Overview -- U.S. paper producer Appleton Papers Inc. announced that its planned merger with unrated Hicks Acquisition Co. II Inc. has been terminated due to unfavorable market conditions. -- It is now less likely that Appleton will quickly reduce leverage without the equity infusion that would have accompanied the previously proposed merger. -- We affirmed our ratings on the company, including our 'B' corporate credit rating, and removed all ratings from CreditWatch positive. -- The stable rating outlook is based primarily on our view that Appleton will continue to generate modest positive free operating cash flow and maintain its adequate liquidity profile. Rating Action On July 16, 2012, Standard & Poor's Ratings Services affirmed its ratings on Appleton, Wis.-based Appleton Papers, including the 'B' corporate credit rating. All ratings were removed from CreditWatch where they were placed with positive implications on May 18, 2012. The outlook is stable. Rationale We removed our ratings on Appleton from CreditWatch positive after the company announced that its proposed merger with unrated Hicks Acquisition Co. II Inc. has been terminated due to unfavorable market conditions. It is now less likely that Appleton will quickly reduce leverage without the equity infusion that would have accompanied the previously proposed merger. The 'B' rating on Wisconsin-based Appleton Papers Inc. reflects our view that the paper manufacturer's financial risk profile will remain highly leveraged despite our expectation for slightly lower debt levels and EBITDA improvements. The rating also incorporates our opinion that the company maintains an adequate liquidity position, given that it has no significant near-term debt maturities or financial maintenance covenant requirements. We continue to view Appleton's business risk to be "weak", primarily due to the long-term decline in demand for the company's core carbonless paper products, which account for over 50% of its sales. Appleton is an employee-owned firm and one of two primary manufacturers of carbonless paper, which is used for multipart forms such as credit card receipts, invoices, and packing slips. The company also manufactures thermal papers and is expanding into the specialty chemical and delivery solutions market through its proprietary Encapsys technology. We expect Appleton to remain highly leveraged in the near term, with some improvement over currently high levels (near 8x during the 12 months ended March 31, 2012). Our baseline scenario for the 2012 fiscal year assumes that revenues grow 2%, EBITDA improves to roughly $100 million, and leverage recedes modestly but remains above 5x for the full fiscal year. Key assumptions under our baseline scenario include: -- Demand for carbonless paper softens and raw material costs remain elevated, -- Appleton realizes higher selling prices and increased sales in other business segments, and -- Margins gradually improve due to the new paper supply agreement with Domtar and the closing of an unprofitable paper plant. Liquidity We view Appleton to have an adequate liquidity profile based on the following observations and assumptions: -- We expect that sources of liquidity will cover anticipated uses by at least 1.2x over the next 12 months. -- We expect that sources would fully cover uses even with a 15% drop in EBITDA. -- We do not anticipate that average availability under Appleton's asset backed revolving credit facility will fall below 20% over the next 12 months. Sources of liquidity include $7 million of cash on March 31, 2012 and $79 million available under its $100 million asset-backed revolving credit facility due 2015 (adjusted for borrowing base limitations and letters of credit). Based on our operating assumptions, we expect the company to generate $10 million to $30 million of free operating cash flow in fiscal 2012, after an estimated $20 million of capital expenditures. Other uses could include about $10 million of common share redemptions and less than $2 million of principal amortization. Notably, Appleton does not face a debt maturity until $32 million of subordinated notes come due in 2014. Appleton eliminated certain financial covenants when it refinanced its debt in 2010. However, the $100 million asset-backed revolving credit facility is subject to a springing fixed-charge coverage ratio if average availability under the facility were to fall below 20%. While we do not anticipate that Appleton's line usage will increase substantially in 2012, we estimate that the company's fixed-charge covenant would remain above the potential 1.1x minimum threshold. Recovery analysis For our full recovery analysis on Appleton, see our recovery report published on RatingsDirect on Feb. 29, 2012. Outlook The stable rating outlook is based primarily on our view that Appleton will continue to generate modest positive free operating cash flow and maintain its adequate liquidity profile. As our baseline assumptions suggest, we expect the company to remain highly leveraged in the near term, which limits the potential for an upgrade over the next 12 months. However, we could raise our rating over the longer term if EBITDA grows more substantially (perhaps by more than 30%) due to new customers and higher contractual revenues in the Encapsys segment and if Appleton uses its free cash flow to reduce debt such that leverage was maintained below 5x. We would also raise our rating if Appleton deleveraged by other means, such as an alternative merger opportunity or an initial public offering. Conversely, we could lower our ratings if operating conditions worsened and we no longer viewed Appleton's liquidity to be adequate. This could occur, in our view, if free operating cash flow were to turn sharply negative (perhaps as a consequence of a double-dip recession) such that sources of liquidity were no longer expected to cover needs by less than 1.2x. Related Criteria And Research -- Industry Economic And Ratings Outlook: Stiffer Headwinds Are On The Horizon For Some U.S. Natural Resources Companies, Though Most Outlooks Hold Stable For Now, July 13, 2012. -- Methodology And Assumptions: Standard & Poor's Standardizes Liquidity Descriptors For Global Corporate Issuers, July 2, 2010. -- Key Credit Factors: Criteria For Rating The Forest Products Industry, Dec. 11, 2009. -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008. Ratings List Ratings Affirmed; Off CreditWatch; Outlook Stable To From Appleton Papers Inc. Corporate Credit Rating B/Stable/-- B/Watch Pos/-- Senior Secured B+ B+/Watch Pos Recovery Rating 2 2 Senior Secured CCC+ CCC+/Watch Pos Recovery Rating 6 6 Subordinated CCC+ CCC+/Watch Pos Recovery Rating 6 6 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.