OREANDA-NEWS. Fitch Ratings has upgraded Lenta LLC's Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) to 'BB' from 'BB-' and its National Long-term rating to 'AA-(rus)' from 'A+(rus)'. The Outlooks are Stable. A full list of rating actions is below.

The upgrade reflects Lenta's proven execution of its sales growth strategy while maintaining strong profitability so far. We also expect Lenta will be able to further strengthen its market position and enlarge business scale over the medium term, while keeping conservative credit metrics consistent with the assigned ratings. This is based on our assumption that the company will maintain strict financial discipline, rigorous control over costs and deliver positive like-for-like (LfL) sales growth, as it continues to execute its expansion plans. The ratings also take into account Lenta's ability to raise equity to fund store roll-outs and manage its leverage as proven in 2015.

KEY RATING DRIVERS

Improving Market Position

Lenta has a moderate market position, as Russia's fifth-largest food retailer by 2015 sales, and small scale with EBITDAR of RUB31bn in 2015 (or EUR455m), which is considered rather weak for its ratings. However, we take into account our expectation that Lenta's business profile will strengthen in the next three years with EBITDAR increasing towards RUB75bn by 2019. The company has a strong record of more than doubling its size in 2012-2015 and moving from seventh to fifth-largest among Russian food retailers. We assume further growth will be supported by Lenta's robust business model and strong growth opportunities in the Russian food retail market arising from its fragmented nature and substantial proportion of traditional retail relative to modern chains.

Strong Credit Metrics

After the deleveraging achieved in 2015 due to substantial equity proceeds and solid profit growth, we expect Lenta to maintain conservative credit metrics with funds from operations (FFO) adjusted gross leverage of 3.2x-3.4x (2015: 3.0x) and FFO fixed charge coverage of around 2.5x (2015: 2.5x) over the medium term. These credit metrics are very comfortable for the upgraded ratings. Our projections assume the company will maintain its conservative and consistent financial policy. We also understand from management that it retains the ability to manage leverage through the timing of its store roll out programme should economic or business conditions become more challenging as well as equity issuance as demonstrated in 2015.

Limited Format Diversification

The ratings are constrained by Lenta's limited diversification outside its core hypermarket format. Fitch expects supermarkets to account for less than 15% of sales by 2019 (2015: 4%), despite Lenta's accelerated expansion in the format. At the same time, Lenta's wide geographic diversification across Russian regions and a continued reduction in reliance on the St. Petersburg market (23% of sales in 1Q16) is positive for the credit profile.

Decreasing but Strong Margins

In 2015 Lenta maintained stable EBITDA margin of 11.2%, above Fitch's prior expectation of 10.6%. We believe this level is unsustainable and project Lenta's EBITDA margin will reduce gradually to 9.2% by 2019 as a result of growing share of leased space in store portfolio and margin sacrifices due to strengthening competition. The expected EBITDA margin will remain strong compared with Russian and European food retail peers.

Subdued Consumer Sentiment

Fitch expects weak consumer spending and decelerating food inflation to constrain average basket growth in 2016. Lenta's 'value-for-money' proposition and insights into consumer needs through its loyalty card program are likely to continue to support the company's LfL sales growth this year, which we assume at low single digits. We expect Lenta's price/value perception, along with its low share of non-food, high priced ticket products in revenues and smaller hypermarket store size in square metres (compared with western European peers) to insulate the group from the continuing weak consumer environment. Given Fitch's expectations of only modest recovery in Russia's economy over 2017-2018, we assume low LfL sales growth rates over the medium term for the whole sector.

Negative Free Cash Flow

Fitch expects Lenta's free cash flow to remain negative at 3%-7% of revenue over 2016-2019 as the company is expanding rapidly. In our view, it does not pressure Lenta's ratings as long as it continues to generate positive LfL sales growth and maintain strong profitability, while executing its store roll-out strategy. We expect Lenta to fund 50%-60% of capex for 2016-2018 with internally generated cash flows, assuming it maintains a negative working capital position, despite our assumption of shorter trade payable days following recent trade law amendments. The ratings are also premised on maintaining adequate access to bank financing and capital markets.

Average Recoveries for Unsecured Bondholders

Lenta's bonds are rated in line with its Long-Term Local Currency IDR of 'BB' as prior-ranking debt, represented by a secured loan, is less than 2x (estimated at 0.2x in 2015) of the group's EBITDA and we expect the debt mix to remain unchanged over the medium term. Therefore, subordination of unsecured creditors is not triggered under Fitch's criteria 'Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers'. The bonds ratings reflect average recovery expectations in case of default.

KEY ASSUMPTIONS

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

- Revenue CAGR above 25% over 2016-2019 driven primarily by increase in selling space, and LfL annual sales growth trending towards 3%

- EBITDA margin gradually decreasing to 9.2%

- Capex at around 10%-15% of revenue

- No external dividends paid by Lenta Ltd funded by Lenta LLC.

- No large-scale debt-funded M&A

- Maintained negative working capital position (stable as percentage of sales)

RATING SENSITIVITIES

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

- A sharp contraction in LfL sales growth relative to close peers along with material failure in executing the company's expansion plan

- EBITDA margin erosion to below 8%

- FFO-adjusted gross leverage above 4.0x on a sustained basis

- FFO fixed charge cover significantly below 2.5x

- Deterioration of liquidity position as a result of high capex, worsened working capital turnover and weakened access to local funding

Positive rating action is unlikely in the coming two years, unless there is a material improvement in Lenta's market position translating into EBITDAR of at least EUR1bn, and subject to:

- Solid execution of the company's expansion plan and good LfL sales growth relative to peers

- Maintaining EBITDA margin at around 9%

- FFO-adjusted gross leverage below 3.0x on a sustained basis

- FFO fixed charge coverage above 2.5x on a sustained basis

LIQUIDITY

As at end-April 2016, Lenta's cash of RUB10.8bn and available undrawn committed credit lines of RUB7.3bn were insufficient to cover expected negative FCF and RUB11.6bn short-term debt. Nevertheless, we believe that the company's liquidity position is supported by its good access to bank loans and capital markets as evidenced by recent refinancing activities. As at end-April Lenta had RUB38bn of undrawn uncommitted credit lines.

FULL LIST OF RATING ACTIONS

Long-Term Foreign Currency IDR upgraded to 'BB' from 'BB-', Stable Outlook

Long-Term Local Currency IDR upgraded to 'BB' from 'BB-', Stable Outlook

National Long-Term rating upgraded to 'AA-(rus)' from 'A+(rus)', Stable Outlook

Senior unsecured rating upgraded to 'BB'/RR4 from 'BB-'/RR4

National senior unsecured rating upgraded to 'AA-(rus)' from 'A+(rus)'