Fitch Rates Zalagh's MAD350m Bond 'B-(mar)'
The rating action follows a review of the final documentation of the bond issued by Zalagh in November 2014. The issuer will channel downstream the bond proceeds to its operating subsidiaries' (opcos) to finance capex and working capital investments and refinance a portion of long-term bank loans.
Fitch takes into account Zalagh's enhanced debt maturity profile and diversified funding sources as a result of the bond issue. Although on a consolidated basis, a large portion of Zalagh's total debt is due within 12 months, this is largely linked to the group's sizeable working capital needs, due to its integrated business model from grain trading to meat processing. This is partly reflected in the ratings by Fitch deducting the portion of debt that can be netted off against liquid and/or hedged inventories through our Readily Marketable Inventory Approach (RMI). The ratings also factor in the support from IFC as a recent new shareholder in Zalagh (holding 18% of its shares post equity injection).
KEY DRIVERS FOR THE BOND
Structural Subordination for Holding Creditors
The MAD350m bond issue is an unsecured, unguaranteed debt obligation of Zalagh. Holding company bondholders do not have direct recourse to the main opcos' assets or profits but only an unsecured claim on intercompany loans in such opcos. The bond rating therefore reflects such structural subordination for bondholders relative to creditors at subsidiary level.
Weak Recovery Prospects
Fitch has conducted a bespoke recovery analysis to assess recovery expectations for holding company bondholders. We consider that expected recoveries upon default would be maximised in a liquidation scenario rather than in a going-concern scenario given the heavy asset base of Zalagh's business. Taking into account the new debt structure post bond issue and private placement, and following a strict payment waterfall, Fitch estimates that the recovery rate for the bond would fall within the 0-10% range, resulting in an instrument rating of 'B-(mar)', two notches below the National Long-term rating of 'B+(mar)'.
The weak recovery prospects are driven by the presence of sizeable senior or secured liabilities at opco level, ranking senior to the bondholders, and the structural subordination of the bond. A reduction in the share of priority opco debt, relative to the total debt of the group, could lead to some convergence between Zalagh's National Long-term rating and the bond rating.
KEY RATING DRIVERS FOR THE NATIONAL LONG-TERM RATING
No Significant Deleveraging before 2017
Fitch estimates Zalagh's leverage at FYE14 to be high with RMI-adjusted FFO gross leverage of 9.4x, which is outside of the parameters compatible with a 'B+(mar)' rating. However, we expect additional top-line growth and profitability enhancement from expansion capex and greater efficiencies. Higher profitability should allow the group to start deleveraging to below 6.5x from 2017. Zalagh should receive around MAD180m in VAT refund from the government over 2015-2016, broadly covering 2015's capex funding needs. If leverage remains above our negative sensitivities guidelines for longer than expected, this may put pressure on Zalagh's ratings in the absence of any cash preservation measures.
High Working Capital in 2014
Based on interim accounts at end-September 2014, we expect Zalagh to have registered high working capital outflows in 2014. We believe that such increase is a direct result of the combination of certain one-off factors such as increased trading activities due to weak grain domestic production in 2013/2014, and the depreciation of MAD/USD (roughly 15% yoy) only partially offset by a decrease in USD prices for grain (the net effect depending on the timing of grain purchases). At present we do not envisage permanent increases in working capital linked to capex in downstream operations as these remain small in scale. We expect cash flow from operations (CFO) to have been negative in 2014 but to improve in 2015, driven by better sales outlook and steady profitability.
Stable Profitability in 2015
We consider management's plan to improve production efficiencies and achieve additional cost savings and economies of scale as sensible. Our conservative forecasts of the impact of the group's restructuring efforts aimed at more harmonised operations and functions and the expansion plan result in stable forecasts of RMI-adjusted EBITDA margin in 2015 and 2016 before increasing to 6.8% by 2017 (2013: 6.2%).
Restricted Financial Flexibility
Debt borrowed at Greenlight Holding to acquire Zalagh's own shares as part of the 2011 buyout creates, in our view, some pressure on Zalagh to upstream cash by way of dividends to service such indebtedness, even though such debt does not feature any cross-default with Zalagh's own indebtedness. This is balanced by the Chaouni family shareholders' commitment to allocate their own share of dividends received, if necessary, to accelerate Greenlight's debt repayment. As such we expect RMI-adjusted FFO fixed charge cover (adjusted for the share of dividends paid by Zalagh used to service debt at Greenlight) to remain tight at 1.2x for 2015 before rising to 1.6x in 2017, in line with the rating.
