Fitch Assigns Russian Railways' Upcoming Notes 'BBB-(EXP)' Rating
The final rating is contingent upon the receipt of final documentation conforming materially to information already received and details regarding the amount, coupon rate and maturity.
The notes will be issued on a limited recourse basis for the sole purpose of funding loans by RZD Capital to RZD. The proceeds of the loans will be used by RZD to refinance existing debt. The noteholders will rely solely and exclusively on RZD's credit and financial standing for the payment of obligations under the LPNs.
KEY RATING DRIVERS
State Support Drives Alignment
RZD's ratings continue to be aligned with those of the Russian Federation (BBB-/Negative), reflecting its 100% state ownership, strategic importance to the Russian economy, strong operational links to the state, including tariff and capex approval by the government, and track record of state support. We view RZD's standalone profile as commensurate with a low 'BBB' rating category.
RZD continues to receive tangible state support in various forms. In 2015 it received subsidies of around RUB63bn, the majority of which related to passenger transportation; direct equity injections of about RUB71bn to fund its key infrastructure projects. It also issued long-dated inflation-linked infrastructure bonds of about RUB97bn in favour of the National Wealth Fund and State Pension Fund to finance its long-term infrastructure projects. RZD also issued RUB50bn of preference shares acquired by the state, which envisions dividends of 0.01% over 2015-2019 and 2.98% starting from 2020.
We expect RZD to continue receiving tangible financial support in the medium term. In 2016 we expect RZD to receive subsidies of about RUB51bn and equity injections of around RUB49bn, mainly for the development of some large-scale projects. RZD plans to issue preference shares, which were approved by the government in 2013 to fund infrastructure development in the Far East.
Weak Market Fundamentals Pressure Volumes
The economic downturn in Russia continues to weigh on the freight rail transportation market. Freight rail transportation volumes declined about 1% yoy in 2015, although rail turnover remained largely flat. In 8M16 freight rail volumes and turnover grew 1.6% and 1.5% yoy, respectively. The decline of oil and oil products and ferrous metals transportation volumes of 7.5% and 4.7% yoy, respectively, was offset by an increase of construction materials and coal transportation volumes by 17.2% and 3.2% yoy.
We expect pressure on volumes to remain in 2016, due to the recession in Russia, increasing competition from other means of transport, especially for crude oil during the period of low oil prices, as well as challenging global market conditions for metallurgical cargoes. Fitch expects the Russian economy to decline by 0.5% this year.
Negative FCF Expected
We expect RZD to continue generating healthy cash flow from operations of about RUB270bn on average over 2016-2019. However, free cash flow (FCF) is expected to be negative over the same period, driven by Fitch-expected extensive capex of about RUB450bn annually on average over 2016-2019. Forecasted negative FCF will add to funding requirements, which RZD expects to partially fund through infrastructure bonds, equity injections and preferred shares. RZD also has the option to postpone capex plans where necessary.
RZD is exposed to FX fluctuations as about half of its debt at end-2015 was denominated in foreign currencies. RZD mitigates this by hedging its exposure to foreign currency borrowings using swaps of Swiss francs, which it receives from its transit operations. In addition, a portion of EBITDA is generated in euros following its acquisition of GEFCO.
Low 'BBB' Category Standalone Credit
We currently assess RZD's standalone profile to be commensurate with a low 'BBB' rating category. We expect RZD's standalone profile to remain under pressure from the contracting Russian economy, inflationary pressure, rouble devaluation, elevated interest rates, extensive capex and an expected increase of dividend pay-out ratio to 50% of net income. We forecast funds from operations (FFO) adjusted net leverage to remain around 3x over 2016-2019, which is within our leverage negative rating guideline. However, we expect FFO fixed charge coverage to remain below Fitch's coverage negative rating guideline of 4x over 2016-2019.
RZD's business profile continues to benefit from the company's position as the monopoly owner and operator of the rail infrastructure, essential for transporting freight and passengers across Russia, and the company's sizeable operations in freight and passenger transportation in Russia.
However, RZD's standalone profile is limited by a still developing long-term tariff system and by its exposure to commodity market risks, FX risk, and somewhat limited geographical diversification. To a large degree, the company is dependent on financial state support to fund large-scale capex projects and loss-making passenger transportation, and is fully exposed to the domestic economic and operating environment.
Tariff Increase Should Support Margins
A 9% tariff indexation was approved for 2016, following a 10% increase last year, partially mitigating a freeze in 2014. RZD has also been permitted a continued right to use a tariff corridor for certain types of cargo. However, the tariff-setting mechanism lacks transparency and predictability, affecting earnings visibility, which constrains the company's standalone profile.
The approved tariffs increase should support EBITDA margins, but lower forecast volumes growth and the economic downturn mean the company's ability to rationalise its cost base is key to supporting margins and FFO, particularly in the view of its plans for heavy capex.
Fitch's key assumptions within our rating case for the issuer include:
- Russian GDP decline of 0.5% in 2016 and growth of 1.3%-2% in 2017-2018;
- Russian CPI of 5%-9% over 2016-2018;
- Transportation volume growth in line with Fitch-forecasted GDP growth;
- Tariff increase as approved by the government for 2016 and in line with inflation thereafter;
- Capex as planned by RZD for 2016 and in line with the preceding three-year average over 2017-2018;
- Subsidies, equity injections and other forms of state support (ie infrastructure bonds, preferred shares) as approved by the government or expected by RZD;
- Inflation-driven cost increase;
- Dividends of 50% of net income under IFRS for 2016-2020;
- Preference shares are treated outside of restricted group's IDR perimeter, given the characteristics of the instrument (eg no events of default, no cross default, structural subordination).
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Downgrade of the sovereign rating
- Sustained FFO net adjusted leverage above 3.5x and FFO fixed charge coverage below 4x, which may be negative for RZD's ratings, unless further evidence of state support is provided.
Positive: The Outlook is Negative, therefore, we do not anticipate positive rating action in the short term. However, a revision of the sovereign's Outlook may result in a similar action on RZD.
For the sovereign rating of the Russian Federation, RZD's parent, the following sensitivities were outlined by Fitch in its rating action commentary of 15 April 2016:
Future developments that could individually, or collectively, result in a downgrade include:
-A further sharp decline in international reserves.
-Failure to recover from recession, coupled with significant deviation from stated macroeconomic and fiscal policy aims.
-Rise in geopolitical tensions or sanctions risks.
Future developments that could individually, or collectively, result in the Outlook being revised to Stable include:
-Continued commitment to contain expenditure and implementation of a credible medium-term fiscal framework.
-Avoiding further significant depletion in international reserves.
RZD's cash and cash equivalents were RUB128bn at end-2015, excluding RUB49bn from National Wealth Fund that were earmarked to finance certain investment projects. Together with unused credit facilities of RUB310bn mainly from the major local state-owned banks, this was sufficient to cover short-term maturities of around RUB159bn. RZD's weighted average debt maturity profile is about 10 years.