OREANDA-NEWS. S&P Global Ratings said that it was keeping its ratings on Germany-based container liner operator Hapag-Lloyd AG, including the 'B+' long-term corporate credit rating and 'B-' issue rating on the company's senior unsecured notes, on CreditWatch with negative implications pending the close of Hapag-Lloyd's planned takeover of Middle East-based container liner United Arab Shipping Company SAG (UASC).

The recovery rating on the senior secured debt remains at '6', indicating our expectation of negligible recovery of 0%-10% in the event of a default.

The CreditWatch placement reflects our view that because of the significant increase in debt incurred in connection with the takeover of UASC in a contribution-in-kind transaction (which is expected to close by the end of 2016), we would likely lower the corporate credit rating on Hapag-Lloyd to 'B' upon completion of the transaction. Such a downgrade would also reflect our expectation that Hapag-Lloyd will likely see constrained earnings, owing to the continued depressed conditions in container shipping, which prompted our most recent downward revision of freight rate assumptions for 2016 and 2017. We believe this weakness--combined with Hapag-Lloyd's takeover of UASC, which involves Hapag-Lloyd's assumption of UASC's debt on balance sheet of about US$4 billion--will likely result in the combined entity's credit measures falling short of the levels we consider commensurate with our current 'B+' rating on Hapag-Lloyd. This includes a ratio of S&P Global Ratings' adjusted funds from operations (FFO) to debt of more than 12%.

According to our base case, we forecast a pro-forma adjusted FFO to debt of about 9% for the combined entity. We furthermore believe that the pace and magnitude of a rebound in Hapag-Lloyd's credit measures after the transaction would remain uncertain and vulnerable to weak industry prospects, owing to structural containership overcapacity and sluggish expansion of global trade. This would likely prompt our reassessment of Hapag-Lloyd's financial risk profile to highly leveraged from aggressive, and the subsequent revision of our anchor for the company to 'b' from 'b+'. Our current rating incorporates our view that Hapag-Lloyd has only moderate financial flexibility for an increase in financial leverage at the 'B+' rating level, despite the improved credit measures in 2015 (including our adjusted FFO to debt of about 19%), which we expected to come under pressure in 2016, amid very difficult industry conditions.

Our current assessment of Hapag-Lloyd's business risk profile as weak would remain unchanged following the potential takeover of UASC. We recognize prospective improvements to the company's competitive advantage and diversity--for example access to a fairly young, but comparatively small fleet of large containerships of UASC--from the takeover and Hapag-Lloyd's demonstrated capability to integrate new businesses and extract synergies.

Nevertheless, given the scope of UASC's operations--with a carrying capacity of 0.6 million twenty-foot equivalent units (TEU), compared with Hapag-Lloyd's current capacity of about 1.0 million TEU--we would be unlikely to consider this sufficiently material overall to revise our view of the business risk profile upward, as it remains constrained by the shipping industry's high risk and fragmentation, and Hapag-Lloyd's vulnerable profitability. This stems from Hapag-Lloyd's operating margins and returns on capital, which are tied to the industry's cyclical swings, heavy exposure to fluctuations in bunker fuel prices, and fairly low short-term flexibility to adjust its operating cost base.

These weaknesses are partly mitigated by Hapag-Lloyd's leading market positions and coverage through a broad and strategically located route network, broad customer base, and attractive (large and fairly diverse) fleet. Our business risk profile assessment incorporates the company's track record of achieving operational efficiencies and its proactive efforts to steadily reduce its cost base, which we consider as a critical support to earnings. We furthermore would not expect management to experience any major difficulties in integrating UASC and realizing its synergy target of at least US$400 million by 2018-2019.

We aim to resolve the CreditWatch placement after the necessary approvals are obtained and transaction is completed, which is expected by the end of 2016. Unless Hapag-Lloyd performs operationally significantly better than our base case in the meantime, for example thanks to higher freight rates than we forecast, we would expect to lower the rating by one notch to 'B' upon completion of the transaction because we believe that the takeover would dilute Hapag-Lloyd's financial leverage beyond the rating-commensurate level, weakening its adjusted FFO to debt to below 12% and raising its adjusted debt to EBITDA above 5.0x.

Alternatively, if the deal is not approved, we would resolve the CreditWatch placement at that time, affirming the rating if we consider that Hapag-Lloyd's credit quality has not deteriorated for other reasons in the meantime, such as lower freight rates or higher bunker fuel prices than we forecast in our base case, combined with the company's inability to adjust its cost base to achieve the rating-commensurate credit measures and adequate liquidity, amid ongoing difficult industry conditions.

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