Overview -- Debt leverage remains very aggressive at New Zealand-based packaging producer Reynolds Group Holdings Ltd., as operating performance and free cash generation has been below expectations. -- We lowered our corporate credit rating on Reynolds and its subsidiaries to 'B' from 'B+'. We also lowered the issue-level ratings on the company. -- The stable outlook reflects expectations that earnings and debt reduction will be sufficient to support credit measures consistent with the lowered ratings. Rating Action On Sept. 7, 2012, Standard & Poor's Ratings Services lowered its corporate credit rating on Reynolds Group Holdings Ltd. to 'B' from 'B+'. We also lowered the issue-level ratings on the company's senior secured debt to 'B+' from 'BB-', and lowered the issue level ratings on its unsecured debt to 'CCC+' from 'B-'. The '2' and '6' recovery ratings, which remains unchanged, reflect our expectation for substantial (70% to 90%) recovery and negligible (0% to 10%) recovery, respectively, in the event of a payment default. The outlook is stable. Rationale The downgrades reflect Reynolds' still highly leveraged financial profile and lack of earnings growth and debt reduction to the extent we previously expected. The ratings on Reynolds reflect Standard & Poor's assessment of the company's business risk profile as "strong" and financial risk profile as "highly leveraged". Reynolds is a market leading provider of food and beverage packaging owned by Rank Group, a New Zealand-based investment firm controlled by a single individual. The company has grown rapidly via debt-financed acquisitions during the past three years, including the acquisitions of Graham Packaging and Pactiv. We expect the company to continue to pursue aggressive growth policies that are likely to include small to moderate bolt-on acquisitions to expand its market positions, and additional steps to consolidate segments of packaging sector. Given the heavy annual interest cost burden of about $1.35 billion, we believe the company would need to demonstrate its ability to generate free cash flows of about $500 million annually and its willingness to permanently reduce debt to improve credit measures to appropriate levels for the ratings in the next 12 months. The company is one of the world's leading and most-diversified consumer and foodservice packaging providers, with annual revenues of nearly $14 billion, pro forma for the September 2011 acquisition of Graham Packaging Holdings Co. for $4.5 billion. The prevalence of food-related products lends considerable stability to sales and operating results even in periods of economic weakness. EBITDA margins are attractive at 18% and among the highest in the industry. Given its high debt leverage, Reynolds is vulnerable to raw material cost swings, particularly in plastic resin and aluminum. It's also subject to seasonal working capital variations, with sales typically higher in the warmer months. Management has a good track record of achieving targeted cost reductions and acquisition-related synergies. However, lower sales volumes and ongoing operational issues in the Graham Packaging segment, as well as sluggish consumer spending patterns, have resulted in lower earnings than it previously expected for the first half of 2012. We believe Reynolds should be able to largely obtain the approximately $400 million of targeted synergies and other cost reductions associated with both of these acquisitions and the smaller acquisition of Dopaco Inc. in May 2011. Synergy realization, together with modest earnings growth or debt reduction, should bring credit measures to appropriate levels so that total adjusted debt to EBITDA is about 6.5x. At June 30, 2012, we estimate total adjusted debt to be about $18.9 billion, including about $1.2 billion of tax-effected postretirement liabilities and capitalized operating leases. As of June 30, 2012, we estimate total adjusted debt to trailing-12-month EBITDA at about 7.3x pro forma for all recent acquisitions before unrealized synergies. Liquidity We view Reynolds' liquidity as "adequate" under our criteria because we expect cash sources to more than cover cash needs over the next two years. Our liquidity assessment reflects on the following factors and assumptions: -- Sources of liquidity over the next 12-24 months will exceed its uses by 1.2x or more; -- Net sources would be positive even with a 20% drop in EBITDA; and -- The company has good standing in the credit markets. Anticipated uses of liquidity include: -- Annual debt maturities, including about $47 million of annual term loan amortization; -- Capital spending of $650 million per year (of which a substantial portion is