Overview -- U.S. silicone and quartz producer Momentive Performance Materials Inc. (MPM) plans to enter into a new $175 million term loan for refinancing. -- We are affirming all our ratings, including the 'B-' corporate credit rating, on MPM. At the same time, we are revising the outlook to negative from stable. -- We are also assigning our 'B' issue-level and '2' recovery ratings to MPM's proposed term loan. -- The negative outlook reflects our view that there is potential for MPM's earnings and cash flow to worsen more than we expect, causing a covenant breach and further deterioration of the financial profile during the next year. Rating Action On March 20, 2012, Standard & Poor's Ratings Services affirmed its ratings, including the 'B-' corporate credit rating, on Albany, N.Y.-based Momentive Performance Materials Inc. (MPM). At the same time, we revised the outlook to negative from stable. We have also assigned our 'B' issue-level and '2' recovery ratings to Germany-based MPM subsidiary Momentive Performance Materials GmbH's proposed $175 million senior secured first-lien term loan maturing in May 2015. The '2' recovery rating reflects our expectation for a substantial (70% to 90%) recovery in the event of a payment default. The loan will be issued under the accordion facility of the company's credit agreement. The borrower plans to use the proceeds to repay term loans due in December 2013. Rationale The outlook revision reflects our expectation that MPM will continue to face challenging market conditions during the next several quarters primarily due to tepid global economic growth and silicone oversupply following industry capacity additions over the past year. We believe this will result in weak EBITDA generation and negative free operating cash flow. However, based on our expectation for stronger global economic growth in the second half of the year, we expect MPM's operating results to gradually improve. Although we think liquidity would remain adequate even if last-12-months EBITDA dropped by 20%, if the pace or magnitude of sequential quarterly improvement throughout this year is less than we expect, or working capital fluctuations are greater than we expect, we believe that MPM could violate the financial covenant in its senior credit facilities. We believe that the merger of MPM and Momentive Specialty Chemicals Inc. (MSC) benefits credit quality only modestly. In October 2010, controlling shareholder Apollo Global Management L.P. (Apollo) placed the two companies under a single holding company. Although each company maintains a separate capital structure, we assess both in a manner that recognizes their shared parentage. As a result, our corporate credit rating on both companies is 'B-'. We are maintaining a stable outlook on MSC, but could revise it to negative or lower the ratings on both companies if MPM's financial profile declines further and we determine that these developments elevate credit risk at the combined company. The ratings on MPM reflect the company's "highly leveraged" financial profile and "fair" business risk profile (as our criteria define those terms). MPM's leverage has been very high ever since Apollo acquired the company from General Electric Co. in 2006. As of Dec. 31, 2011, the ratio of total adjusted debt to EBITDA was about 10x. Total adjusted debt was approximately $3.9 billion. We adjust debt to include pay-in-kind (PIK) seller notes at MSC's direct parent company Momentive Performance Materials Holdings Inc. (unrated). This debt adjustment also includes tax-adjusted unfunded postretirement obligations, capitalized operating leases, and trade receivables sold. After improving in the first half of 2011, results weakened in the second half of the year on less-favorable economic conditions, industry capacity additions that resulted in price competition in the silicones business, a slowdown in the semiconductor industry that affected the quartz business, and customers reducing inventory. Although we expect market conditions in the first half of 2012 to remain very challenging, our assumption of moderate global economic growth for the full year should produce stronger results in the second half. Nevertheless, we factor in the likelihood that MPM's free operating cash flow will be significantly negative in 2012 after capital spending of $120 million to $130 million, pension funding that management expects to total $19 million, and modest costs to achieve synergies with MSC. We do not currently expect working capital to be a significant use of cash this year. However, this could change if raw material costs spike. In future years, we expect free operating cash flow to be modestly positive, but we think there is limited potential to reduce leverage significantly with free cash. In addition, the PIK feature of the seller note at the parent holding company represents a significant offset to any potential future debt reduction at the operating company. If MPM performs worse than we expect and leverage continues to climb, we believe the likelihood of a default or debt restructuring could increase. Moreover, MPM has considerably more debt than its primary competitors, which could erode its competitiveness over time if it impedes sufficient business reinvestment. MPM is a large producer of silicones (representing more than 90% of sales and about 75% of EBITDA in 2011), which are used in a wide variety of applications, and quartz, which