OREANDA-NEWS. Fitch Ratings has affirmed South African state-owned defence company Denel (SOC) Limited's (Denel) National Long-term rating at 'AAA(zaf)' and Short-term National Rating at 'F1+(zaf)'. The Outlook is Stable.

The affirmation reflects Denel's strong legal, operational and strategic links with the state and in particular the irrevocable and unconditional guarantee of ZAR1.85bn of DMTN debt. The alignment of Denel's rating with the sovereign reflects the expectation of timely support being provided by the state to service and repay Denel's debts if required. In FY14 Denel continued to deliver improved performance exhibiting continuing successful execution of its turnaround strategy.

The affirmation also considers the potential impact on Denel from the acquisition of BAE Land Systems South Africa (LSSA) from BAE Systems as well as the proposed funding structure and anticipated shareholder support.

KEY RATING DRIVERS
Strong Links with the State
Denel's rating remains underpinned by the full state ownership and support it maintains from the state. Notably this includes the explicit shareholder support it receives both in the form of capital injections and guarantees for the group's debt funding (the state has guaranteed issuance under Denel's ZAR2.2bn DMTN programme of up to ZAR1.85bn). Fitch also continues to view the financial support by the government as critical to Denel's liquidity needs in order for the group to execute its contracts under its order book.

Improved Performance
Denel delivered an improved performance in FY14 with revenues increasing 17.1% for ZAR4.6bn, which exceeded our expectations. Notably the group delivered a positive operating profit for FY14 with operating profit before interest and tax of ZAR20m (FY13: loss before interest and tax of ZAR114m) with the group benefiting from increased export sales, reduced operating costs and a weaker operating currency. (Fitch's calculation of EBIT differs from Denel's reported EBIT of ZAR224m as we exclude other income of ZAR204m disclosed on Denel's income statement from reported EBIT).

Non-investment Grade Standalone Credit Rating
Denel continues to improve performance and implement its long-term turnaround strategy effectively, with the increasing profitability and export orders exhibiting the progress achieved. However, we believe that Denel's standalone credit profile remains below investment grade with low levels of profitability, weak cash flow generation and high leverage metrics. The limited number of manufacturing platforms and low level of self-funded research continue to negatively impact Denel's operating profile and our view of the group's standalone credit profile.

Improved Order Book, Solid Outlook
In FY14 the group delivered a multi-year order book in excess of ZAR32bn, providing the highest order cover since inception of the company, which includes traditional annuity business as well as recently concluded orders (the local Hoefyster production contract, the turret contract for a Southeast Asian client, A400M work packages and the Al-Tariq standoff weapons contract). Denel's future performance is supported by a significant targeted order pipeline with up to ZAR20bn at advanced stages of being converted to orders, which is expected to support management's projections.

Diversification of Revenues
In FY14 the group further diversified its revenue generating capabilities with export orders growing by 28% and export revenue now comprising 50% of Denel's total revenue. Denel should be somewhat shielded from the subdued global defence market as much of the group's current and targeted orders are focused on Africa and emerging markets, with defence budgets that are likely to be less constrained that developed economies. Additionally, the group is looking to make headway in generating non-defence revenues and is working with the South African government to identify opportunities to participate in the National Industrial Participation work packages.

RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to negative rating action include:
- Withdrawal of government support. If the government infers or explicitly indicates that it is no longer committed to Denel's long-term turnaround strategy and failure to assist the company to operate as a going concern. More specifically, this would also include a reduction in the portion of Denel's debt guaranteed by the state or any indication that this guarantee may not be renewed at expiry.
- Any weakening in financial support, which would lead to Fitch assessing Denel on a standalone basis.