OREANDA-NEWS. Fitch Ratings has assigned O'KEY LLC's upcoming RUB5bn bond (4B02-06-36415-R) under the entity's RUB25bn programme an expected 'B+(EXP)' rating and an expected National Long-term 'A(rus)(EXP)' rating, both with Recovery Ratings of 'RR4'.

The assignment of the final rating is subject to the receipt of final documentation conforming to information already received.

The notes are rated at the same level as O'key Group SA's (O'KEY) Issuer Default Rating (IDR) of 'B+', as they will rank equally with other unsecured debt issued by the Russian retailer. The planned five-year RUB5bn senior unsecured bond is expected to be issued by O'KEY LLC, with a guarantee by the holding company O'KEY and a suretyship of JSC Dorinda, the group entity that owns real estate and long-term lease rights. These notes rank junior to O'KEY's RUB5bn secured debt instruments. Creditors will also benefit from a put option in two and a half years.

The proceeds will be used to refinance part of O'KEY's short-term debt (RUB12bn at end-2015) and finance its capex plans. As a result, the bond issue will not lead to a material increase in gross or net debt.

KEY RATING DRIVERS
Early Signs of Improvement
Since 2H15 O'KEY started to see the first signs of improvement in LFL footfall (up 13.5% in 4Q15 vs. down 5.2% in 2Q15). This improvement was the result of O'KEY adapting its product mix and pricing policy during 2H14 and 1H15 in response to the difficult trading environment in the Russian retail sector. In our view, changes in product mix and price proposition, together with its strong brand and customer loyalty, should help to protect LFL sales in 2016-2017.

Changes in Management
During 2015 the company saw another set of management changes. Heigo Kera was appointed as Chief Executive Officer and Chairman in April 2015, succeeding Tony Maher who had been with O'key since February 2014. In Fitch's view Mr. Kera has strong knowledge of the company and the market as he has been on the Board of Directors of O'KEY since 2010 and was first employed by shareholders in 2000 as a consultant where he was responsible for the group's modern chain concept.

Other appointments included new heads of store formats, supplies, logistics and marketing. Although these individuals come with vast industry experience and have in-depth knowledge of the Russian market, we see execution risks in the company's strategy, which include expanding the discounter format in a challenging trading environment.

Tough Operating Environment
Fitch expects limited improvement in O'KEY's performance due to a tough operating environment in 2016. O'KEY will face more intense competition from major market players, which will translate into pressure on operating margins, especially if Russian consumer spending remains subdued and price-sensitive. Fitch also expects the discounter format will negatively impact group profit margin in 2016 before improving in 2017 once O'KEY achieves some critical mass in this channel.

Stretched Credit Metrics
Despite material reduction in capex in 2015, funds from operations (FFO) adjusted gross leverage remained flat at 4.3x, close to Fitch's 4.5x guideline for negative rating action. This is due to lower EBITDA resulting from the launch of the new format in 2015, which is expected to generate losses in the first two years of operations. Fitch expects O'KEY to deleverage toward 4x by 2018.

In addition, increased rents associated with the discount channel, together with high financing costs due to high interest rates prevailing in Russia, translated into weak FFO fixed charge cover of 1.8x in 2015, albeit still in line with the ratings. We expect the metric to stay below 2x over the next three years.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for O'KEY include:
- Revenue growth to accelerate to 10%-13% pa over 2016-2019, driven by discounter format openings.
- EBITDA margin of 6.3% in 2016 (2015: 6.1%), mostly due to losses incurred by the new discounter format, but also due to pressure from increased competition. Gradual recovery from 2017 onwards to 7%.
- Capex at 3%-4% over 2016-2019, reflecting fewer store openings.
- Neutral free cash flow (FCF margin; 2015:-3%) from 2016 onwards.
- Dividend payout ratio of 25%.
- Adequate liquidity.

RATING SENSITIVITIES
Negative: Future developments that could lead to a negative rating action including but not limited to the Outlook being revised to Negative, are:
- Continued contraction in LFL sales growth relative to peers and failure in executing its expansion plan
- EBITDAR margin erosion to below 9% sustainably (2015: 9%)
- FFO-adjusted gross leverage above 4.5x on a sustained basis;
- FFO fixed charge coverage contracting to below 1.7x on a sustained basis
- Deterioration of liquidity as a result of high capex and weakened financing conditions in the country.

Positive: Future developments that could lead to a positive rating action include:-
- Solid execution of its expansion plan with faster revenue growth from improved LFL sales and accelerated store expansion, while preserving its market position and financial discipline
- Ability to maintain the group's EBITDAR margin of above 9.5%
- FFO-adjusted gross leverage below 3.5x on a sustained basis;
- FFO fixed charge coverage around 2.0x on a sustained basis.

LIQUIDITY
Available unrestricted cash totalled RUB8.2bn and undrawn committed credit facilities amounted to RUB6.3bn as of 31 December 2015, which is sufficient to cover RUB12bn of short-term debt maturing in 2016. At end-2015 66% of O'KEY's debt was long-term (RUB23.5bn) and most short-term debt maturities were revolving credit facilities. In addition, O'KEY has a bond programme with a total value of RUB25bn, including six tranches (RUB3bn-5bn) of five-year maturity each. Three tranches have been issued.