015, Heraeus had cash and cash equivalents of around €510 million and marketable securities of around €485 million. Moreover, Heraeus maintains a €300 million syndicated credit facility, which was undrawn as at 2015 and is expected to remain undrawn in 2016. This facility is set to mature in December 2020 (both two one year extension options have been exercised). This is considered a strong source of liquidity since it contains neither financial covenants nor a repeating MAC clause. Together with expected FFO generation these sources are more sufficient to accommodate unexpected swings in working capital, capital expenditure needs, restructuring costs and short-term debt maturities of around €12 million as well as the upcoming maturity of its outstanding €250 million senior notes in May 2017. In addition, Heraeus benefits from a few bilateral credit facilities, the majority of which are not considered in our liquidity assessment due to their short-term nature. Heraeus also has access to a €500 million commercial paper program, but given the company's healthy cash balance, this is used infrequently. Structural Considerations Profile Heraeus is a family-owned company, headquartered in Hanau, Germany, with around 12,500 employees. The company, founded in 1851, is a leading provider of diversified high-value technological solutions in the markets chemical and metals, energy and the environment, communications and electronics, health, mobility, and industrial applications. A large proportion of the products contain or use precious metals, such as gold, silver and platinum metals in their production process. 5 15 July 2016 Heraeus Holding GmbH: Update to Key Credit Considerations CORPORATES MOODY'S INVESTORS SERVICE As of 1 January 2015, Heraeus has divided its Precious Metals and Material Technologies Business Groups to be more industry-focused and will operate in a new management structure of 11 Global Business Units. These in turn report under five segments: Health; Electronics; Environment; Industrial Applications; and Corporate. In 2015, Heraeus generated revenues excluding precious metal (non-PM sales) of €1.9bn (2014: €1.8 billion) and around €13 billion of total sales including its precious metal trading and the precious metal content of products sold. Up until 2014 the company reported its product sales, which include precious metal content of products sold. Heraeus is one of the top five industrial precious metal trading companies globally. Heraeus' trading division supplies its own manufacturing processes but predominantly procures precious metals for customers, in which it charges a trading fee Rating Methodology and Scorecard Factors The principal methodology used in this rating was the Global Manufacturing Methodology published in July 2014. The grid-implied rating for the year ending 31 December 2015 and the 12-18 months forward-looking grid indicate a Baa2 rating, one notch below the current Baa1 rating. This is due to the scoring of the company's business profile, which is considered borderline with a Baa business profile, and Heraeus' strong liquidity reserve, which is not factored into Moody's methodology rating grid. Heraeus' trading operations, also negatively distort the company's operating margins. On a more meaningful Product Revenue only basis, the EBITA margin is expected to remain in the high single-digit range, albeit we recognize the revenue scoring is also overstated by the company's trading business. Exhibit 4 Ratings Exhibit 5 Category HERAEUS HOLDING GMBH Outlook 6 15 July 2016 Moody's Rating Stable Heraeus Holding GmbH: Update to Key Credit Considerations CORPORATES MOODY'S INVESTORS SERVICE Issuer Rating Baa1 Source: Moody's Investors Service 7 15 July 2016 Heraeus Holding GmbH: Update to Key Credit Considerations CORPORATES MOODY'S INVESTORS SERVICE © 2016 Moody's Corporation, Moody's Investors Service, Inc., Moody's Analytics, Inc. and/or their licensors and affiliates (collectively, "MOODY'S"). All rights reserved. CREDIT RATINGS ISSUED BY MOODY'S INVESTORS SERVICE, INC. AND ITS RATINGS AFFILIATES ("MIS") ARE MOODY'S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES, AND CREDIT RATINGS AND RESEARCH PUBLICATIONS PUBLISHED BY MOODY'S ("MOODY'S PUBLICATIONS") MAY INCLUDE MOODY'S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. 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