OREANDA-NEWS. Fitch Ratings has upgraded Steinhoff International Holdings Limited's (Steinhoff) Long-term National Rating to 'A+(zaf)' from 'A-(zaf)' and its Short-term National Rating to 'F1(zaf)' from 'F2(zaf)'. The Outlook is Stable.

At the same time Fitch is withdrawing the senior unsecured debt ratings of Steinhoff Services (Pty) Limited which are currently rated at 'A-(zaf)' as Steinhoff has chosen to stop participating in the rating process. Therefore, Fitch will no longer have sufficient information to maintain the ratings of this entity. Accordingly, Fitch will no longer provide ratings for Steinhoff Services (Pty) Limited (now named Steinhoff Services Limited).

The upgrade reflects the successful completion of the Pepkor acquisition, Steinhoff's strengthened balance sheet resulting from a recent rights issue and solid trading performance for the financial year to 30 June 2015, delivering an improved credit profile despite challenging trading conditions in certain core markets.

Fitch expects Steinhoff to maintain steady or marginally improving through-the-cycle credit metrics, benefitting from both product and geographic diversification. Its large exposure to Europe and developed Asia, representing approximately 60% of revenues, helps insulate the group from potential weakness in consumption in its core South African market. This is further mitigated by its track record of resilient sales growth and profit margins as an integrated discount retailer.

KEY RATING DRIVERS
Strengthened Balance Sheet
The upgrade reflects a significantly enhanced balance sheet, following the rights issue completed in July and August 2014 and which raised ZAR17.8bn (net proceeds). This, together with a strong free cash flow (FCF) generation in FY15, helped comfortably finance the cash component of the Pepkor acquisition completed earlier this year. While we cannot rule out other acquisitions, we expect any further expansion will be bolt-on in scale and/or funded by existing cash and liquidity resources.

Solid Trading Performance
Despite low growth environments across all of the group's segments, Steinhoff delivered a 15% increase in revenues (continuing operations), which partially reflected the completed Pepkor acquisition (included for three months) as well as favourable FX movements (EUR/ZAF). We expect organic growth rates to remain in mid single-digits in its core household goods division, benefitting from European expansion and investment in the store network, which compares with a 7% growth for household goods revenue (excluding acquisitions) in FY15.

While the group's operating profitability margin increased in FY15, the full-year impact of the Pepkor acquisition will only be realised in FY16, which could result in some risk of margin pressure due to Pepkor's inherent lower margin relative to Steinhoff's other activities.

Pepkor Acquisition
The group has now finalised the acquisition of Pepkor and results were included for three months of FY15. This moves Steinhoff into new product categories but further entrenches the group's key discounted retailing strategy, which is expected to be resilient through economic cycles. The addition of Pepkor rebalances the group's geographic exposure with continental Europe declining to 50% from nearly two-thirds, while both Southern Africa and Pacific Rim increase their proportion.

Enhanced Scale and Vertical Integration
Steinhoff's discount retail strategy is supported by a vertically integrated business model and the increasing scale of the group, which provides operational flexibility to its mass discount strategy. This has historically been seen to strongly drive the European business over the past few years as consumer are increasingly value-conscious, and has potential to drive future demand in southern Africa as deteriorating macro conditions impact consumers. The manufacturing and sourcing units, which are increasingly integrated with the enlarged group, will be important for the discount retailer's margin progression.

Acquisitions and Leverage
Fitch views the group as having an acquisitive growth strategy; however, the ratings reflect the group's financial flexibility to pursue acquisitions without incurring significant leverage. While the group has a history of successfully undertaking and integrating acquisitions, any large scale debt-funded transactions that would materially impact gross debt may pressure the ratings. This is, however, considered event risk.

Frankfurt Listing
On 7 December 2015 the group completed its primary listing on the Frankfurt Stock Exchange with a market capitalisation of EUR19bn but will continue to have a secondary listing on the Johannesburg Stock Exchange. Although the latest listing does not entail any cash proceeds to the group, Fitch believes the international listing will improve financial flexibility by widening its access to global capital markets, which would support the group's international operations and growth opportunities.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Steinhoff include:
- Mid single-digit revenue growth for household goods;
- Low single-digit increase in revenue growth for general merchandise due to exposure to the southern Africa market with full year impact from Pepkor acquisition included from FY16;
- Mid single-digit revenue increase for automotive given sound historical performance despite market pressures;
- Fairly stable margins for household goods and automotive while a decline in margins for the overall group is expected from FY16 with the inclusion of lower-margin Pepkor and market pressures.
- Increase in capex intensity
- Maintenance of dividend payout ratio

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- A conservative financial policy, including future dividends and M&A, allowing for deleveraging with FFO adjusted net leverage below 2.5x (FY15: 2.7x) on a sustained basis
- FFO fixed charge cover sustained at or above 4.5x (FY15: 4x)
- Continued geographic diversification delivering stable or improving FFO margins (currently 12.3%).

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Further acquisitions potentially increasing the business risk profile and debt levels with an increase in FFO adjusted net leverage above 3.5x.
- Weak free cash flow on the back of higher capex or weaker cash generated from operations (impacted by poor business performance and/or evidence of eroding market share in key segments or countries).
- Significant equity distributions above the current expected dividend payout ratio.

LIQUIDITY
At 30 June 2015 Steinhoff has unrestricted cash balances of ZAR34.9bn (as defined by Fitch excluding ZAR3bn assumed for any intra-year working capital requirements) and unutilised bank facilities of ZAR29.3bn against maturing debt of ZAR7.7bn by June 2016. The strong liquidity position is further supported by our expectation of ZAR9.5bn of free cash flow generation in FY16.