discretionary); -- Working capital fluctuations due to changes in raw material prices and seasonal requirements; and -- Pension funding requirements, which we believe should not be onerous over the next couple of years but could increase significantly depending on investment performance and discount rates. Reynolds had about $1.22 billion in cash and availability of about $129 million under its $120 million and EUR80 million revolving credit facilities as of June 30, 2012. Reynolds used the net proceeds from the $1.2 billion notes issuance completed in February 2012 to primarily redeem the Graham Packaging and Pactiv notes. Besides the debt paydown, Reynolds has maintained remaining proceeds as cash on the balance sheet to bolster liquidity and for general corporate purposes. We expect Reynolds to maintain at least $500 million in readily accessible cash at all times. This is to compensate for its comparatively small revolving credit facilities, which we expect it to use primarily for letters of credit. The company generated free cash flows of $20 million in the first six months of 2012. We expect significantly higher cash flow from operations in the second half of 2012 to support about $350 million of free cash generation in 2012, which the company plans to primarily use to reduce debt. Under terms of the credit agreement, the company has a 50% cash flow sweep. We expect Reynolds to remain in compliance with the financial covenants, including a maximum senior secured leverage ratio (of 4x or below) and minimum interest coverage ratio. We expect limited headroom under the minimum interest coverage as the covenant steps up from 1.65x as of June 30, 2012, to 1.7x at March 31, 2013, and steps up further to 1.75x at March 31, 2014, and we would expect the company to take timely steps to obtain an amendment if necessary. Recovery analysis For the complete recovery analysis, see our recovery report on Reynolds, to be published shortly on RatingsDirect. Outlook The outlook is stable. We expect credit measures to strengthen to the appropriate 6.5x we consider consistent with the rating. We could lower the ratings if Reynolds does not consistently generate positive free operating cash flow, or if liquidity erodes significantly, or if it were in danger of violating financial covenants. We could also lower the ratings if the company undertakes another large, debt-financed acquisition, which causes debt leverage to increase significantly. For us to consider a downgrade, EBITDA margins would have to deteriorate to about 17% on sales declines of 5% or more, based on our view of the company's adjusted debt levels. This would result in debt leverage of 7.5x or more. Cash flow could weaken to less than we currently anticipate if deteriorating economic conditions cause a significant slowdown in consumer spending or the company experiences heightened competition in any of its businesses or if raw material prices rise so sharply that the company is unable to pass on its higher costs to customers. Reynolds' current very aggressive financial policies and high debt leverage make an upgrade unlikely at this time. If earnings growth and debt reduction improved credit measures such that total debt-to-EBITDA was 6x, and funds from operations-to-total adjusted debt was 10% on a sustained basis, we could consider an upgrade. This would require the company to both improve operating results in the current difficult operating environment and to pursue its growth objectives in a manner that does not stretch the balance sheet. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- Key Credit Factors: Methodology And Assumptions On Risks In The Packaging Industry, Dec. 4, 2008 Ratings List Downgraded; Outlook Revised Reynolds Group Holdings Ltd. Pactiv Corp. Beverage Packaging Holdings (Luxembourg) II S.A. Beverage Packaging Holdings (Luxembourg) I S.A. To From Corporate Credit Rating B/Stable/-- B+/Negative/-- Downgraded To From Beverage Packaging Holdings (Luxembourg) II S.A. Senior Secured CCC+ B- Recovery rating 6 6 Subordinated CCC+ B- Recovery rating 6 6 Pactiv Corp. Senior Secured B+ BB- Recovery rating 2 2 Senior Unsecured CCC+ B- Recovery rating 6 6 Reynolds Consumer Products Holdings Inc./Reynolds Group Holdings Inc. Senior Secured B+ BB- Recovery rating 2 2 Reynolds Group Issuer (Luxembourg) S.A./Reynolds Group Issuer Inc. Senior Secured B+ BB- Recovery rating 2 2 Senior Unsecured CCC+ B- Recovery rating 6 6 Reynolds Group Issuer LLC Senior Secured B+ BB- Recovery rating 2 2 Senior Unsecured CCC+ B- Recovery rating 6 6 Sig Austria Holding GMBH/Sig Euro Holding AG & Co. KGAA Senior Secured B+ BB- Recovery rating 2 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.