Solid Local Market Position
Zalagh has a strong position in the agri-business in Morocco, and is unique in that it is fully integrated across the entire industry value chain. The group has fairly significant storage capacities throughout the country, allowing it to secure 22% of national imports of soft commodities, which is a key positive rating consideration. Competition is more acute in slaughtering and meat processing compared with commodity trading and animal feed; its key competitors are, however, not backward integrated into procurement and, hence are more exposed to raw materials and feed price volatility and sharp supply/demand imbalances in the poultry sector than Zalagh.
Mixed Business Risk Profile
Zalagh is considered a price taker in the international commodity markets that trade in US dollars, although it is largely a price setter in animal feed domestically given its leading position. Transactional FX mismatch is expected to grow as Zalagh expands its feed operations domestically, but this is mitigated by its proven pass-through mechanisms, and the fact that most debt is borrowed in domestic currency. We also expect opportunities for further penetration of poultry production and demand. However, Fitch expects the supply/demand balance to remain unpredictable as production remains largely unorganised in Morocco. Also, any potential benefit from market growth is subject to local regulation changes in favour of integrated poultry producers.
KEYASSUMPTIONS
Fitch's key assumptions within our rating case include:
-Revenue growth expected to accelerate by 2017, driven by additional capacity investments in 2014, 2015 and 2016 and lag effect from working capital investments feeding through to sales growth
-Profitability expected to increase from 2017 resulting from revenue growth and management efficiencies plan
-Working capital to normalise over the coming years in line with average historical figures
-Capex driven by capacities expansion within chick hatchery, pout and turkey broiler and animal feed capacity
-Liquidity supported by Zalagh's access to renewable bank lines
RATING SENSITIVITIES
Positive: We see the probability of an upgrade as low in the foreseeable future given the small scale of the business relative to international Fitch-rated peers and the execution risk to grow the business while enhancing profitability. However, future developments that could lead to a positive rating action include:
-FFO adjusted leverage below 6x (RMI-adjusted FFO leverage below 5x) on a sustained basis
-RMI-adjusted FFO fixed charge cover (including dividends to cover Greenlight's debt service) sustainably above 1.8x
-Strong profitability measured as operating EBITDAR/ gross profit, above 60% on a consistent basis, or EBITDA margin exceeding 8%, suggesting improved operating leverage from its majority of wholly-owned operations and enhanced pricing power
-Evidence of positive free cash flow (FCF) supported by a conservative business expansion or, if negative, funded largely by additional equity funds
Negative: future developments that could lead to a negative rating action include:
-Weakening profitability measured as RMI-adjusted operating EBITDAR/ gross profit of below 40%, together with continuing negative FCF eroding internal liquidity buffer - defined as cash+RMI+accounts receivables divided by total current liabilities - to below 0.5x (excluding committed bank lines)
-RMI-adjusted FFO fixed charge cover (including apportioned dividends to cover Greenlight's debt service) below 1.2x
-FFO adjusted leverage above 7.5x (RMI-adjusted FFO leverage above 6.5x) for more than two consecutive years reflecting an increasingly unsustainable capital structure
LIQUIDITY
Zalagh has adequate liquidity in its core commodity trading and animal feed businesses. However, liquidity is considered somewhat weaker at the consolidated level, weighed down by its downstream activities. Overall, the company's Fitch-defined unrestricted cash balance of MAD300m, estimated liquid inventories and receivables (RMI) and undrawn revolving credit facilities of MAD700m are just sufficient to cover short-term debt of MAD1.5bn as of end-December 2014. Excluding external sources of liquidity, Zalagh's internal liquidity (defined as unrestricted cash+RMI+A/R divided by total current liabilities) is rather weak at 0.7x-0.8x but in line with the ratings.
Fitch expects FCF to remain negative in 2015 due to high capex and for liquidity to remain stretched. However, capex of MAD74m in 2015 are scalable, introducing some flexibility in FCF. The ratings also reflect Zalagh's capacity to diversify its funding sources by raising the MAD350m bond in the local bond market and MAD125m private placement.
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