OREANDA-NEWS. Fitch Ratings has affirmed India-based Adani Ports and Special Economic Zone Limited's (APSEZ) Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'BBB-'. The Outlook is Stable. The agency has also affirmed APSEZ's senior unsecured rating at 'BBB-' and the 'BBB-' rating on its USD650m 3.5% senior unsecured notes due 2020.

APSEZ's headroom under its ratings has shrunk, with slower-than-expected improvements in its financial profile in the financial year ended 31 March 2016 (FY16) due largely to higher capex and an increase in loans and advances (L&A), some to related parties. However, we have affirmed APSEZ's ratings with a Stable Outlook to reflect the company's strengths, operating flexibility and ability to generate strong cash flows. The management has also indicated a strong commitment to address the high capex and L&A, and their commitment to maintaining the ratings. We consider management's commitment in these areas, including not engaging in any aggressive M&A until the financial profile of the company improves to provide greater headroom for its ratings, as key drivers of its credit profile in the next 12 to 18 months.

The ratings continue to benefit from APSEZ's robust business model and strong market position. We expect the group's financial profile to improve over the next two years as the company generates positive free cash flows after M&A under our rating case assumptions, which include a recovery of related-party loans and reduction in its total indebtedness. We expect financial leverage, as measured by net adjusted debt (including off balance-sheet liabilities arising from guarantees) to EBITDA, to improve to around 4.0x in FY18 from 5.6x in FY16.

KEY RATING DRIVERS

Improvement in Financial Profile Delayed: APSEZ's revenue growth slowed in FY16, mainly due to a decline in coal imports by India, which we think is a structural adjustment given the country's increasing self-sufficiency in the commodity. However, the group's operational profit in FY16 was broadly in line with our expectations, driven by a higher proportion of high-margin cargo and cost-control initiatives. However, APSEZ incurred higher-than-expected capex in the financial year and its L&A rose sharply, resulting in the company's credit metrics being weaker than Fitch's earlier expectations.

Financial Discipline Key to Ratings: Fitch continues to see APSEZ as being well-positioned to benefit from India's growth and related cargo opportunities. The company, unlike some other rated peers in the region, has significantly better flexibility in infrastructure renewal and expansion capex, which gives it the ability to generate strong free cash flows. The main risk to its rating is the management's commitment to contain outflows in terms of advances, capex and M&A. We affirmed the ratings with a Stable Outlook based on management commitment to reduce related-party loans and maintain its ratings. Failure to sufficiently reduce advances and maintain investment discipline over the next six to 12 months may lead to a negative rating action.

Robust Business Model: APSEZ operates 10 ports across the Indian coast line. Its largest port, Mundra, accounted for around 64% of revenue and 70% of profit in FY16, and is the largest port in India by cargo volumes handled. The top 10 customers accounted for about 50% of cargo volumes in FY16, most of which is sticky in nature, and no single customer accounted for more than 10% of revenue. About 97% of cargo originates or is destined for India, and hence APSEZ is likely to benefit as the Indian economy grows. Cargo volumes are also likely to be resilient because APSEZ's ports have long-term arrangements with customers and industries close by.

Volume Growth to Pick Up: Fitch expects consolidated cargo volumes to increase at a CAGR of 14% over FY16-FY20. This will follow growth of 5% in FY16, which was reined in by the 8% decline in coal volumes as India imported less of the fuel. APSEZ's growth has outperformed the industry's over last decade, helped by its diversified cargo - that ranges from coal to containers. The group's investment plan is focused on increasing cargo volumes and diversification of cargo, especially containers. APSEZ will benefit from commissioning of its fourth terminal at Mundra Port, improved operations at Kattupalli Port, additional contracts for coal at Dahej and Hazira Ports, and increased coastal shipping in India. About 60% of the group's total cargo - including a large share of coal - is contracted or sticky in nature.

Positive Cash Flows, High Capex: Fitch expects APSEZ's free cash flows pre-M&A to revert to positive in FY18 in spite of its large investment plan. Most of the capex is driven by the company's aim to increase containers volume to compensate for lower coal volumes. The group plans to complete acquisition of Kattupalli Port (INR18bn-20bn) in this financial year and develop the first phase of Vizinjham Port (INR29bn) over FY17-FY19. About INR40bn of capex is planned for Dhamra and Hazira Ports over FY17-FY20, out of which about INR22bn over FY19-FY20 is discretionary, according to the management. Given APSEZ's track record of planning, implementation and growth, Fitch does not expect any significant execution risk in the investment plan. Fitch has not factored in any other acquisitions into its ratings.

Related-Party Loans to Recover Gradually: APSEZ's total loans increased to INR45bn in FY16 from INR35bn in FY15, with loans extended to related parties rising to INR25bn from INR22bn. The management expects to unwind about INR30bn of related-party loans, and deposits, over the next two years. In FY17, most of the reversals will be from advances to Mundra Solar Techno Park Ltd and other related parties, along with fixed-income instruments, in our view.

Credit Profile Can Improve: Fitch expects the company to deleverage as cargo volume growth and income from its Special Economic Zone (SEZ) drives cash generation, and L&A are recovered. The EBITDA-based net leverage is likely to fall to less than 4.0x in FY18 from 5.6x in FY16. However, APSEZ's leverage metrics will remain above what is comfortable for the ratings in FY17 given the group's significant capex and payment for its acquisition of Kattupalli Port.

KEY ASSUMPTIONS

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

- Volume CAGR of about 14% over next four years

- Receipt of SEZ income from Container Terminal IV, Container Terminal III extension and LNG Terminal in FY17 and thereafter

- EBITDA margin to remain at around 64%

- Capex of around INR121bn over FY17-FY20

- No M&A other than Kattupalli Port

- Gradual recovery of loans and advances

RATING SENSITIVITIES

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

- Lack of a commitment to address loans and advances and/or aggressive capex or M&A

- Failure to achieve substantial positive free cash flow after M&A, at least until the company's credit metrics improve to a very comfortable level for its ratings

- Significantly weaker-than-expected operating performance

- Inability to improve financial leverage (net adjusted debt/EBITDA) to below 4.0x and/or EBITDA interest cover above 4.5x on sustained basis from FY18

No positive rating action is expected over the medium term, as the ratings factor in the expected improvement in the company's financial profile.