OREANDA-NEWS. Fitch Ratings has revised Premier Foods plc's (Premier) Outlook to Stable from Negative, while affirming the company's Long-term Issuer Default Rating (IDR) at 'B'.

Premier Foods Finance plc's senior secured floating-rate GBP175m and fixed-rate GBP325m notes have been affirmed at 'B' with Recovery Rating 'RR4'.

The Outlook revision to Stable reflects the company's successful turnaround plan, as revenue resumed mild growth and free cash flow (FCF) turned positive. Moreover, profitability has remained solid for the rating and relative to other peers in packaged food, a trend which we expect to continue over the financial year ending 2 April 2017.

We forecast that funds from operations (FFO)-adjusted net leverage will worsen above the 6.0x threshold compatible with Premier's 'B' IDR, once pension contributions resume in FY17. Although this will be above the comfortable level of 4.9x achieved in FY16, the business model is nonetheless proving to be sustainable with moderate execution risks. We expect resilient profitability and the prospect of low single-digit FCF margin to support de-leveraging towards 5.7x by FY19. We forecast Premier will, as a result, retain adequate financial flexibility, translating into limited refinancing risks.

KEY RATING DRIVERS

Stabilising Trading Performance

Following several quarters of contraction, Premier's FY16 revenues showed that innovation and marketing efforts undertaken have started to pay off. This has resulted in organic revenue growth over the four reported quarters up to 2 July 2016 and stable FY16 operating profit, confirming a strong EBITDA margin of over 18%.

This improvement was driven by lower input costs and a shift to more effective consumer marketing spending away from discounts and promotions, which increased brand awareness and supported new product launches. We believe this process represents the beginning of a virtuous cycle, as management plans to revamp more product categories and engage in new product launches.

Brexit Poses Challenges

Even though a portion of Premier's input costs are denominated in USD or other currencies, we do not expect the company's profit margin to be immediately affected by the recent GBP depreciation, as the majority of the company's foreign currency needs are hedged for FY17. Once these hedges expire, Premier may find it difficult to pass on higher costs to consumers who in turn may be pressed by a general increase in prices. However, these risks are mitigated by the company's ability to introduce cost-saving measures and increased pricing power, due to ongoing product innovation.

Deleveraging Delayed to FY19

According to our projections, Premier's near-term financial flexibility will be constrained by high interest costs of approximately GBP40m per annum and the rise of pension contributions to nearly GBP60m annually from FY17 as the company fulfils its agreements with pension trustees.

Therefore, while management remains focused on paying down debt, Fitch expects FFO adjusted net leverage to peak at around 6.7x in FY18. Such leverage will be high for Premier's 'B' IDR but Fitch expects this to fall back to below 6.0x after FY18 as Premier generates positive FCF in the low-to-mid single digits of sales from strengthening trading performance. We also expect interest cover (FFO fixed charge cover) to rise above 2.0x which together with Premier's proven access to various financing and liquidity sources, should help mitigate refinancing risks.

Reliance on Challenging UK Market

Premier's revenue is mainly generated from the "big-four retailers" in the UK: Tesco (BB+/Stable), Asda, J Sainsbury's and Morrisons. However, an ongoing shift in consumer shopping behaviour from these traditional big retailers to hard discounters, online and convenience stores is challenging Premier's performance, prompting it to adapt its product offer and keep a lean cost base.

In addition, the UK market has continued to experience price deflation and strong competitive pressures, leading to a high level of promotions. These trends are constraining Premier's planned recovery, in spite of the company's product launches to target the discount and convenience channels.

Leading UK Ambient Food Producer

Premier enjoys a strong position as one of the UK's largest ambient food producers, with an almost 5% share in the fragmented and competitive GBP28.7bn UK ambient grocery market. Despite the benefits in manufacturing, logistics and procurement Premier derives in the UK from its wide range of branded and non-branded food products, the company mainly competes in mature segments such as ambient desserts and ambient cakes. This limits its growth prospects, making Premier reliant on continuing its marketing and innovation efforts to protect its market share.

New Shareholder Enhances Growth Opportunities

The company has been strengthening its marketing team to expand sales outside the UK, in Australia, the USA and the Middle East. We believe that so far this effort has affected group operating profit as, based on our estimates, Premier's international scale is insufficient to generate material profitability. We expect the international operations of the new shareholder Nissin Foods, with which Premier is developing a new strategy, to enhance Premier's opportunities and ability to pursue this expansion strategy at little extra costs. Additionally, Premier now has scope to sell Nissin's products in the UK, providing further revenue upside.

Average Senior Secured Notes' Recoveries

The 'B'/'RR4' senior secured rating reflects average recoveries (31%-50%), albeit at the low end (36%), for senior secured noteholders in the event of default. Fitch assumes that the enterprise value (EV) of the company and the resulting recovery of its creditors (including the pension trustees) would be maximised in a restructuring scenario under our going-concern approach rather than in a liquidation due to the asset-light nature of the business as well as the strength of its brands. Furthermore, a default would likely be triggered by unsustainable financial leverage, possibly as a result of weak consumer spending affecting sales and profits if combined with ongoing punitive pension deficit contributions.

Fitch has applied a 30% discount to EBITDA and a distressed EV/EBITDA multiple of 5.0x, reflecting challenging market conditions in the UK and the reliance on a single country, which are partially offset by a portfolio of well-known product brands. The notes rank equally with the pension schemes for up to GBP450m and are included as a senior obligation in the debt waterfall within our recovery calculation.

RATING SENSITIVITIES

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

- Failure to stabilise performance with continued revenue decline and EBITDA margin falling below 18%

- Neutral-to-negative FCF on a sustained basis due to profitability erosion, higher or unexpected capex and increases in pension contribution or funding costs

- FFO adjusted net leverage remaining permanently around 6.0x (pension deficit contributions are deducted from FFO)

- FFO fixed charge coverage below 1.8x (FY16: 2.6x) on a sustained basis.

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

- Trading performance continuing to recover (organic revenue growth) and the ability to maintain EBITDA margin above 18% after having sufficiently invested in advertising and promotions to protect its market position and drive growth

- FFO adjusted net leverage below 5.0x (pension deficit contributions are deducted from FFO)

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

- FCF margin in positive territory (FY16: 8.5%) on a sustained basis after adequate capital investments.

LIQUIDITY AND DEBT STRUCTURE

Under the assumption of positive FCF generation of at least GBP15m per annum, Premier should be able to gradually repay the drawn portion (GBP55m reported as of FYE16) of its GBP272m revolving credit facility due in 2019. Subsequently the next major debt repayment is the company's GBP175m notes due in March 2020. Assuming its trading performance continues to recover, the company should have GBP50m accumulated cash and be able to refinance any outstanding bonds in 2020/2021.