OREANDA-NEWS. Fitch Ratings has affirmed Russia-based Joint Stock Company Federal Passenger Company's (FPC) Long-Term Issuer Default Rating (IDR) at 'BB+' with Negative Outlook.

Fitch has also assigned the company's RUB5bn 10-year local bonds with a put option in 2019 a 'BB+' senior unsecured rating, in line with the company's IDR. A full list of rating actions is available at the end of this commentary.

The ratings reflect strong ties between FPC and sole shareholder state-owned JSC Russian Railways (RZD, BBB-/Negative), and its domestic monopoly in long distance rail. FPC continues to be dependent on subsidies from the government and we expect considerable operational and financial support from both RZD and the Russian Federation (BBB-/Negative) to be made available, if needed, given its social function in providing affordable long-distance rail transportation. The Negative Outlook mirrors that of RZD, which in turn reflects that of the Russian Federation. Rating actions on RZD are likely to be replicated in FPC's ratings, maintaining a one-notch differential.

KEY RATING DRIVERS

One Notch below RZD's IDR

FPC's ratings continue to benefit from strong operational, strategic and, to a lesser extent, legal ties with RZD given the latter's 100% direct ownership, control over FPC's strategy, and inter-dependency of operations. FPC holds a monopoly in long-haul rail transportation and continued to receive sizeable subsidies of RUB25bn in 2015 to compensate for state-regulated below-cost tariffs.

Fitch has not aligned FPC's ratings with that of RZD's owing to the absence of explicit guarantees and also because FPC's revenue is just around the 10% threshold, as stipulated in RZD's Eurobonds documentation, for the company to qualify as a principal subsidiary. At end-2015 FPC's revenue share decreased to 9.1% (10.3% in 2014). Therefore FPC may not always be captured within RZD's cross default provision.

Subsidies to Continue

FPC received subsidies of about RUB25bn on average annually over 2012-2015 to compensate state-regulated below-cost tariffs. Excluding these subsidies, FPC generates negative EBITDA (RUB4bn in 2015) and is economically unviable on a standalone basis. FPC's unregulated business is not sufficiently profitable or cash-generative to offset losses generated by its regulated business.

We expect EBITDA to remain under pressure from declining passenger volumes as well as continued pricing and inflationary cost pressures. Fitch expects management to optimise revenues and to cut costs through increased staff productivity and asset efficiency, but these alone are unlikely to enable FPC to become financially self-sufficient. We expect FPC to receive subsidies of about RUB21bn annually on average over 2016-2019. Fitch assesses FPC's standalone rating in the 'B' category.

2016 Additional Tariff Increase

In January 2016 the government approved a 4% increase to FPC's regulated passenger transportation tariff. The government in March 2016 also revised FPC's value added tax (VAT) on passenger transportation to 10% from 18%, indirectly increasing FPC's tariff by an additional 7% without affecting ultimate passenger fares.

FPC estimates that the lower VAT would generate additional revenue of RUB6bn in the regulated business, partially offsetting lower approved subsidies for 2016 of RUB20.2bn (RUB24.7bn in 2015) and an expected decline in passenger transportation volumes. FPC also estimates additional revenue of RUB4bn in the deregulated business as a result of the VAT revision.

Volumes Pressure Remains

A contracting Russian economy, the population's declining purchasing power, as well increasing competition from airlines continue to weigh on railway passenger transportation volumes. In 2015 FPC reported a 9% yoy decline in railway passenger turnover. This was attributed to a 15% decline in the deregulated business, followed by a 30% decrease in international passenger volume. While the regulated business saw only a 3% yoy decline in passenger volume, it accounted for about 66% of total FPC's railway passenger turnover and 47% of total revenue. We expect railway transportation volumes to decline further over 2016-2017, albeit at a slower pace, before starting to improve in 2018.

Capex Drives Negative FCF

We expect FPC to continue generating healthy cash flow from operations of about RUB15bn on average over 2016-2019. However, free cash flow (FCF) is likely to be negative over the same period, due to the company's ambitious investment plans of about RUB21bn annually on average over 2016-2019 and our assumptions of increasing dividends.

We expect the company to rely on new borrowings to fund the expected cash shortfalls. Therefore, we expect FPC's net debt/EBITDA to gradually increase to about 1.4x by 2018 from 0.2x in 2015. However, this would still be below the covenant of net debt/EBITDA of 2.5x. We do not expect FPC to scale back its capex plans, given the company's rather old assets.

No FX risks

FPC is not exposed to FX fluctuations as only a negligible share of opex and capex is denominated in foreign currencies. The share of cash in foreign currencies is also negligible. FPC has no interest rate risk as its only loan raised under floating interest rate (18% of total debt at end-2015) was repaid in full in June 2016.

Increasing Airline Competition

The share of airline in long-haul passenger traffic continued to increase and accounted for 48% of total long-haul passenger turnover in 2015, up from about 33% in 2010. While air travel is likely to be a growing threat, FPC should remain the main carrier of long-haul passengers over the medium-term as Russia does not currently have adequate airport infrastructure to accommodate increasing demand.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

- Domestic GDP decline of 0.7% in 2016 and growth of 1.3%-2% per year in 2017-2019;

- Inflation of 8.2% in 2016 and 5%-7.1% per year over 2017-2019;

- Passenger turnover to decline by 1%-3% per year over 2016-2017, before some improvement in 2018;

- Tariff growth of about 10% in the regulated business and 5% in the deregulated business in 2016 and slightly below CPI across all segments thereafter;

- Costs mainly in line with CPI;

- Capital expenditure and subsidies in line with management's expectations.

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

- A downgrade of RZD's ratings, assuming the parent links do not strengthen at the same time.

- Evidence of weakening ties with RZD (and indirectly the state) including but not limited to reduced financial support in the form of insufficient subsidies, tariffs or equity injections such that net debt/EBITDA exceeds 1.5x.

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

- RZD's Outlook being revised to Stable or an upgrade in RZD's ratings, unless FPC's links with RZD weaken.

- Guarantees by RZD of a substantial portion of FPC's debt, which would imply stronger legal ties with RZD.

For the rating of RZD, the following sensitivities were outlined by Fitch in its rating action commentary as of 20 May 2016:

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

- Downgrade of the sovereign rating

- Sustained funds from operations (FFO)-adjusted net leverage above 3.5x and FFO fixed charge coverage below 4x, which may be negative for RZD's ratings, unless further evidence of state support is provided.

Positive: The rating is on Negative Outlook, therefore we do not anticipate a positive rating action in the short term. However, a revision in the sovereign's Outlook may result in a similar action on RZD.

LIQUIDITY

Fitch views FPC's liquidity as adequate as its cash and cash equivalents of RUB11bn at end-2015 would comfortably cover short-term debt of RUB2.8bn and most of the negative FCF expected by Fitch of about RUB9bn in 2016. However, we expect the latter to be largely funded by additional debt rather than by existing cash. FPC has also placed RUB5bn 10-year local bonds with a put option in 2019 for general corporate purposes. Additionally, FPC has unused credit facilities of RUB15bn from major state-owned banks. FPC does not pay commitment fees for these lines, which is common practice in Russia. At end-April 2016, FPC contracted a RUB7bn loan from Sberbank at 12.15%, which is to be repaid within the year.

FULL LIST OF RATING ACTIONS

Long-Term Foreign and Local Currency IDRs affirmed at 'BB+' with Negative Outlook

Short-Term Foreign and Local Currency IDRs affirmed at 'B'

Long-Term National Rating affirmed at 'AA+(rus)' with Stable Outlook

FPC's RUB5bn local senior unsecured bonds assigned 'BB+'