Fitch Ratings has assigned a Long-Term Issuer Default Rating (IDR) of 'B(EXP)' to Pegasus Merger Co. (Pegasus), an affiliate of funds managed by Apollo Global Management, Inc. (Apollo) that will merge with and into Tenneco Inc. (Tenneco) (B+/Rating Watch Negative) to effectuate Apollo's acquisition of Tenneco.

Fitch has also assigned a rating of 'BB-(EXP)'/'RR2' to Pegasus' proposed first lien secured revolving credit facility, term loans and notes. Fitch has assigned a rating of 'CCC+(EXP)'/'RR6' to Pegasus' proposed issuance of senior unsecured notes. Proceeds from the term loans and notes will be used to cover a portion of the acquisition costs and to refinance most of Tenneco's existing capital structure.

Fitch's expected ratings apply to a proposed $600 million secured revolving credit facility, a $1.3 billion secured term loan A, a $1.4 billion secured term loan B, $1.75 billion of senior secured notes and $1.0 billion of senior unsecured notes.

Conversion of the expected ratings to final ratings is contingent on the transactions closing as contemplated and receipt of final documents conforming materially to preliminary documentation reviewed, including sizing of the new debt instruments.

Key Rating Drivers

Ratings Overview: Pegasus' IDR reflects Fitch's expected pro forma post-acquisition credit profile of Tenneco. Tenneco's leverage will increase upon the closing of the acquisition and the refinancing of its capital structure. However, Fitch expects the company could have options to accelerate debt reduction over the intermediate term as it realizes incremental benefits from its expected cost savings initiatives.

Also incorporated into the IDR are the inherent risks and cyclicality of the global auto supply industry, including risks of longer-term technological change, as over 35% of Tenneco's value-added revenue is related to light vehicle internal combustion engine (ICE) products. That said, Fitch expects demand for ICE-related products to remain relatively solid over the intermediate term, while the cash they generate will provide Tenneco with resources to invest in growth technologies. Fitch also expects demand for emission control equipment to grow in the global commercial truck and off-highway sectors as emission regulations for covering those engines continue to tighten.

Apollo Acquisition: In February 2022, Tenneco entered into a definitive agreement to be acquired by funds managed by affiliates of Apollo in an all-cash transaction that values the company at an enterprise value of about $7.1 billion. The acquisition will allow Tenneco to continue restructuring its business without the complexities of operating as a public company, and Apollo has identified additional cost savings initiatives that will help to grow margins over the next several years.

Profit Improvement Initiatives: In addition to Tenneco's existing Accelerate+ plan, which aimed to reduce run-rate annual costs by $265 million by YE 2021, the company has identified an incremental $400 million of run-rate cost savings that it plans to implement over the next two years. The most significant cost savings will come from improving direct material cost pass-throughs and increasing manufacturing efficiencies. Other savings will come from optimizing overhead costs and increasing productivity, as well as eliminating public company costs. The cost to implement the savings is estimated at about $300 million. If the initiatives are successful, Fitch expects Tenneco's margins to improve, and the savings could help to mitigate potential pressures on the business resulting from weakening macroeconomic conditions.

Potential FCF Growth: Fitch expects FCF (based on Fitch's calculations) could grow over the next several years if Tenneco realizes benefits from its cost savings initiatives. FCF over the intermediate term will also be supported by benefits from actions the company has taken over the past couple of years to manage working capital and improve capex efficiency. However, higher cash interest costs related to the new debt, as well as costs to attain the aforementioned cost savings, will offset a portion of these benefits in the near term.

Fitch expects capex to run at about 2% of gross revenue going forward, down from historical levels closer to 4%, as the company focuses on improved capital utilization. Going forward, Fitch expects Tenneco to generate low-single digit value-added FCF margins once operating conditions stabilize.

Elevated Initial Leverage: Fitch expects Tenneco's gross leverage to rise upon closing of the acquisition, with the amount of new debt expected to be over $400 million higher than the company's existing debt at Sept. 30, 2022. As such, Fitch expects gross EBITDA leverage (debt, including off-balance sheet factoring/EBITDA), based on Fitch's calculations, to be in the mid-6x range at YE 2022. Fitch expects leverage to decline over the next couple of years if the company's cost savings initiatives are successful and EBITDA rises. A substantial portion of the new debt will be in the form of pre-payable term loans, which could also provide the company with flexibility to reduce leverage more quickly.

