OREANDA-NEWS. Fitch Ratings has upgraded Kernel's Long-Term Local-Currency Issuer Default Rating (LT LC IDR) to 'B-' from 'CCC' and National Long-Term Rating to 'AA+(ukr)' from 'A-(ukr)'. The Outlook on the ratings is Stable. Fitch has also affirmed Kernel's Long-Term Foreign-Currency (FC) IDR at 'CCC'.

The upgrade of LC IDR and National Long-Term Rating reflects Kernel's resilience to political and economic turmoil in Ukraine thanks to its export-oriented business model and limited dependence on the Ukrainian banking system. Together with strong credit metrics, these warrant the company's LC IDR being one notch above Ukraine's LC IDR of 'CCC'. Kernel's FC IDR of 'CCC' remains constrained by Ukraine's Country Ceiling of 'CCC'.

KEY RATING DRIVERS

LC IDR Upgrade

Kernel's LC IDR of 'B-' is one notch above Ukraine's LC IDR of 'CCC', reflecting the company's limited reliance on Ukrainian banking system and Fitch's assessment that the company's moderate dependence on the local operating environment is not prejudicial to its performance. Over the past two years, Kernel performed strongly and had good access to external liquidity, despite economic and political turmoil in Ukraine. This is due to its substantial export-oriented operations and therefore limited exposure to recessionary pressures in its domestic market. Exports accounted for 96% of revenue in the first nine months of the financial year to June 2016 (9MFY16).

Wider notching from Ukraine's LC IDR is constrained by the refinancing risks the company faces every year in relation to the extension of its credit lines to fund the trading and sunflower-oil production cycle. In addition, the 'B-' rating incorporates risks associated with the company's reliance on domestically sourced inputs (grain and sunflower seeds) and on the country's infrastructure.

Country Ceiling Constraint

Kernel's FC IDR is one notch lower than its LC IDR as it remains constrained by Ukraine's Country Ceiling of 'CCC'. The high volatility of the company's debt service ratio around the minimum threshold of 1x over the past four years as well as over the rating horizon suggests that there is not enough support for the ratings to be above the Country Ceiling, although we estimate that as at FYE16 the ratio was 1x and this could justify the one-notch uplift in accordance with Fitch's criteria. A debt service ratio sustainably above 1x over several years or a change in the capital structure towards less reliance on short-term financing could suggest a potential upgrade of the FC IDR.

In line with Fitch's methodology Rating Non-Financial Corporates Above the Country Ceiling the debt service ratio for Kernel considers Fitch-adjusted EBITDA from exports and Russian grain trading activities, Fitch-adjusted readily marketable inventory (RMI) and offshore liquidity in relation to short-term debt and interest expense.

Profits Slide

We expect Kernel's Fitch-adjusted EBITDA to decrease to around USD300m in FY16-FY17 (FY15: USD346m) due to a decrease in crushing margins from exceptionally high levels in FY15, while on the positive side profits will be supported by good yields in the farming segment and the extension of crushing capacity following the acquisition of Creative's sunflower seed-crushing plant. A further decrease in EBITDA to around USD250m-260m is possible from FY18, taking into account higher crop-growing costs, assuming no material hryvnia depreciation, and more conservative crop-yield assumptions for the farming division. Nevertheless, operating cash flows should remain sufficient to cover expected capex and dividends.

Appetite for Releveraging

After a reduction in its net-debt-to-EBITDA ratio from 3.6x in FY14 to 1.1x in FY15 and estimated 1.0x in FY16, Kernel now plans to increase it to 1.5x-2.0x through bolt-on acquisitions and investments in terminal capacity and its land bank in Ukraine. This corresponds to similar levels of gross RMI-adjusted FFO adjusted leverage in FY17-FY19, which are relatively conservative and, based on Fitch's 'Commodity Processing and Trading Companies Ratings Navigator Companion' are aligned with the median for the 'BBB' rating category. In addition, we believe that investment plans are largely scalable and the management will not jeopardise the company's financial standing and access to liquidity in case of weaker-than-expected operating cash flows.

