OREANDA-NEWS. Fitch Ratings has downgraded Anton Oilfield Services Group's (Anton) Long-Term Issuer Default Rating and senior unsecured rating to 'B+' with a Recovery Rating of RR4 from 'BB-'. The Outlook remains Negative.

The downgrade reflects Anton's tightening liquidity, which stems from a rise in short-term debt to fund working capital needs, growth in operating expenses despite revenue contraction, and continuing high capex for 2015, amid challenging market conditions. Anton's business mix has also tilted towards overseas markets, especially Iraq, which elevates the company's business risk.

The Negative Outlook captures uncertainties over the company's ability to aggressively cut costs and to continue to secure new orders at reasonable margins. The company also has considerable refinancing requirements over the next 18 months.

KEY RATING DRIVERS

Cost Efficiencies Yet to Materialise: Anton has taken steps to improve cost efficiency, including via staff cuts, since the market downturn in 2H14, but the impact of these measures has yet to materialise. The ratio of selling, general and administrative (SG&A) expenses to revenue rose to 26% in 2014, compared with 19% in 2013. In particular, staff expenses increased 30% in 2H14 from 1H14, despite a decline in revenue over the same period. Anton would need very aggressive cost cuts to revert to a bottom line profit in 2015, because its revenue generation is not likely to improve markedly.

Challenging Industry Conditions: The rapid decline of oil prices has resulted in project cancellation or shrinkage in 2H14. Fitch does not expect the situation to improve significantly in 2015 given the capex cuts announced by many oil majors, including those of China, which is Anton's core market. In addition, in China, independent service providers are now at a disadvantage compared to the in-house service arms of the state-owned enterprises. While Anton was able to secure new orders, most of these are at margins thinner than historical levels.

Increasing Overseas Exposure: Anton has turned to markets overseas to offset the impact of the sluggish domestic market. The company has expanded its business in Iraq, which accounted for 24% of total revenue in 2014, up from 16% a year earlier. Although Anton's geographical diversity is enhanced, geopolitical risk is higher in Iraq, and Anton faces stiff competition in overseas markets.

Persistent Negative Free Cash Flow: Anton plans capex of about CNY400m in 2015, higher than Fitch's previous expectation. There appears to be little flexibility, as a large share of this capex relates to payments for equipment orders made in 2014, according to Anton's management. As a result, a considerable free cash flow deficit will persist in 2015, and the net debt position is not likely to improve. Fitch expects the company's net debt to remain at around CNY1.9bn-2.2bn at end-2015, compared with CNY1.9bn at end-2014.

Substantial Refinancing Requirement: At end-2014, Anton had CNY993.45m of debt maturing within a year, compared with CNY395.9m at end-2013. There was a 75% rise in short-term debt (excluding current maturities of long-term bonds) to fund working capital at a time when the working capital conversion cycle was lengthy. The company will face refinancing pressure again in 2016, when another CNY200m of domestic bonds mature in August.

However, management says the company has already managed to refinance CNY200m of working capital loans since the start of 2015; and the company is due to complete another refinancing arrangement for CNY300m of domestic bonds maturing in May 2015. The company also has some financial flexibility. At end-2014, Anton had unrestricted cash of CNY759.8m and undrawn credit facilities of CNY526.3m. Most of its assets are largely unencumbered, apart from accounts receivable of CNY346.64m (which account for 25% of third-party trade receivables) being secured under a receivable financing facility of CNY320m.

Tight Rating Headroom: Anton's considerable refinancing needs and its expected free cash flow deficit limit its rating headroom. Fitch estimates Anton's FFO net leverage at over 6x and FFO fixed charge cover at below 2x for 2015, aggressive for its 'B+' rating given its weakened business risk profile and liquidity needs.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for the issuer include:
- Revenue and gross margin in 2015 to remain steady compared with 2014, a marginal improvement expected thereafter
- Working capital cycle to marginally improve
- Capex of CNY400m in 2015

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to a downgrade include:
- An inability to improve profitability so that EBITA/revenue is to lose to 20%- FFO-adjusted net leverage of over 5x or FFO fixed charge cover of less than 2.5x on a sustained basis
- A continued shrinkage in order backlog and weakening of market position in China and/ or a rise in operational risks as a result of overseas expansion
- A further deterioration in working capital conversion cycle
- Substantial outlays for capex in periods of weak operating cash flow generation
- A further weakening of liquidity

Positive: Future developments that may, individually or collectively, lead to the Outlook being revised to Stable include:
- FFO-adjusted net leverage below 5x or fixed charge cover above 2.5x on a sustained basis
- Recovery in profitability with EBITDA margin improving to around 20% on a sustained basis
- A continued increase in order backlog but without increasing its overall risk profile
- Comfortable liquidity position