Reduced Liquidity: With the proposed new revolver sized at only $600 million, Tenneco will have materially less liquidity following the acquisition. The company's current revolver is $1.5 billion. Although the size of the new revolver will be adequate to help the company manage a period of moderate stress in its business, it could be more concerning in a severe economic downturn. Concerns about the smaller revolver could be mitigated somewhat if Tenneco chooses to carry larger cash balances going forward.

Derivation Summary

Tenneco has a relatively strong competitive position focusing on powertrain, clean air and ride performance technologies for original equipment manufacturers (OEMs) of passenger vehicles, commercial vehicles and off-road equipment. It also has a large presence in branded automotive aftermarket parts and components. The company's Tier 1 technologies are likely to grow in demand over the intermediate term as OEMs increasingly focus on ways to improve powertrain fuel efficiency, reduce emissions and improve vehicle ride quality. At the same time, the company's aftermarket business insulates it somewhat from the heavier cyclicality of the Tier 1 business while providing growth opportunities as the on-road vehicle fleet ages in both developed and developing markets.

Although the company's clean air and powertrain businesses will likely be pressured over the longer term as the global auto industry increasingly focuses on electrification, in the intermediate term, tightening emissions regulations in the global commercial truck and off-highway sectors will likely drive increased demand for Tenneco's emission control products for internal combustion engines. At the same time, growing demand for increasingly sophisticated suspensions is likely to result in higher demand for the ride control business' more profitable active suspension systems. However, compared with auto suppliers that focus on high-technology, software-based vehicle safety and automation systems, such as Aptiv PLC (BBB/Stable) or Visteon Corporation, Tenneco's business remains more tied to engine and suspension products that affect vehicle performance characteristics.

Tenneco is among the largest U.S. auto suppliers, but it is smaller than the largest global auto suppliers, such as Continental AG (BBB/Stable), Magna International Inc. or Robert Bosch GmbH (A/Stable). Over the intermediate term, Fitch expects Tenneco's margins to be roughly consistent with issuers in the 'BB' range, although they will be pressured in the near to intermediate term by weaker macro conditions. Fitch expects Tenneco's credit protection metrics, particularly leverage and coverage, will be more consistent with a 'B'-range IDR for an extended period.

Key Assumptions

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

The acquisition by Apollo is completed in the fourth quarter of 2022;

Global light vehicle production rises about 3% in 2022, with a further modest recovery in production seen in subsequent years as an improving supply chain is partially offset by weaker macro conditions in the U.S. and Europe;

EBITDA margins rise over the next several years on higher business levels, cost savings initiatives and a more stable operating environment;

Capex runs at about 2% of revenue over the next several years;

The FCF margin is slightly negative in 2022, then it turns positive and grows in subsequent years as the global production environment stabilizes and the company achieves cost savings benefits;

The company maintains a solid liquidity position over the next several years, including cash and credit facility availability.

KEY RECOVERY RATING ASSUMPTIONS

The recovery analysis assumes that Tenneco would be reorganized as a going-concern in bankruptcy rather than liquidated.

Fitch has assumed a 10% administrative claim.

Going-Concern (GC) Approach

Tenneco's recovery analysis estimates a GC EBITDA at $1.18 billion, which reflects Fitch's view of a sustainable, post-reorganization EBITDA level upon which the valuation of the company would be based following a hypothetical default. The sustainable, post-reorganization EBITDA is for analytical valuation purposes only and does not reflect a level of EBITDA at which Fitch believes the company would fall into distress. The GC EBITDA considers Tenneco's customer supply agreements with most major global OEMs, with its products embedded in the powertrains and suspension systems of many global vehicles; the critical nature of its emission control technologies; and the less-cyclical nature of its branded aftermarket products. The $1.18 billion ongoing EBITDA assumption is 2.6% above Tenneco's actual EBITDA of $1.14 billion (according to Fitch's calculations) in 2021.

Fitch has used a 5.0x multiple to calculate a post-reorganization valuation. According to the 'Automotive Bankruptcy Enterprise Values and Creditor Recoveries' report published by Fitch in January 2022, 52% of auto-related defaulters had exit multiples above 5.0x, with 30% in the 5.0x to 7.0x range. However, the median multiple observed across 23 bankruptcies was only 5.1x. Within the report, Fitch observed that 87% of the bankruptcy cases analyzed were resolved as a GC. Automotive defaulters were typically weighed down by capital structures that became untenable during a period of severe demand weakness, either due to economic cyclicality or the loss of a significant customer, or they were subject to significant operational issues.