RMI Adjustments

Fitch started to apply RMI adjustments in evaluating Kernel's leverage and interest coverage ratios and liquidity position. Kernel fulfils the eligibility criteria for RMI adjustment as set out in the Commodity Processing and Trading Companies Ratings Navigator Companion report dated February 2015 as it hedges its price risk related to its trading and processing operations with forward sale contracts, which bear moderate counterparty risks, and also uses CBOT futures for a large proportion of internally produced crops.

For the purpose of Fitch's RMI calculations we applied a 70% advance rate to company-reported RMI to reflect the counterparty risk of its off-takers and the lower liquidity of sunflower seeds as they are used for further processing into sunflower oil and meals. In our calculation of leverage and interest cover metrics, we excluded debt associated with financing RMI and reclassified the related interest costs as cost of goods sold. The differential between RMI-adjusted and RMI-unadjusted FFO leverage is around 0.5x.

Moderate Diversification

Kernel is focused only on few commodities, primarily sunflower oil and meal, corn, wheat and barley, and remains largely reliant on Ukraine for sourcing these. This exposes it to risks of a contraction in the Ukrainian harvest, but so far such risks have not materialised, despite farmers' access to external financing weakening over the past three years. At the same time, even if the harvest declines, we believe Kernel would be able to manage the risks due to its leading market position, ownership of port and other infrastructure assets and its better access to external liquidity than many of its Ukrainian competitors.

The rating benefits from Kernel's good diversification by destination countries and adequate customer concentration. Some diversification benefit is also provided from its Russian grain trading operations, which we estimate will contribute 10%-15% to Kernel's revenues in FY17-FY19, after the recent increase in capacity at the Taman port terminal. We consider the disposal of the company's Russian sunflower oil plants in FY16 neutral from a credit perspective as their contribution to Kernel's profits was immaterial.

Asset-Heavy Business Model

Compared with global agricultural commodity processors and traders, Kernel operates on a stronger FFO margin of 7%-10%. This is a result of Kernel's asset-heavy business model with substantial processing operations (relative to trading) and infrastructure assets as well as integration into farming. The group's asset structure and integration within operating segments allows the company to retain leading market positions in sunflower oil and grain exports and are positive for Kernel's credit profile.

KEY ASSUMPTIONS

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

- Weak international soft commodity prices over the medium term

- EBITDA margin up to 15.5% in FY16 before decreasing to 13% in FY17 and 12% thereafter

- Stable dividends at USD20m per year over FY17-FY19

- Capex at around USD100m over FY17-FY19

- M&A spending not exceeding USD100m per year

- No material reduction in VAT reimbursements related to exports

- Adequate liquidity

RATING SENSITIVITIES

Future Developments That May, Individually or Collectively, Lead to Positive Rating Action

An upgrade of the Local-Currency IDR is unlikely unless liquidity and refinancing risks fall. An upgrade of the Foreign-Currency IDR is contingent on:

The debt service metric for hard-currency obligations being sustainably above 1x (as calculated in accordance with Fitch's methodology Rating Non-Financial Corporates Above the Country Ceiling) or

Ukraine's Country Ceiling being revised higher

Future Developments That May, Individually or Collectively, Lead to Negative Rating Action

A liquidity shortage caused by limited available bank financing of working capital investments or by refinancing at more onerous terms than expected

A severe shock from soft commodity prices, detrimental export restrictions, material reduction in VAT refunds or limited crop availability in Ukraine leading to material deterioration of Kernel's credit metrics

LIQUIDITY

Adequate RMI-Adjusted Liquidity, PXF Facilities Renewal

At end-March 2016, Kernel's RMI-adjusted liquidity was around 1.0x as unrestricted cash balances (USD137m), Fitch-estimated RMI (USD127m), trade receivables (USD138m) and expected positive FCF were sufficient to cover Kernel's current liabilities (USD507m), including short-term debt of USD360m. According to our estimates, this ratio remained at the same level as at FYE16 (ended June 2016).

The liquidity position is also supported by the recent renewal of pre-export financing facilities with a total maximum limit of USD515m, which should cover the company's working-capital needs for trading and the crushing cycle in FY17. Kernel's strong record of successful renewal of these facilities against the difficult economic backdrop in Ukraine is positive for the company's credit profile.