OREANDA-NEWS. Fitch Ratings has assigned Russia-based X5 Finance LLC's recently issued RUB5bn bonds (4B02-06-36241-R) a senior unsecured rating of 'BB-', a Recovery Rating of 'RR5' and a National senior unsecured rating of 'A+(rus)'. X5 Finance LLC is a fully consolidated non-operating subsidiary of X5 Retail Group N.V. (X5).

Similar to four other bonds issued by X5 Finance LLC, which Fitch also rates 'BB-', the new bond only features a suretyship from the holding company, X5. Therefore, Fitch considers these bonds structurally subordinated to other senior unsecured obligations of the group, which are represented by bank debt at the level of operating companies and a RUB8bn bond that is covered by suretyship from CJSC Trade House Perekrestok, the major EBITDA-generating entity within the group.

Fitch rates the bond one notch below X5's Long-Term Local Currency 'BB' IDR (Stable Outlook) as prior-ranking debt exceeds 2x (estimated at 2.2x in the 12 months to March 2016) of group EBITDA and we expect the debt mix to remain unchanged over the medium term.

KEY RATING DRIVERS
Below-average Recoveries for Unsecured Bondholders
The bond rating reflects below-average recovery expectations in case of default. We have applied a one-notch discount to the bond rating relative to X5's Long-Term IDR as prior-ranking debt constitutes more than 2x of group EBITDA, thus constituting material subordination and lower recoveries for unsecured creditors under Fitch's criteria 'Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers'.

Leading Multi-Format Retailer in Russia
The rating reflects X5's strong market position as the second-largest food retailer in Russia. The business model is supported by X5's own logistics and distribution systems and multi-format strategy, with a focus on the defensive discounter format. In our view, these factors should enable X5 to retain and improve its market position, despite increasing competition from other large retail chains in the country, as proven in 2015. The ratings also factor in X5's strong bargaining power over suppliers due to the group's large scale and growing geographical presence across Russian regions.

Strong Trading
In 2015 X5 demonstrated strong revenue growth of 28% yoy, supported by an unprecedented number of new store openings and industry-leading LfL sales growth (14% yoy). The latter was driven not only by strong average basket growth but also an increase in footfall. In 1Q16 X5 maintained strong revenue and LfL sales growth of 27% yoy and 8% yoy respectively.

The strong 2015 operating results have led X5 to approve a large payment to its top management under a long-term incentive (LTI) programme; the payment was accrued in 2015 but paid in 2016. Together with exit payment to former CEO and other related expenses these one-off expenses amounted to RUB4.2bn and led to EBITDA margin decreasing to 6.8% in 2015 (2014: 7.2%). However, adjusted for these one-off expenses, EBITDA margin would have been stable at 7.3%, despite accelerated expansion and weaker trading conditions. Our financial forecasts assume no further LTI payments in 2018-2019 due to our conservative revenue and EBITDA projections for these years.

Subdued Consumer Sentiment
As real disposable incomes in Russia continue to decline, we expect consumers to keep trading down in 2016. This would hamper average shopping basket growth and lead to stronger competition among the major retail chains. Therefore, Fitch expects X5's LfL sales growth to decelerate in 2016-2017 but remain strong compared with peers due to the group's ongoing refurbishment programme and repositioning of its supermarket and hypermarket formats.

We also project a decrease in EBITDA margin to 6.5% by 2019 on the back of strong promotional activities and gross margin sacrifices to withstand increased competition and protect footfall rates. Positively, we factor in some support to margins from improvements in logistics and slower increases in selling, general and administrative expenses relative to sales growth.

Weak Coverage Metrics
We expect the funds from operations (FFO) fixed charge coverage ratio to remain weak for the ratings at 1.6x-1.8x over 2016-2019 (2015: 1.8x), as a result of substantial operating lease expenses and a high interest rate environment in Russia. However, this is somewhat mitigated by favourable lease cancellation terms and the partial dependence of leases on store turnover.

Stable Leverage
We expect X5's FFO adjusted gross leverage to peak at 4.9x in 2016 (2015: 4.3x), due to large payment under the LTI programme before returning to around 4.5x in 2017-2019. Deleveraging is constrained by the large capex planned by the group for further expansion of the retail chain, ongoing store refurbishments and investments in logistics. X5's capex remains largely scalable and the group has some flexibility in managing its leverage, due to strong and growing operating cash flows.

KEY ASSUMPTIONS
-Annual revenue growth of around 20%, driven by mid-single digit LfL sales growth and selling space CAGR of 15% over 2016-2019
-EBITDA margin gradually decreasing to 6.5% by 2019
-Capex at around 5%-7% of revenue
-No dividends
-Neutral to negative free cash flow (FCF) margin
-No large-scale M&A activity
-Adequate liquidity

RATING SENSITIVITIES
Negative: Future developments that could lead to negative rating action include:
- A sharp contraction in LfL sales growth relative to close peers.
- EBITDA margin erosion to below 6.5%.
- FFO-adjusted gross leverage above 5.0x on a sustained basis.
- FFO fixed charge cover significantly below 2.0x on a sustained basis if not mitigated by flexibility in managing operating lease expenses.
- Deterioration of liquidity as a result of high capex, worsened working capital turnover and weakened access to local funding as rouble bonds mature in 2016.

Positive: Future developments that could lead to positive rating action include:
- Positive LfL sales growth comparable with close peers, together with maintenance of its leading market position in Russia's food retail sector.
- Ability to maintain the group's EBITDA margin at around 7%.
- FFO-adjusted gross leverage below 3.5x on a sustained basis.
- FFO fixed charge coverage around 2.5x on a sustained basis.

LIQUIDITY
At end-March 2016 X5's cash of RUB4.5bn, together with available undrawn committed credit lines of RUB54.6bn, were not sufficient to fully cover RUB46.1bn short-term debt and expected negative FCF. However, RUB28.1bn of debt was related to tranches under revolving credit facilities, which we expect to be extended upon maturity.

We believe X5 retains firm access to local funding, due to its large scale, non-cyclical food retail operations and strong operating performance. In addition, X5 has flexibility in managing its capex, which is the major reason for expected negative FCF, while the group's operating cash flow generation remains strong.