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March 6 (The following statement was released by the rating agency)
Fitch Ratings has revised Russia-based OJSC Holding Company United Confectioners' (UC) Outlook to Negative from Stable, affirmed the company's Long-term Issuer Default Rating (IDR) at 'B' and downgraded the National Long-term rating to 'BBB-(rus)' from 'BBB+(rus)'. The agency has also affirmed the senior unsecured rating applicable to OOO United Confectioners Finance's (UC Finance) bond due April 2023 at 'B'/'RR4'.
The revision of the Outlook to Negative reflects Fitch's expectation of a net increase in UC's related-party investments in 2013 above the downgrade trigger levels, which would lead to a deterioration of credit metrics with funds from operations (FFO) adjusted leverage approaching a negative rating guideline of 3x (2012: 1.7x). In addition, we expect operating performance and free cash flow (FCF) generation to be weaker than in the past driven by capex and working capital investments and downward margin pressure given the increased relevance of the retail distribution channel. The above factors also justify the downgrade on the National Rating to 'BBB-(rus)' from 'BBB+(rus)'.
KEY RATING DRIVERS
Related-party Loan Transactions Pressuring Ratings
Fitch considers corporate governance issues to remain a key ratings driver for UC. Based on UC's interim financial statements for 9M13 Fitch expects a material increase in loans to related parties last year evidencing a cash leakage from the company, leading to increased debt and higher than expected leverage. UC plans to keep new related-parties loans closer to historic levels, thus Fitch assumes new loans will not exceed net income. Lack of management independence and the portion of UC's cash kept at Guta Bank also demonstrate UC's dependence from Guta Group, which caps any rating uplift.
Leading Market Position
UC continues to hold leading positions in core confectionery market segments in Russia, benefiting from its strong portfolio of nationally recognised brands. Fitch expects UC to benefit from changes in product mix towards more premium offerings and grow slightly above the market, keeping its market share stable even despite an increase in competition from international players and private labels.
Volatile Operating Performance
Over the last few years Fitch-calculated EBITDA margin has been fluctuating between 11%-17% owing to the changes in distribution scheme, additional marketing expenses and swings in soft commodity prices given the inability to enter into effective hedging. The highest margin was reached in 2012 due to cyclically low world prices on cocoa and other strategic raw materials. Despite some support from product portfolio premiumisation, UC's profit margins are expected to weaken in 2013-2016 mostly as a result of cost base inflation, related to less favourable raw materials prices combined with negative impact from RUB devaluation.
Deteriorating Financial Flexibility
Projected deterioration of operating profitability coupled with increasing capex planned for 2014-2016 would result in FCF margin contraction from 3.2% in 2012 to below 1% by 2016. As a result, we expect UC's FFO-adjusted leverage to be close to 3x with limited scope for deleveraging in the mid-term. If new loans to related parties were maintained at elevated levels, such cash drainage combined with weak FCF could introduce further downward pressure on the IDR.
Sufficient liquidity is supported by RUB5.5bn of cash as of 1st January 2014, RUB1.1bn available committed bilateral bank lines at end-2013 and positive FCF generation. Short-term debt amounted to RUB2.9bn at end-2013. Even though a portion of cash is kept at Guta Bank, UC's overall liquidity situation is adequate relative to the assigned rating level.
Structural Subordination Offset by Adequate Recovery Prospects
Fitch notes that the bond issued by UC Finance is covered only by a guarantee (suretyship under Russian law) from the holding company OJSC Holding Company United Confectioners, and therefore structurally subordinated to all other debt, including related party unsecured borrowings, altogether representing RUB13bn of debt ranking ahead of the bond. However, expected recoveries in case of default are supported by Fitch's going concern valuation approach which would support superior recoveries for all unsecured debt. However we apply a soft cap for Russian jurisdiction, hence the assigned senior unsecured rating of 'B'/'RR4'.
Negative: Future developments that may, individually or collectively, lead to negative rating actions include:
- Any material deterioration in FCF generation combined with larger than expected distribution of funds to Guta Group or any major debt-funded acquisitions
- Sustained FFO adjusted leverage above 3x
- Net increase in related-party investments plus a net decrease in related party borrowings altogether exceeding cash flow from operations minus maintenance capex.
Positive: Future developments that may, individually or collectively, lead to the rating outlook stabilization include:
- Sustained FFO adjusted leverage below 2.5x for at least two consecutive years
- Maintenance of positive FCF above RUB1bn annually
- Liquidity score of more than 1.5x (cash, available committed lines and FCF for the next year divided by the amount of short-term debt commitments).
Any potential future upgrade is constrained until there is evidence of a standalone business model with reduced inter-relationship with Guta Group.