Fitch Ratings has placed Arconic Corporation's (ARNC) 'BB+' Long-Term Issuer Default Rating (IDR) and its instrument ratings on Rating Watch Negative (RWN) following the announcement on May 4, 2023 that Apollo Global Management, Inc. (APO; A/Stable) and affiliates plan to acquire ARNC for approximately $5.2 billion.

The RWN reflects the uncertainty regarding Arconic's long-term financial and capital allocation policies, particularly regarding the post-transaction capital structure and the potential need for external funding for planned strategic investments identified in the company's acquisition announcement. An incremental debt burden could weigh on the company's future FCF, relative to current levels.

Fitch plans to resolve the Watch once we have assessed the post-acquisition strategy and the financial policies to be pursued by the new owners, and Fitch believes the resolution could result in a downgrade of ARNC's ratings. The transaction is expected to close in the 2H23 and is subject to regulatory and also Arconic shareholders' approvals, at which point Fitch intends to resolve the RWN.

Key Rating Drivers

1Q23 Earnings Remain Resilient: 1Q23 sales were down 12% yoy to $1.9 billion, mostly due to the disposal of Russian operations and lower aluminum prices, but organically up by 6% on the back of strong growth in aerospace, packaging and ground transportation, offset by weaker diversified industrial sector. Air traffic demand and limited aircraft capacity are likely to drive increasing original equipment manufacturer (OEM) production rates during 2023. For 2023, the company expects strong automotive and commercial transportation in North America to offset weakness in Europe. Fitch expects to see continued operational improvements and additional growth throughout 2023-2025, trending towards pre-transaction gross EBITDA leverage of around 2x.

Strong End-Market Demand: Each of Arconic's end-markets support the company's growth over the rating horizon, with aerospace and packaging being the most substantial drivers in the near term. Revenue from aerospace and packaging grew yoy by 52% and 32%, respectively, in 2022, leading the way for overall revenue to grow 19% to around USD9 billion. The continued effect of commodity price changes on EBITDA will likely be relatively neutral, as costs are mostly passed through to customers or hedged.

Fitch expects aerospace demand will steadily increase over the next few years despite near-term recessionary fears given airline customers taking a long-term view on fleet planning, particularly following lower levels of fleet replacement occurring between 2019 and 2021. Fitch projects aircraft delivery and build rates will increase by around 20% over the next six to 12 months after a substantial ramp up during 2022 following pandemic lows. Higher production rates during 2023 assuming minimal supply chain disruptions.

Cyclical, But Diversified End Markets: ARNC's end markets are cyclical, though some of this risk is partially mitigated by the company's diversified mix of end markets, long-term contracts and relationships, and innovative offerings. The company's customers operate in the commercial aerospace, ground transportation, packaging, diversified industrial, and building and construction industries.

Each of these end-markets are cyclical individually, and exposure to economic cycles and demand fluctuations within these industries could contribute to yoy revenue volatility, though the risk to the company's financial profile is generally limited as it is able to hedge or pass through the majority of metal exposure to customers. Significant top-line volatility, which if persistent and coupled with operational disruptions, could lead to negative rating momentum. However, Fitch views market diversification as a positive factor for the company's credit profile given the likely counter-performance during a broad economic downturn.

Improving Pre-Transaction Financial Structure: ARNC's pre-transaction leverage is relatively low and its financial structure is comparatively strong for the ratings and a contributing factor for the pre-transaction Positive Outlook. Fitch forecasts 2023 pre-transaction gross debt/EBITDA to remain at around 2.5x before decline to the low-2x range thereafter. Fitch believes the previously identified need to maintain low leverage to offset profitability concerns has somewhat dissipated given the company's lower required pension contributions going forward and improved product and end-market diversification. Fitch considers the company's profitability to be solid and in line with other 'BB' category issuers and somewhat sensitive to working capital fluctuations.

Moderate Profitability, Improving Cash Flow: Fitch expects ARNC will generate EBITDA margins in the high-single digit or low-double-digit range over the next few years as the company largely passes commodity and labor costs to customers. FCF has marginally turned positive in 2022 and we expect pre-transaction FCF to remain in the low-single-digit range over the rating forecast, aided by lower pension contributions, end-market recovery and growth, and less severe working capital swings compared with historical levels. Fitch understands the post-transaction FCF profile could be lower due to a potentially increased debt level. Fitch expects the company would have some flexibility to continue to incorporate incremental price increases in the case of prolonged cost pressure, though potentially to a modestly lesser degree.

Derivation Summary

In general, Arconic has weaker profitability than similarly rated peers such as Kaiser Aluminum Corp. (BB-/Stable), but a stronger pre-transaction capital structure, which is more in line with investment-grade issuers. Fitch considers ARNC's end markets to be relatively diversified and expects the company's cash flow to gradually improve following several cost-cutting measures, reduced environmental costs and lower pension contributions.

Key Assumptions

Fitch's Key Assumptions within Our Rating Case for the Issuer

After a volatile 2022, Fitch assumes relatively stable aluminum prices through 2024 with an average price between $2,500 and $2,600 per tonne before declining to around $2,250 per tonne in 2025;

Sales volume continue to increase in the mid-single digit range throughout the forecasted period, led by aerospace and packaging;

Margins remain steady and trend toward the low-double digit range over the next few years;

Capex between 2% and 3% of revenue per year;

Annual dividend up to $100 million per year;

Pension contributions plus other post-employment benefit (OPEB) payments decline to around $100 million per year over the forecast;

No voluntary debt repayment or M&A.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Demonstrated commitment to a financial policy leading to mid-cycle gross EBITDA leverage sustained below 2.0x;

FCF margin sustained above 2.0% while maintaining advantaged operational and cost profile relative to other global manufacturers;

Improved financial flexibility evidenced by a less encumbered capital structure;

Clearly defined capital allocation plan, inclusive of Phase 3 and Phase 4 operational investments.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

To resolve the Negative Watch:

Completion of the announced acquisition, including the company's operational and financial strategy

To downgrade the IDR to 'BB':

Mid-cycle gross EBITDA leverage sustained around or above 2.5x;

Contingent legal liabilities, pension contributions, or environmental liabilities result in significant impact to FCF margins.

Failure to complete the acquisition as contemplated would likely result in removal of the Negative Watch.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Strong Liquidity Position: Fitch considers pre-transaction ARNC's liquidity position to be strong. Total liquidity comprised nearly $261 million of cash and equivalents and full availability under its $1.2 billion ABL facility at the end of 2022. Fitch anticipates ARNC, on a pre-transaction basis, will maintain liquidity of between $1.0 billion and $1.5 billion on average over the next several years between cash and its ABL facility, which could be drawn upon during the year to cover short-term working capital fluctuations but would likely be subsequently paid down. ARNC's pre-transaction capital structure consists of an ABL credit facility, senior first lien secured notes and senior second lien secured notes outstanding. The $700 million first lien notes are the earliest maturity and are due in 2025.

Issuer Profile

Arconic Corporation (ARNC) is a provider of rolled aluminum products, extrusions, and building products within the building and construction, industrial, packaging, ground transportation, and aerospace & defense end-markets.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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