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We assess USJ's business risk profile as "fair." The company's portfolio of premium sugar products for the domestic market and sound operating track record - including high levels of agricultural productivity - help soften the risks inherent to the sugar and ethanol industry, such as exposure to volatility and cyclicality of sugar and ethanol prices and exposure to uncontrollable weather conditions. The company compensates its small scale and the risks of operating one site with high percentage of owned-land and its favorable location.
USJ is located in the southeastern part of the country, which is one of the world's most productive sugarcane regions, mainly due to its favorable soil, good weather conditions, and available logistics infrastructure. USJ's industrial mill is near its plantations, with an average distance of 25 kilometers, and close to Brazil's main port and USJ's important customers, such as food and beverage producers. We believe that USJ's high percentage of owned lands provides it with important competitive cost advantages, because it reduces competition for raw material sources and cash costs, compared with leased operations. We expect the company's adjusted EBITDA margin to be about 40% in the next four years, which is one of the highest among the global sugar producers we rate.
We assess USJ's financial risk profile as "aggressive." Although 69% of USJ's debt is long term, we believe the company is still somewhat exposed to refinancing risks. The planned $200 million bond issuance will contribute to refinance its short-term guaranteed debt. We assume the company will be able to extend maturities either by the bond issuance or bank loans. The ratings on the notes don't have any subordination despite the current significant amount of debt guaranteed by land. This is because we assume the notes will be used to pay down the guaranteed debt.
We expect USJ to maintain somewhat stable credit metrics despite significant investments in sugarcane expansion and crop renewal, with an annual capex of about R$80 million in the current harvest and about R$50 from fiscal year 2014 on (excluding crop renewal, as we consider it as a cost). An improved productivity will boost cash generation and help reduce debt. The lower, but still favorable prices for sugar will support the company's margins. USJ's crushed volumes are expected to increase due to higher investments in the fields in the past two harvests, resulting in higher productivity, measured by sugar availability in the cane and tons of cane per hectare. We project USJ to report total adjusted debt to EBITDA of less than 4x and funds from operations (FFO) to debt of 20%-25% in fiscal 2013. We adjust the company's EBITDA and FFO for its biological assets' fair value accounting and crop expenses capitalization.
We view USJ's liquidity as "adequate". As of June 30, 2012, the company reported cash reserves of R$70.1 million. We take into account the company's proposed bond issuance as a source of liquidity. We expect annual FFO of more than R$100 million in the next couple of years, and we consider as additional source of funding some R$90 million of credit lines that are available, but not drawn. The company's sources of cash compare favorably with its expected cash uses, which include R$115 million of short-term debt, approximately R$80 million of capital expenditures (excluding crop renewal), low payout ratios of about 6% of net income, and annual cash dividends of about R$1 million. It is important to highlight that if the company is not successful in issuing the bonds, we can revise liquidity to "less than adequate," given our belief that there will be some refinancing pressure. The industry is seasonal, and quarterly cash flows can be impacted by weather and availability to crush the sugarcane and generate cash flows.
We estimate USJ's sources of cash to exceed uses by more than 1x in the next two years. The company has adequate cushion of more than 20% on its bonds' covenants' trigger, which requires a minimum net debt to EBITDA ratio of 3.5x and are incurrence covenants only. The company's covenant calculations differ considerably from our ratios which include the leasing and crop treatment adjustments as aforementioned. In our forecasts, SJC doesn't need additional investments from USJ, as the joint venture is run as a stand-alone company and will fund its expenses through its cash flow generation.
The stable outlook reflects our opinion that the company's leverage metrics will improve gradually--total adjusted debt to EBITDA of less than 4x--while it maintains a moderate financial policy, which includes focusing on internal expansion and limiting dividends distribution. We believe USJ will maintain its above-average profitability, as it continues investing in the renewal and expansion of agricultural yields and gradually increase utilization capacity, sustaining high agricultural and industrial productivity. Still attractive global prices for sugar and positive demand fundamentals for ethanol should improve the company's profitability in the next 12-18 months.
We could downgrade USJ if its financial metrics deteriorate, leading to an adjusted total debt to EBITDA of more than 4x and adjusted FFO to debt lower than 15%, on a more permanent basis. We could also lower the ratings if liquidity deteriorates, increasing refinancing needs and pressuring investments to sustain productivity, which might result in lower-than-expected cash generation. Given USJ's more limited business profile, we see the potential for rating upside as more long term, and dependent on a substantial improvement in credit metrics and a consistent track record of moderate policies, such as adjusted total debt to EBITDA is consistently below 3x, FFO to debt above than 35%, and satisfactory debt profile with no refinancing pressures.
Related Criteria And Research
-- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008
New Rating; CreditWatch/Outlook Action
USJ Acucar e Alcool S/A
Corporate Credit Rating BB-/Stable/--
Brazilian Rating Scale brA/Stable/--
USJ Acucar e Alcool S/A
Senior Unsecured BB-