OREANDA-NEWS. Fitch Ratings has affirmed China Oriental Group Company Limited's (COG) Long-Term Foreign-Currency Issuer Default Rating (IDR) and senior unsecured rating at 'BB-'. The Outlook is Stable.

COG's ratings reflect the weakness in the Chinese steel industry, which Fitch believes will persist in the near term, mitigated by the company's leading position in H-section steel production, its demonstrated financial flexibility and sufficient liquidity.

In addition, Fitch does not consider COG's offer on 9 February 2015 to repurchase its notes due 2015 and 2017 as a distressed debt exchange (DDE). We believe that COG's offer is not an attempt to avoid a payment default as the company has sufficient resources to meet its debt obligations.

KEY RATING DRIVERS
Weak Industry Constrains Ratings: Excess capacity and volatile raw material costs have kept profit margins thin since 2011. However, plans by steel producers to trim capex and lower raw material costs as a result of a significant increase in iron ore supply may allow a sustained earnings recovery by 2016. COG remains profitable despite the downturn in the Chinese steel sector, with an EBITDA margin of 6.2% in 1H14, up from 4.0% in 2013.

Limited Business Profile Improvement: COG has not materially strengthened its product offerings since 2010, when it raised USD850m via two bond issues. The company added rebar products to its offerings in 2011 and it started making steel sheet pile products in 2014. Although sheet pile is a high-value-added product, it is unlikely to become a major earnings contributor immediately while COG builds its track record in this new product. The sustained weakness of the Chinese steel market has limited COG's options in pursuing further steel product diversification, and has forced the company to adopt a defensive posture towards further investments in steel operation.

Product Leadership Supports Ratings: COG's ratings remain supported by its leadership in H-section steel production. H-section steel remains one of the most profitable steel products, accounting for 35% of COG's gross profit (and 41% of its steel gross profit) in 1H14It also consistently generates a higher per-tonne gross profit (CNY159 in 1H14, CNY152 in 2013) than the company average (CNY127 in 1H14, CNY100 in 2013).

Demonstrated Financial Flexibility: Fitch believes COG has the flexibility to improve its financial profile through improvements in working capital management. In 2013, COG reduced its net debt by over CNY800m, mostly through working capital reduction. Prior to this, COG's negative free cash flow (FCF) was driven by its strategy of increasing working capital to defend its operating margins. At end-June 2014, COG had notes receivables of CNY4.3bn, part of which can be liquidated to meet debt repayment.

Continuous Support from ArcelorMittal: The company's ratings are also supported by ArcelorMittal S.A. (BB+/Stable). Fitch expects ArcelorMittal to remain committed to the Chinese steel market, with China Oriental as one of its key integrated steel manufacturing investments in China. The ongoing dispute between ArcelorMittal and COG's chairman, Mr. Jingyuan Han, over shareholding arrangements does not appear to have affected the operations of the company.

Tender Offer Not DDE: As noted in Fitch's DDE criteria, even if a tender imposes a material reduction in terms compared with original contractual terms, it would not be considered a DDE unless it is conducted in order avoid bankruptcy, similar insolvency or intervention proceedings or a traditional payment default.

We believe the tender materially reduces the original contractual terms. The company is offering existing holders of the outstanding notes a fixed price of USD950 cash per USD1,000 principle of the 2015 notes, and a fixed price of USD840 cash per USD1,000 principle of the 2017 notes, if holders tender before 23 February 2015. The offer will fall to USD860 cash for the 2015 notes and USD780 cash for the 2017 notes if holders tender after 23 February 2015 and before 9 March 2015. The tender also includes a consent solicitation to eliminate substantially all of the restrictive covenants in the indentures.

The company intends to finance the repurchase (approximately CNY3.9bn if all outstanding notes are tendered on and before the earlier tender date) through a combination of cash on hand (CNY999m as of 30 June 2014), partial conversion of notes receivables (CNY4.3bn as of 30 June 2014) and drawdown of credit facilities (conditional upon final drawdown approval by the relevant banks).

Following the completion of the tender offer, Fitch may downgrade the ratings on the outstanding notes, if any, if the level of onshore debt increases to a level that materially lowers offshore creditors' recovery prospects.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Slow recovery of Chinese steel sector
- High metal spread (as defined in gross profit per tonne of metal) for H-section sustained given limited producers in the market
- Iron ore prices remain low for the near term and in line with Fitch assumptions (USD65/75/80 per tonne for China import iron ore fines 62% CFR for 2014/2015/2016, respectively)
- Capex between CNY500m and CNY700m per annum

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- FFO adjusted net leverage sustained above 2.5x (5.4x in 2013 and estimated to be over 4.0x in 2014)
- Sustained negative free cash flow

Positive: Future developments that may, individually or collectively, lead to the positive rating action include:
- FFO adjusted net leverage falling below 1.5x on a sustained basis