OREANDA-NEWS. Fitch Ratings has affirmed JSC Russian Railways' (RZD) Long-term foreign and local currency Issuer Default Ratings (IDR) at 'BBB-'. The Outlook is Negative. A full list of rating actions is at the end of this release.

Fitch continues to align RZD's ratings with those of the Russian Federation (BBB-/Negative), the sole direct shareholder, to reflect the strong legal, operational and strategic ties between the company and the state, as per Fitch's Parent and Subsidiary Rating Linkage methodology. In particular, the rating alignment reflects the company's strategic importance to the Russian economy and strong operational links, including tariff and capex approval by the government, and track record of state support.

KEY RATING DRIVERS
State Support Continues
RZD continues to receive tangible state support including subsidies of around RUB77bn in 2014, the majority of which related to passenger transportation, and additional RUB30bn as advance financing for 2015, as well as direct equity injections to fund its key infrastructure projects (RUB249bn over 2011-2013 and RUB30bn in 2014) and the state pension fund financing of long-term infrastructure projects with long-dated CPI-linked infrastructure bonds (RUB150bn in 2013 and RUB50bn in 2014).

In the medium term, we expect RZD to continue receiving tangible financial support in the form of subsidies (about RUB70bn on average annually over 2015-2017) and equity injections through ordinary shares of around RUB288bn over 2015-2017 given the development of the Far East and some other large-scale projects. Additionally, in 2013 the government approved the issuance of RUB150bn 2.98% preferred shares, to be purchased by the National Wealth Fund over 2015-2016 to finance infrastructure development in the Far East. RZD also anticipate issuing another RUB100bn CPI-linked infrastructure bonds in 2015.

Capex Drives Negative FCF
Capex net of state equity injections has gradually increased over the past few years and peaked at around RUB515bn in 2013, around 177% of funds from operations (FFO) generation. In the medium term, Fitch expects some decrease in capex relative to earnings. RZD estimates it will invest around RUB415bn (excluding equity injections of RUB30bn) in 2014 and another RUB1.2trn (around RUB1.6trn on a gross basis) over 2015-2017. Fitch expects RZD will continue generating solid cash flow from operations of about RUB280bn on average over 2014-2017. However, the continued extensive capex programme is expected to drive sizable negative free cash flow of about RUB230bn on average over the same period. Forecast negative free cash flow will add to funding requirements that RZD partially expects to fund through infrastructure bonds and preferred shares. RZD also has the option to postpone capex plans where necessary.

Volumes Under Pressure
Freight transportation volume continued to decline in 2014 and 2m15 albeit at a slower pace (0.8% and 0.2% yoy, respectively) compared with 2.8% yoy decrease in 2013, as construction-related transportation continued to fall on the back of a slowdown in the construction industry and the overall economy. Construction volumes are likely to remain low in 2015 but may witness a recovery in the medium term as arguably the sharp declines during 2013-2m15 were primarily due to a high 2012 comparable and the completion of infrastructure for the Sochi Olympic Games. Fitch notes that although freight transportation volumes decreased in 2014, freight rail turnover (excluding empty runs) rose by 4.7% yoy in 2014 mainly due to an increase in the average length of freight haulage and a redirection of cargo flows to Far East ports. In the medium term, we expect freight transportation volumes to remain under pressure on the back of Fitch anticipated GDP contraction of 4% in 2015 and 1% in 2016.

Relatively High 2015 Tariff Growth
Fitch views positively the 2015 annual tariff indexation of 10% approved by the Federal Tariff Service for RZD in 2015. Furthermore, at end-2014 additional 13.4% tariff increase for all export cargoes (excluding energy coal, which had additional 1.3% increase) was approved. This substantial growth in tariffs has partly mitigated tariff freeze for 2014. However, we note that the tariff-setting mechanisms lack transparency and predictability and in turn earnings visibility, which constrain the standalone ratings.

FX Risks
RZD is exposed to currency risk as about 35% of outstanding loans and borrowings at end-1H14 comprised foreign-currency denominated Eurobonds and loans (mainly in USD, EUR, GBP and CHF). Foreign currency risk is partially mitigated by a natural hedge as RZD hedges its currency and interest risk exposure to foreign-currency borrowings using swaps into Swiss francs, as it receives about CHF1.2bn (about 2.8% of estimated IFRS based 2014 total revenue) in revenues annually from its transit operations as well as a portion of EBITDA generated in euros after GEFCO's acquisition (about 2% in 1H14).

