Fitch Affirms UCL Rail and Freight One at 'BB+'; Outlook Negative
The Negative Outlook reflects continuing weak market fundamentals pressuring freight volumes and rates, which result in weaker cash flows, slower debt reduction and higher-than-expected leverage. We expect the companies' credit ratios to remain in breach of our negative rating guidelines in 2015, but to improve to the levels commensurate with the current rating in 2016. The rating would be downgraded if the company fails to demonstrate sustained de-leveraging to below our negative rating guideline of 2.5x by end-1H16.
The ratings reflect UCLR's position as the leading rolling stock owner and operator in Russia's rail freight market. A sizeable asset base provides UCLR with a strong ability to meet customer demand and a diversified fleet and customer base. However, UCLR's business is exposed to volatile economic drivers affecting both transported volumes and freight rates.
Freight One's ratings equalised with those of UCLR, reflecting its role as the sole contributor of the group's revenues and earnings after its reorganisation.
KEY RATING DRIVERS
Credit Metrics Remain Under Pressure
We expect the company to again exceed our negative rating guidance of 2.5x for funds from operations (FFO) adjusted net leverage at end-2015, due to weak market conditions resulting in a decrease in revenue and cash flow generation. This metric increased sharply to 3.27x at end-2014 from 2.76x a year ago. In December 2014 - January 2015 the company converted a shareholder's loan of RUB16bn into equity that should slightly improve leverage metrics. Although we expect FFO adjusted net leverage to remain above 2.5x at end-2015 we forecast it to decrease below this level at end-2016 on the back of modest capex, zero dividends and cost-cutting initiatives, which would help the company to reduce its debt burden and improve leverage.
Weak Market Conditions
The Russian rail cargo transportation market remains under pressure from a contracting domestic economy. UCLR's freight rates have been stagnating for the most part of 2015, with some improvement seen only in 3Q15 according to management. Expected low rail volume growth, coupled with overcapacity in the rolling stock market, will continue to pressure tariffs, at least in the short-to medium-term. Therefore UCLR's ability to rationalise its cost base will be a critical factor in supporting margins and FFO levels.
Weaker Margin but FCF Positive
In 1H15 UCLR reported an EBITDA margin of 26%, down from 30% in 1H14. We forecast it to remain at this level on average over 2015-2017. However, we expect UCLR to continue generating positive free cash flow (FCF), fuelled by moderate capex expectations, a conservative financial strategy and zero-dividend policy as long as net debt/EBITDA exceeds 2x.
Strong Competitive Position
UCLR is the leading nationwide commercial rolling-stock operator in Russia by fleet size (estimated at 16% of the market). The company has a diversified fleet and customer base, which along with a broad network of regional branches, secures its competitive advantage and efficiency over smaller market players.
Diversified Customers, Services Contracts Focused
UCLR has a diversified customer base with the seven-largest customers representing about half of total revenue in 9M15. To increase the visibility of cash flows freight transportation companies, including UCLR/Freight One, have entered into medium-to long-term service agreements with their key customers. UCLR currently operates under medium-to long-term service agreements with OJSC Novolipetsk Steel (NLMK, BBB-/Stable), OAO Severstal (BB+/Positive), RN Trans, RUSAL and Eurotsement and is responsible for transporting 25%-100% of their freight cargo.
The medium- to long-term contracts with major customers covered 49% of UCLRs revenue in 1H15. The agreements' tenor ranges from two to seven years. However, UCLR remains exposed to volume risk as some contracts fix only the percentage of the customers' cargo volumes, but not actual volumes.
Interest Fluctuations; Limited FX Exposure
UCLR has limited exposure to foreign currency risks as only 6% of total debt as of 30 October 2015 is denominated in US dollars. But rouble depreciation has had a negative impact through interest rate fluctuations, as floating-rate debt (of which some are linked to Mosprime that spiked to about 29% at end-2014-1Q15) accounted for about 70% of total debt in October 2014. In September-November 2015 the company refinanced some debt, reducing the share of floating-rate debt to 27% of total outstanding debt. The company anticipates reducing the share of floating-rate debt further.