Fitch utilizes a 5.0x enterprise value (EV) multiple based on Tenneco's global market position, including its position as a supplier to a number of top global vehicle platforms, and the non-discretionary nature of its aftermarket products. For comparison, Apollo's purchase price for Tenneco implies an EV of about 4.6x Tenneco's LTM pro forma EBITDA (according to Apollo's EBITDA calculation) as of March 31, 2022.

Consistent with Fitch's criteria, the recovery analysis assumes that off-balance-sheet factoring is replaced with a super-senior facility that has the highest priority in the distribution of value. Fitch also assumes a full draw on the company's proposed $600 million secured revolver. The revolver, secured term loans and secured notes receive second priority in the distribution of value after the factoring. As such, the first lien secured debt, excluding factoring, totals about $5.05 billion, which results in a Recovery Rating of 'RR2' with a waterfall generated recovery computation (WGRC) in the 71%-90% range.

The $1.0 billion of senior unsecured notes have the lowest priority in the distribution of value. This results in a Recovery Rating of 'RR6' with a WGRC in the 0%-10% range, owing to the significant amount of secured debt positioned above it in the hierarchy.

RATING SENSITIVITIES

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade

Realization of the company's $400 million cost savings target;

A sustained value-added FCF margin of 0.5% on a consistent basis;

Sustained decline in gross EBITDA leverage to 4.0x;

Sustained increase in EBITDA interest coverage above 4.0x and FFO interest coverage above 3.0x.

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

Liquidity pressure arising as a result of the company's smaller revolver;

Sponsor-initiated actions that reduce the company's financial flexibility;

A sustained negative value-added FCF margin;

Sustained gross EBITDA leverage above 5.0x without a clear path to de-levering;

Sustained EBITDA interest coverage below 2.5x and FFO interest coverage below 1.5x.

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

Adequate Liquidity: Fitch expects Tenneco to maintain adequate liquidity following its acquisition by Apollo. As of Sept. 30, 2022, the company had $415 million of unrestricted cash and cash equivalents (excluding Fitch's adjustments for not readily available cash) and about $1.4 billion of availability on its secured revolver after accounting for $39 million and $69 million of LOCs. As part of the refinancing of the company's capital structure, Tenneco will have access to a $600 million secured revolver following the acquisition, compared with a $1.5 billion revolver currently. Despite having a smaller revolver, Fitch expects Tenneco to have adequate liquidity to meet its financial obligations.

Following the acquisition and the changes to its capital structure, Tenneco will have no significant debt maturities until 2028, when its proposed secured notes and the majority of its secured term loans will mature. That said, the maturity of the new secured revolver is expected to be in 2027.

According to its criteria, Fitch has treated $320 million of Tenneco's cash and cash equivalents as not readily available for purposes of calculating net metrics. This is based on Fitch's estimate of the amount of cash the company needs to keep on hand to cover seasonality in its business.

Debt Structure: Following the overhaul of its capital structure, Tenneco's debt will primarily consist of $2.7 billion of borrowings on its new secured term loans, $1.75 billion of senior secured notes and $1.0 billion of senior unsecured notes.

In addition to its balance sheet debt, Fitch expects Tenneco to continue with about $1.0 billion to $1.3 billion of off-balance sheet factoring that Fitch treats as debt. As of Sept. 30, 2022, Tenneco had $1.1 billion of off-balance sheet factoring outstanding.

Tenneco's off-balance sheet factoring includes the effect of supply-chain financing programs with some of the company's aftermarket customers with whom it has entered into extended payment terms. If the financial institutions involved in these programs were to curtail or end their participation, Tenneco might need to borrow from its revolver to offset the effect, but it could also mitigate at least a portion of the effect by exercising its contractual right to shorten the payment terms with these particular aftermarket customers.

Issuer Profile

Pegasus is an affiliate of funds managed by Apollo that will merge with Tenneco to effectuate Apollo's acquisition of Tenneco. Tenneco is a global automotive supplier that sells products to both original equipment manufacturers and the automotive aftermarket.

ESG Considerations

Tenneco has an ESG Relevance Score of '4[+]' for GHG Emissions & Air Quality due to the company's positioning as a top supplier of products that reduce vehicle emissions from internal combustion engines, which has a positive impact on the credit profile and is relevant to the ratings in conjunction with other factors.

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

(C) 2022 Electronic News Publishing, source ENP Newswire