Weakening Standalone Profile
RZD's standalone profile has weakened and we expect it to remain under pressure mostly due to the slowdown of the Russian economy, inflationary pressure, rouble devaluation, increasing interest rates and company's extensive capex programme that drives negative free cash flow generation. We forecast FFO adjusted net leverage to remain above 3x and FFO fixed charge coverage below 5x on average over 2014-2017 compared to about 1.2x and 10x on average respectively over 2010-2013. As a result, we currently assess RZD's standalone profile to be commensurate with a low investment-grade category.

RZD's business profile continues to benefit from its position as the monopoly owner and operator of the rail infrastructure, essential for transporting freight and passengers across Russia and abroad and sizeable operations in freight and passenger transportation in Russia. However, the company's standalone profile is limited by still developing long-term tariffs system as well as its exposure to commodity market risks, FX risk, and somewhat limited, albeit improving, geographical diversification. Fitch notes that to a large degree, the company is dependent on financial state support to fund large-scale capex projects and loss-making passenger transportation and is fully exposed to the domestic economic and operating environment.

Margin Pressure
RZD's margins and consequently FFO generation have faced increasing pressure since 2010. In 1H14, Fitch-calculated EBITDA margins declined to 19% from 21% in 1H13. This was largely driven by the 2014 tariff freeze and somewhat high fixed cost base. The approved 2015 tariff increase should support EBITDA margins. However, in an environment of lower forecast volumes growth and economic downturn the importance of the company's ability to rationalise its cost base is increasing in order to support margins and FFO levels, particularly in the view of high capex plans.

LIQUIDITY & DEBT STRUCTURE
Manageable Liquidity
RZD's cash and cash equivalents stood at RUB58bn at end-1H14, which combined with unused credit facilities of RUB231bn mainly from the major local state-owned banks, was sufficient to cover short-term maturities of around RUB119bn. Forecast negative free cash flow will add to funding requirements. RZD expects to issue RUB100bn of CPI-linked infrastructure bonds in 2015 (RUB200bn already issued over 2013-2014) and RUB150bn of 2.98% preferred shares to be acquired by National Wealth Fund over 2015-2016. RZD also has the option to postpone capex plans where necessary. Fitch notes that one of RZD's loans stipulates a net debt/EBITDA covenant of 3x. Fitch expects limited headroom under this covenant over the forecast period due to the forecast deterioration of credit metrics. RZD's average debt maturity profile exceeded eight years.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Transportation volume growth in line with Fitch forecasted GDP of -4%-0% over 2015-2017.
- Tariffs growth as approved by the government for 2015 and in line with inflation, which Fitch forecasts at about 7.3% in 2016-2017.
- Capex as expected by RZD.
- Subsidies, equity injections and other forms of state support (ie infrastructure bonds, preferred shares) as approved by the government or expected by RZD.
- Inflation-driven cost increase.

RATING SENSITIVITIES
Negative: Future developments that could lead to negative rating action include:
- Fitch expects to continue aligning RZD's IDR with Russia, given the strength of government links. Therefore, Fitch is unlikely to downgrade RZD before downgrading Russia. However, sustained FFO net adjusted leverage above 3.5x and FFO fixed charge coverage below 4x may be negative for RZD's ratings unless further evidence of state support is provided.

Positive: Future developments that could lead to positive rating action include:
- A positive change in Russia's rating may be replicated for RZD (up to BBB level), unless its links with the state weaken

For the sovereign rating of the Russian Federation, RZD's parent, the following sensitivities were outlined by Fitch in its rating action commentary of 9 January 2015:
The following risk factors individually, or collectively, could trigger a negative rating action:
- Continued exchange rate volatility, leading to broader financial sector instability requiring greater public financial support.
- Sustained low oil prices and/or continued recession in 2016, with adverse implications for the public finances and financial sector stability.
- Faster than forecast depletion of international reserves, reflecting larger than expected capital flight and/or accelerated dollarisation domestically.
- An intensification of sanctions or a geopolitical risk event.

The Outlook is Negative. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a positive rating change.

Future developments that could individually, or collectively, result in a stabilisation of the Outlook include:
- A reduction in tensions with the international community, resulting in an unwinding of sanctions and renewed access for Russian entities to international capital markets
- A sustained recovery in the oil price, coupled with an easing of macroeconomic and financial stress.

The rating actions are as follows
RZD
Long-term foreign currency IDR affirmed at 'BBB-', Outlook Negative
Long-term local currency IDR affirmed at 'BBB-', Outlook Negative
Long-term National Rating affirmed at 'AAA(rus)', Outlook Stable
Short-term foreign currency IDR affirmed at 'F3'
Short-term local currency IDR affirmed at 'F3'
Local currency senior unsecured affirmed at 'BBB-'
National senior unsecured affirmed at 'AAA(rus)'

RZD Capital P.L.C.
Foreign currency senior unsecured affirmed at 'BBB-'