OREANDA-NEWS. Fitch Ratings has downgraded Far-Eastern Shipping Company Plc's (FESCO) Long-term foreign currency Issuer Default Rating (IDR) to 'B' from 'B+'. The Outlook is Stable.

The downgrade reflects a weaker-than-expected market environment in 2013 and so far in 2014, resulting in weaker cash flow and deterioration of credit metrics. We do not expect FESCO's credit metrics to improve significantly in the medium term and forecast leverage will only modestly improve in 2014-2016. The modest improvement will be driven by a moderate recovery of the company's key divisions, in addition to its policy of zero dividend payments until net debt to EBITDA falls below 2.5x (5.1x in 2013) and fairly flexible, subject to market conditions, capex.

KEY RATING DRIVERS

Materially Weaker Credit Metrics
At end-2013 FESCO reported net FFO adjusted leverage of 5.6x and fixed charge coverage (FCC) of 1.3x that were considerably weaker than Fitch's expectations of 4.4x and 2.2x respectively. This was primarily driven by a fall in revenue and EBITDA in 2013 of 4.8% and 24.7% yoy respectively, due to underperformance of the rail division amid challenging rail market conditions. Fitch expects, over the short-to-medium-term, FFO net adjusted leverage to remain well above 4x and FCC at below 2x.

Our credit metrics calculations exclude the REPO loan of USD150m obtained from VTB with a pledge of FESCO's 24.1% stake in Transcontainer. We do not assess this loan to be fully ring-fenced and treat it as limited recourse debt.

Material Rail Division Underperformance
The rail business is subject to cyclical variations given its dependency on GDP growth and commodity exposure. Freight rail volumes and prices declined in 2013, mostly due to intensifying competition from smaller players and overall stagnation of the Russian economy and, in particular, industrial production. FESCO's rail division reported revenue of USD251m and EBITDA of USD90m in 2013, a 28% and 46% yoy decrease respectively, due to a decline in non-container cargo transportation volumes and gondola rates that were halved in 2013. Fitch does not expect significant volume recovery in the short-to-medium-term given still depressed GDP growth (Fitch forecast: 1%-2% in 2014 and 2015) and does not expect significant increase in gondola rates partly due to surplus capacity.

Port Stable but Restructuring Delayed
FESCO's port business is a key source of the company's earnings given its higher margins and lower earnings volatility. Vladivostok is one of the largest ports in the Russian Far-East and is key in the importing and exporting of commodities as well as consumer goods.

FESCO's port division reported revenue of USD200m and EBITDA of USD90m in 2013, a 12.5% and 4.3% yoy increase respectively, on higher container handling volumes and consolidation of Port of Vladivostok and Vladivostok Container Terminal. However, while the port division continues to perform well relative to the rail division, synergies from the merger of Port of Vladivostok and the terminal business are not expected to make an impact until 2014. This should result in more cost savings, i.e. reduced headcount and improved business processes, etc.

Flexible Capex Ensures Positive FCF
Fitch expects FESCO to continue to generate stable cash flow from operations of USD90m on average over 2014-2016. FESCO's capex programme is fairly flexible and subject to market conditions. This, together with its policy of zero dividend payments until net debt/EBITDA falls below 2.5x, allow management to keep free cash flow in the positive territory. Management confirmed that it will not increase expansion capex until the market for rail services improves. Maintenance capex is estimated to average USD18m-USD20m, which represents almost half of our capex forecast per annum over 2014-2016. The company demonstrated flexibility in 2013, when it cut capex to USD47m from USD65m. This has meant that despite the deterioration in the rail business the company has continued to generate positive free cash flow and limit deterioration in credit metrics.

FX Risk
FESCO is subject to foreign currency fluctuations risks as about 80% of its total debt is denominated in USD, comprising two eurobonds that mature in 2018 and 2020. This contrasts with only around 50%-60% of revenues that are USD-linked or USD-denominated. The company is seeking to improve the natural hedge of its earnings through the negotiation of its contracts and through focusing on exports at the Vladivostok port. While repayment risk is not imminent in the short-term continued decline of RUB versus the USD could result in conversion risk.

Diversified Exposure; Commodities Dominate
FESCO is fairly well-diversified by cargo type, facilitated by its balanced and flexible fleet portfolio. In common with some of its rail peers, commoditised goods including coal, iron ore and construction materials dominate its rail division, comprising around 77% of total volumes transported by rail in 2012. FESCO's Port and Liner and Logistics divisions provide the group with greater exposure to higher-value goods, as well as diversity in terms of geographical markets. Although bulk cargo is skewed towards exports, given Asia's demand for raw materials, trade flows in terms of container throughput are fairly well-balanced.

Moderate Customer Diversification
Although FESCO's customer base is fairly broad (around 1,500 customers spanning a variety of industries and of fairly sound quality) it exhibits greater concentration than peers, particularly in the rail division where the five largest direct clients accounted for 38% of the division's revenues in 2012.

LIQUIDITY & DEBT STRUCTURE

At end-2013 FESCO's cash and cash equivalents stood at USD191m which comfortably covered short-term debt of USD20m, excluding limited recourse short-term REPO loan of USD150m, which we do not include in our credit metrics calculations. Additionally, FESCO started to generate positive free cash flows in 2012 and we expect it to continue in the medium term. FESCO's debt repayment profile is not onerous with local bonds of USD151m due in 2016 and eurobonds of USD550m and USD325m due in 2018 and 2020 respectively.

Financial covenants (i.e. fixed charge coverage ratio (FCCR) at 2.0x or higher and consolidated total leverage ratio (CTLR) of less than 3.25x) per the eurobonds documentation limit the ability to incur additional debt but their breach will not constitute an event of default as they are not maintenance covenants. The company adhered to its non-financial covenants as at FY13.

RATING SENSITIVITIES

Positive: Future developments that could lead to positive rating actions include:
- A sustainable improvement in FFO net adjusted leverage to below 4.0x and FFO fixed charge cover trending towards 2.0x

Negative: Future developments that could lead to negative rating action include:
- Inability to reduce FFO net adjusted leverage towards 5.0x by 2015 and maintain FFO fixed charge cover above 1.5x due to lower-than-expected growth and/or efficiency-savings in the port division and/or material debt-funded acquisitions or dividends
- Signs of increased competition or greater volatility of earnings in the port and/or rail business.