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Jan 29 (Reuters) - (The following statement was released by the rating agency)
Fitch Ratings has downgraded China Oriental Group Company Limiteda€™s (COG) Long-Term Foreign-Currency Issuer Default Rating (IDR), and senior unsecured rating to a€˜BB-a€™ from a€˜BBa€™. The Outlook is Stable. A full list of rating actions is at the end of this commentary. The downgrade reflects the weakness in the Chinese steel industry, which Fitch believes will persist. COGa€™s weak profitability in 2012 and 2013 is a reflection of the industry trend. COG also has not invested the funds it had raised to build a stronger product offering, which could have mitigated the negative industry trend. The Stable Outlook is supported by COGa€™s ability to generate positive free cash flow (FCF) even in a weakened industry environment, which supports its ability to address impending debt maturities.
KEY RATING DRIVERS
Persistently Weak Operating Environment: We believe there will continue to be over-production of long steel products in China. Government economic stimulus in 2009 spurred a surge in construction and infrastructure, which fed demand for long steel products. However, steel-making capacity geared towards long products has been slow to adjust to the Chinese governmenta€™s move to steer the economy towards consumption, which favours flat steel products. For COG, long products such as H-section steel, billets and rebar contributed to 55% of its steel production revenue in 1H13. COG was barely profitable in 2012 and 2013 as a result of the industry weakness.
Limited Business Profile Improvement: COG has not seen material strengthening of its product offerings since 2010, when it raised USD850m via two bond issues. The company added rebar products to its offerings in 2011 and its steel sheet pile product will only start entering the market in 2014. Although sheet pile is a high-value added product, it is unlikely to become a major earnings contributor immediately while COG builds its track record in this new product.
The sustained weakness of the Chinese steel market has limited COGa€™s options in pursuing further steel product diversification, and forces the company to adopt a defensive posture towards further investments in steel operation. With USD490m in outstanding bonds maturing in 2015, COG has missed its window to build a stronger business profile because it will now have to focus on raising funds for the refinancing or redemption of the senior notes.
Demonstrated Financial Flexibility: Fitch believes COG has the flexibility to improve its financial profile through improvements in working capital management. In 1H13, COG reduced its net debt by CNY1.2bn mostly by reducing working capital. Prior to this, COGa€™s negative free cash flow (FCF) was driven by its strategy of increasing working capital to defend its operating margins. COG had secured better pricing from its customers and suppliers by giving them better payment terms. COG has also been prudent with capex spending. Capex between 2009 and 2012 was only 36% of the funds flow from operation generated over the same period.
Refinancing Options Readily Available: COG has demonstrated that it is able to obtain bank loans of over CNY4bn from both offshore and onshore banks. Furthermore, COG has the option of raising capital in the domestic bond markets. Based on its 1H13 bank balances of CNY1.2bn and an estimate of CNY 1.5bn per annum average cash flow from operations for 2H13 to 1H15, COG has sufficient liquidity to meet the redemption of its notes due 2015. This is provided that COG does not again increase its investment in working capital as well as in its non-core operations.
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- FFO adjusted net leverage staying above 3.0x from 2014 (2013 estimated at above 4.0x)
- Negative free cash flow
- Failure to put in place a refinancing plan for the USD490m outstanding senior notes due 2015 by end of 2014
Positive: Future developments that may, individually or collectively, lead to the positive rating action include:
- FFO adjusted net leverage falling below 1.5x on a sustained basis
The list of rating actions is as follows:
Long-Term Foreign-Currency IDR downgraded to a€˜BB-a€™ from a€˜BBa€™; Stable Outlook
Senior unsecured rating downgraded to a€˜BB-a€™ from a€˜BBa€™
Rating on USD550m 8% notes due 2015 downgraded to a€˜BB-a€™ from a€˜BBa€™
Rating on USD300m 7% notes due 2017 downgraded to a€˜BB-a€™ from a€˜BBa€™