Reorganisation Complete
UCL Rail has completed the reorganisation of Freight One, after it renamed NTK as Freight One and consolidated all other cargo rail operating subsidiaries under Freight One. This was to optimise the group structure, which should lead to cost reduction. The operational profiles of both UCLR and Freight One are unaffected by the reorganisation, in our view.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for the issuers include:
- Domestic GDP decline of 4% in 2015 and 0.5%-1.5% growth over 2016-2018
- Inflation to grow at 15.5% in 2015 and 5.5%-9% over 2016-2018
- Freight prices to grow lower than inflation rate
- Capex as per company's guidance
- Rail fleet under operations in line with management expectations, with a 15% haircut on the expected sale of rail fleet
- Expected implementation of cost-cutting measures resulting in 5% increase of total costs on average over 2016-2018
RATING SENSITIVITIES
Positive: Future developments that could lead to a revision of the Outlook to Stable include:
-FFO adjusted net leverage falling below 2.5x and FFO interest cover above 3x on a sustained basis
-Sustainable improvement in rolling stock market conditions leading to stronger operating cash flows and positive FCF assuming through-the-cycle capex
Negative: Future developments that could lead to a downgrade include:
-FFO adjusted net leverage above 2.5x and FFO interest coverage below 3x on a sustained basis, due to weak industrial activity in Russia and weaker-than-expected operating results, larger capex or dividend payments or failure to execute asset disposals as planned. Failure to demonstrate leverage reduction below our negative rating guideline by end-1H16 would also lead to the rating downgrade.
-Unfavourable changes to the Russian legislative framework for the railway transportation industry
LIQUIDITY
At end-1H15 UCLR's cash and cash equivalent stood at RUB9bn, together with unused credit facilities of RUB40.5bn mainly from VTB Bank, PromsvyazBank and Alfabank at 30 October 2015. This, together with expected positive FCF are sufficient to cover short-term maturities of RUB15bn. UCLR does not pay commitment fees for unused credit facilities, which is common for Russian companies.
In September-November 2015 the majority of outstanding short-term debt was refinanced with local senior unsecured bonds of RUB25bn issued by Freight One. As of 5 November 2015 Freight One's outstanding debt amounted to RUB68.8bn, comprising finance lease and leaseback loans (46% of total outstanding debt), local bonds (36%) and bank debt (18%).
Bank debt was secured on rolling stock (RUB4.4bn) and Freight One's shares pledge (RUB8bn). Rail fleet with a balance value of RUB53bn at 30 October 2015 out of RUB122bn is secured under bank loans and finance lease agreements. Although the majority of Freight One's outstanding debt is formally secured only a moderate part of total rail fleet is encumbered, leaving significant asset value for senior unsecured creditors. Therefore the RUB25bn local bonds have a senior unsecured rating at the same level as the company's IDR.
FULL LIST OF RATING ACTIONS
UCLR
Long-term foreign currency IDR affirmed at 'BB+'; Outlook Negative
Short-term foreign currency IDR affirmed at 'B'
Foreign currency senior unsecured rating affirmed at 'BB+'
Long-term local currency IDR affirmed at 'BB+'; Outlook Negative
Short-term local currency IDR affirmed at 'B'
Local currency senior unsecured rating affirmed at 'BB+'
National Long-term rating affirmed at 'AA(rus)', Outlook Negative
Freight One
Long-term foreign currency IDR affirmed at 'BB+', Outlook Negative
Short-term foreign currency IDR affirmed at 'B'
Foreign currency senior unsecured rating affirmed at 'BB+'
Long-term local currency IDR affirmed at 'BB+', Outlook Negative
Short-term local currency IDR affirmed at 'B'
National Long-term rating affirmed at 'AA(rus)', Outlook Negative
RUB25bn bonds assigned local currency senior unsecured rating at 'BB+'.
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