is used primarily in semiconductors. Both its businesses are cyclical, but this cyclicality has historically been more pronounced in quartz than in silicones. Silicones are used in construction, transportation, personal care, electronics, and agriculture. They are generally used as an additive, providing or enhancing attributes such as resistance (to heat, ultraviolet light, or chemicals), lubrication, adhesion, or viscosity. Positive industry factors include significant consolidation and historically above-average growth rates, though there is vulnerability to volume and margin declines during periods of economic contraction or downturns in key end markets. We believe that capital intensity, technological know-how, and well-established customer relations provide meaningful entry barriers. MPM benefits from good diversification by end market and region, as well as an increasing contribution from specialty products. MPM is backward integrated to a high degree into the production of siloxane, a key intermediate raw material. Siloxane industry capacity increased significantly in 2011, with an MPM joint venture and another major competitor completing expansions in Asia. With the economic slowdown there and in Europe, this new capacity has resulted in price competition in silicones. MPM is also subject to fluctuations in market prices for silicon metal and methanol, which have proven more difficult to pass on to customers amid soft recent market conditions. In its quartz business, MPM relies on a large supplier with whom it has historically had a long-term agreement. The parties have extended their current agreement to June 30, 2012, while they negotiate a new long-term agreement. We assume an agreement can be reached that assures MPM of supply at an affordable cost. Liquidity Liquidity is "adequate," as defined in our liquidity criteria. In our base case scenario--a 20% year-over-year decline in EBITDA in 2012, we expect MPM's sources of funds to exceed uses by 1.2x or more over the next year. Our assessment of liquidity is based on the following assumptions and observations: -- As of Dec. 31, 2011, the company had $258 million of availability under its revolving credit facility, plus $203 million in cash; -- Despite weak fourth-quarter EBITDA, expectations for only modest improvement in the first half of 2012, and a likely increase in net debt, we expect MPM to remain in compliance with the 4.25x maximum senior secured debt to EBITDA covenant in its credit facility--we believe covenant headroom will be tightest in the third quarter of this year; -- The company also has a provision for equity cures under its financial covenant, which could provide the equity sponsor an opportunity to support its investment in MPM if the company breaches this covenant; -- Debt maturities in 2012 are modest and, if the proposed refinancing is successful, 2013 maturities would also be minimal; and -- We do not assume any sizable acquisitions or any shareholder rewards. Recovery analysis For the complete recovery analysis, see our recovery report on MPM to be published later on RatingsDirect. Outlook The negative outlook reflects our expectation that MPM's first-half 2012 results will be very weak. We believe that operating earnings and cash flow will gradually and modestly strengthen during the second half of this year--in line with our expectation of moderate global economic growth. However, in view of our base case expectation of a 20% full-year EBITDA decline in 2012, we assume that MPM's free operating cash flow will be negative. But even in this scenario, we believe liquidity is likely to remain adequate, as long as performance continues to recover. However, we could lower the ratings during the next year if industry conditions or the company's performance are worse than we expect, or if MPM consumes more cash than we anticipate, placing the company in danger of violating financial covenants and making a debt restructuring or default more likely. This could occur if siloxane overcapacity results in fiercer price competition or significant loss of market share, if MPM has difficulty passing recent or future raw material cost increases on to its customers, if it is unable to renew its quartz supply agreement on affordable terms, or if global economic growth stalls. On the other hand, if earnings, cash flow, and liquidity do not worsen beyond our expectations and begin to trend upward to the degree we expect, liquidity remains adequate, and MPM remains comfortably in compliance with covenants, we could revise the outlook to stable later this year. Related Criteria And Research -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- Key Credit Factors: Business And Financial Risks In The Commodity And Specialty Chemical Industry, Nov. 20, 2008 Ratings List Ratings Affirmed; Outlook Action To From Momentive Performance Materials Inc. Corporate Credit Rating B-/Negative/-- B-/Stable/-- Ratings Affirmed; Recovery Ratings Unchanged Momentive Performance Materials Inc. Senior Secured CCC Recovery Rating 6 Senior Secured B Recovery Rating 2 Senior Unsecured CCC Recovery Rating 6 Subordinated CCC Recovery Rating 6 Momentive Performance Materials GmbH Momentive Performance Materials USA Inc. Senior Secured B Recovery Rating 2 New Rating Momentive Performance Materials GmbH Senior Secured US$175 mil bank ln due 2015 B Recovery Rating 2 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.