OREANDA-NEWS. Fitch Ratings has affirmed Tupy S. A.'s Foreign and Local Currency Long-Term Issuer Default Ratings (IDRs) at 'BB' and Long-Term National Scale Rating at 'AA(bra)'. At the same time, Fitch has affirmed Tupy Overseas S. A.'s USD350 million senior unsecured notes due 2024 at 'BB'. The Rating Outlook for the corporate ratings is Stable. A complete list of rating actions follows at the end of this release.

KEY RATING DRIVERS

Tupy's ratings reflect its capacity to continue generating adequate operational cash flows even during unfavorable macroeconomic environments, such as the current depressed automotive market in Brazil. Tupy has been benefited by approximately 80% of its revenues from the external market, resulting in higher stability in revenues and margins, and historically presented positive free cash flow (FCF).

The ratings also incorporate Tupy's conservative capital structure and comfortable liquidity, as well as its leading position in the global engine blocks and cylinder heads manufacturing over the last years. High operating flexibility to rapidly adjust to demand fluctuations allows the company to maintain resilient operating margins through cycles.

Tupy's ratings are somehow constrained by its relatively low scale and still limited geographic diversification when compared to other global auto part companies and by the high cyclicality and competitive environment of the automotive industry. The high concentration in the U. S. market is a concern, as a potential contraction in this market could negatively impact Tupy's performance. Also factored into the ratings is the challenging scenario in the Brazilian economy and the domestic auto sector, which are not expected to improve materially in the near term.

Limited Geographic Diversification and High Value-Added Products

Tupy's credit profile benefits from its international footprint and high value-add of its products. In a volatile and cyclical industry as the automotive, these attributes play an important role to support cash flow generation. As of the latest 12 months (LTM) ended March 31, 2016, 82% of BRL3.5 billion in sales (USD976 million) were in hard currency from almost 50 countries. Nevertheless, the 61% concentrated in the U. S. market in the LTM ended March 2016 is considered high.

Market share is estimated by the company at 43% in the Americas, 7% in Europe, and 25% in the Western hemisphere. The company produces cast iron parts with a positive wide application in the industry, ranging from light vehicles, trucks, buses, agricultural and construction machineries as well as hydraulics for industrial and engineering applications. Its cast engine blocks and cylinder heads have high value-add as they involve high technology to produce and are key to automakers. Since original equipment manufactory (OEM) predominantly have only one or two suppliers of engine blocks and cylinder heads, switching costs are high, resulting in a mutual reliance between the two.

Conservative Capital Structure

Fitch expects Tupy to maintain an adequate capital structure over the next few years, with net leverage below 2.0x. As of the LTM ended March 31, 2016, the company reported a gross leverage of 3.9x, which favorably compares to 4.2x reported in both 2015 and 2014. Net leverage reached 1.3x in the same period, improving from the 1.6x registered in both 2015 and 2014 as Tupy was able to use its positive FCF to reduce overall debt while keeping EBITDA stable.

Positive FCF to Continue

Fitch forecasts Tupy will continue to generate positive FCF over the next three years. The agency estimates that the slowdown in domestic sales will be offset by the growth in exports, while maintain capex at historical lows and dividends at 50% pay out rate. As of the LTM ended March 31, 2016, the company reported funds from operations (FFO) of BRL318 million, which unfavorably compares to the BRL400 million-BRL500 million presented in 2013-2015 period. Lower volumes and the learning curve of transferred assembly lines, as well as some severance payments were the main reasons for the FFO decline.

However, the BRL200 million working capital inflow led cash flow from operations (CFFO) to BRL519 million, which was enough to cover capex of BRL145 million and dividends of BRL107 million, resulting in a positive FCF of BRL266 million.

Tupy has been efficient in supporting its operating margins at adequate levels. In March 2016 (LTM), EBITDA of BRL590 million represented an EBITDA margin of 16.9%, in line with previous years despite the adverse domestic environment. Fitch expects EBITDA margin to range 14%-19% in the coming years.

Potential Threat from Aluminum

Fitch believes Tupy will continue to experience competition from aluminum engine blocks in the light vehicle segment. Fitch forecasts that Tupy will lose approximately 2%-3% of revenues over the next four to five years due to aluminum shifts from customers. Overall, the agency estimates that 4%-5% of revenues are somehow threatened by aluminum. On the other hand, its cast iron and compact graphite iron (CGI) parts will continue to prevail in the light to heavy commercial vehicles, which represent 80% of the company's revenues as of the LTM ended March 31, 2016. All in all, Fitch believes the two metals will co-exist for a long period of time and that changes favoring one or the other in the small-engine segment will be gradual given the long term contracts.

KEY ASSUMPTIONS

--Domestic market revenues dropping 14% and 8% in 2016 and 2017;

--External revenues growing 2% in 2016 and relatively flat in 2017;

--EBITDA margin of 14% and 17% in 2016 and 2017;

--Capital expenditures of BRL300 million in 2016 and 2017 combined;

--Dividends payout rate of 50%; and

--No major acquisitions in the near term.

RATING SENSITIVITIES

Future developments that may individually or collectively lead to a negative rating action include:

--Severe decline in the American auto production that reduces demand for Tupy's products;

--Net leverage consistently above 2.0x;

--FCF turning negative, eroding company's liquidity;

--Advance of aluminum leading Tupy to lose contracts.

Positive rating actions are unlikely in the medium term due to Tupy's cyclical and volatile industry characteristics, still moderate scale compared to large players and geographic diversification, and depressed automotive market in Brazil.

LIQUIDITY

Fitch expects Tupy to keep robust liquidity in the next three years as part of its conservative financial policy. On March 31, 2016, company's cash position of BRL1.5 billion covered 3.4x the short-term debt of BRL443 million. Tupy's short-term debt coverage jumps to 4.6x when CFFO is added to cash. Short-term debt is mostly related to trade finance, funding company's exports. Following the successful bond issuance in July 2014, Tupy substantially improved its debt amortization schedule. The current cash position is enough to cover total debt maturities until 2023.