OREANDA-NEWS. S&P Global Ratings today revised its outlook on Spanish pulp and electricity producer ENCE Energia y Celulosa S. A. (Ence) to positive from stable. At the same time, we affirmed our 'BB-' corporate credit rating on Ence.

We also affirmed our 'BB-' issue rating on the group's €250 million senior unsecured debt, in line with the corporate credit rating. The recovery rating on the senior unsecured debt remains at '4', reflecting our expectations of average recovery prospects, in the lower half of the 30%-50% range, in the event of a payment default.

The outlook revision reflects the potential for an upgrade over the next 12 months if Ence continues to demonstrate strong profitability and positive free cash flow that results in low debt leverage ratios despite our expectation of lower pulp prices. In addition, we expect there to be more clarity around the potential risks associated with the Pontevedra concession extension and the group's investment plans for its stand-alone biomass plants that could lead us to revise upward our assessment of its financial risk profile.

Ence benefitted from strong momentum in bleached eucalyptus pulp (BEK) prices and a weakening euro against the U. S. dollar in 2015. Despite our expectations of lower pulp prices in 2016, compared with the peak we saw last year, continued improvement in Ence's cash cost position, following the closure of the pulp plant in Huelva in 2014 and efficiency investments, supports the group's strong profitability. Combined with prudent investments and financial policy, this has resulted in lower leverage, with funds from operations (FFO) to debt of 37% as of end-March 2016 compared with 20% a year earlier.

We still consider Ence's financial risk profile to be constrained by its volatile cash flow generation, which is highly dependent on the market price for pulp. The market price for bleached hardwood kraft price has dropped by around 15% in the last 12 months and appears to have bottomed out at about $680 per ton. We think that lower pulp prices will only partly be offset by increasing pulp volumes in 2016. As a result, we anticipate that Ence's credit metrics will deteriorate slightly compared with 2015. However, we still expect FFO to debt to remain above 30% in our base case. In 2017 and beyond, we think that Ence, despite weak pulp prices, could maintain credit metrics at this level or stronger, but that it will largely be dependent on the size of its investment program and its shareholder remuneration policy. While Ence's ambitious investment program is positive for its long-term competitive position, we think that the group's investment strategy could constrain its financial risk profile in the coming years, if the company goes ahead with several new projects in biomass energy generation. We think that these projects come with timing and execution risks, as well as potential exposure to regulatory risks. We consolidate Ence's project finance debt (€128 million as of Dec. 31, 2015) in our calculation of adjusted debt because, although it is non-recourse, we assess the energy operations as core to the group. We also include Ence's utilization under its factoring arrangements of about €103 million and operating lease liabilities of approximately €14 million, but deduct €150 million of surplus cash. This results in adjusted debt of €398 million as of year-end 2015. We think that Ence's relatively high leverage and volatile cash flow generation is partly balanced by its long-dated debt maturity profile and its flexible investment program.

We think that Ence's business risk profile is constrained by its inherent exposure to volatile pulp prices and limited size and scope, with only two pulp mills and three stand-alone biomass energy plants, all of which are located in Spain. We think that profitability will continue to be volatile but that EBITDA margins will stay above 20% and return on capital at least about 10%, which is still very strong for the broader paper and forest products sector. We also continue to acknowledge Ence's fairly efficient logistics with pulp mills located close to port terminals and just-in-time delivery to clients in Europe, as well as its exposure to growing end-markets, with tissue companies accounting for about 50% of pulp sales.

In our base case, we assume: BEK list price (for delivery in Europe) of about $700 per ton for 2016 and on, as demand is somewhat outpaced with capacity additions. Slightly higher average discount of about 25% on pulp sales;A U. S. dollar Euro exchange rate of 1.10 in 2016 and 1.05 in 2017, as forecasted by S&P Global Ratings economists;Pulp volumes to increase in 2016 to about 940,000 tons, slightly rising thereafter following capacity expansions;Adjusted EBITDA margin of about 23% for 2016 and improving thereafter as a result of lower cash costs; Capital expenditures (capex) of about €60 million-€70 million in 2016, possibly increasing significantly from 2017 as the company pursues investments at Pontevedara and investments into stand-alone biomass plants; andFree cash flow to be partly utilized for total shareholder remuneration of about €35 million annually. Based on these assumptions, we arrive at the following credit measures: FFO to debt of 33% in 2016 and improving toward 40% in 2017.Debt to EBITDA of about 2.4x in 2016 and about 2.0x in 2017.Free operating cash flow to debt of approximately 20% and significantly lower in 2017 if Ence carries out all planned investments.

The positive outlook indicates at least a one-in-three likelihood that we could raise the rating in the coming 12 months if Ence's credit metrics were to remain strong while the group maintained solid profitability (even in a scenario of low sustained low pulp prices), and a prudent financial policy. We will continue to monitor the company's ability to sustain these leverage levels in the event of higher biomass energy investments or for any potential adverse impact related to cancellation of Pontevedra pulp mill concession.

We could raise the rating over the next 12 months if Ence continues to maintain solid EBITDA margins and a prudent financial policy regarding investments, dividends, and share buybacks. An upgrade would hinge on Ence maintaining adjusted FFO to debt of more than 35% and debt to EBITDA of below 2.5x. An upgrade would also depend on our assessment of potential risks associated with the Pontevedra concession.

We could revise the outlook to stable over the next 12 months if Ence's profitability deteriorates meaningfully or if the group's financial policy becomes more aggressive, resulting in FFO to debt of below 30% and debt to EBITDA of above 3x. An outlook revision to stable could also stem from uncertainty regarding the group's substantial debt-funded biomass energy investment plans or if we believe the company faces aggravated concerns related to the Pontevedra concession.