OREANDA-NEWS. Fitch Ratings has downgraded the foreign and local currency Issuer Default Ratings (IDRs) of U.S.J. - Acucar e Alcool S.A. (USJ) to 'B' from 'B+' and the National Scale Rating to 'BBB(bra)' from 'A-(bra)'. Fitch has also downgraded to 'B/RR4' from 'B+/RR4' the rating for the company's USD275 million senior unsecured notes due 2019. USJ's ratings are currently on Rating Watch Negative.

KEY RATING DRIVERS
The downgrades are based upon USJ's weakening financial profile in the volatile sugar and ethanol business, due to negative free cash flow generation (FCF) and an increase in the concentration of short-term debt. Systemic risk remains high for the Brazilian sugar and ethanol (S&E) sector following the default by Aralco S.A. Industria e Comercio and Virgolino de Oliveira S.A. Acucar e Alcool's (GVO) struggle to restructure its debt, which has made it increasingly difficult for companies to obtain long-term financing.

The Watch Negative reflects Fitch's continued concerns about USJ's high refinancing risks. While it has extended some debt maturities during 2015, USJ's short-term debt has increased as availability of medium and long-term unsecured loans has become scarce for most Brazilian S&E companies.

Prices for sugar and ethanol are expected to remain under pressure despite improvements on the ethanol industry dynamics in 2015 compared to 2014. The generation of more robust operational cash flow in the new season ending March 31, 2016 will depend largely on the maintenance of favorable weather conditions as seen in early 2015.

Positively, USJ has unencumbered land properties worth BRL1.1 billion and operating assets such as sugar cane and inventory that could be used for collateral to improve its financial position.

Higher Refinancing Risk
USJ's liquidity is under pressure as short-term debt is increasing at a higher pace than the cash position. As of Dec. 31, 2014, USJ's cash position of BRL143 million compared unfavorably with short-term debt of BRL228 million to yield a 0.63x coverage ratio. This compares unfavorably with March 31 2014 when the company had cash and short-term debt positions of BRL232 million and BRL128 million, respectively.

The company has used part of its cash to make a BRL60 million capital injection into SJC Bioenergia S.A (SJC), the Joint-Venture with Cargill, and acquire some land and cane fields from a financially-distressed sugar cane supplier in 2014. USJ's higher refinancing risks are also underpinned by negative free cash flows (FCF). The company's cash flows have been pressured by investments in a new boiler that are expected to enable the company to sell energy during the 2015/16 season.

Negative Free Cash Flow
In the last 12 months ended Dec. 31 2014, the company posted cash flow from operations (CFFO) of BRL156 million, which was not enough to cover capital expenditures of BRL254 million, leaving FCF at a negative BRL107 million. FCF was further pressured by BRL10 million dividends.

Capex should be reduced to BRL105 for the fiscal year 2016. Nevertheless, Fitch expects USJ's FCF to remain negative in the next two crop years. The expected recovery of international sugar prices is taking longer than forecasted to occur and the positive short-term impact on the domestic ethanol industry caused by a series of government measures both at the federal and state levels is expected to be limited.

High Leverage and FX Risk:
USJ's leverage remains high. The company's total adjusted debt as per Fitch's internal criteria amounted to BRL1.4 billion as of Dec. 31 2014, which is an increase from BRL1.2 billion in March 31 2014. In the last 12 months ended Dec. 31, 2014, the company's consolidated net adjusted debt/EBITDAR ratio was 5.0x. A material improvement in leverage is not forecast for the fiscal year ended March 2016.
The company is exposed to foreign exchange risk as USD-denominated debt accounts for 70% of its on balance debt, though sugar revenues are linked to the USD. FX risk is spread over the long term as most of USJ's USD-denominated debt consists of the USD275 million senior unsecured notes due 2019. Part of USJ's hard currency debt was protected by hedging instruments as of Dec 31 2014. The company's total adjusted debt consists of the following obligations: USD275 million unsecured senior notes due 2019 (49%); working capital lines (14%); land lease agreements as per Fitch's internal criteria and guarantees issued in favor of BNDES under loan agreements with SJC (19%); exports pre-payments and other trade finance facilities (4%); subsidized loans FINAME and FINEM (4.4%) and others with the balance.
Investments at SJC
USJ made a BRL60 million capital injection into SJC in July 2014. The JV used the proceeds (BRL120 million equally shared between USJ and Cargill) to fund its working capital requirements. Fitch is not expecting the JV to pay dividends in the current season.

During March 2015, Cargill and USJ announced plans to make corn out of ethanol in SJC's Sao Francisco mill located in the State of Goias. The plan is to start producing ethanol from corn in late 2015 with production concentrated in the period going from December to March, inter-harvest period for sugar cane, and during rainy days of the sugar cane season. The investment also contemplates energy cogeneration and production of DDGS (Dried Distillers Grains with Solubles).

Differentiated Business Position
USJ's business profile is built on a product mix that leads to product differentiation compared to peers. USJ's sugar output is focused on crystal sugar, whose sales are carried out under medium and long term contracts with financially strong food and beverage companies. This helps USJ to mitigate demand risks. The Sao Joao mill is strategically located near the food and beverage companies, the Santos port terminal (247 km) and Paulinia (70 km), a distribution hub for most of the fuel produced in the State of Sao Paulo. Ethanol sales are concentrated on anhydrous and industrial ethanol, the price of which carries a premium over that of hydrous ethanol.

KEY ASSUMPTIONS
--Crushed volumes of 3.2 million tons in 2015/2016 and gradual increases of 5% thereafter;
--Mix relatively unchanged at 66% sugar and 34% ethanol for the projected period;
--Average sugar prices at USD14 cents/pound in 2015/2016, USD16 cents/pound in 2016/2017 and USD17 cents/pound onwards;
--Domestic ethanol prices keeping the historical correlation with international sugar prices;
--No dividends coming from SJC in 2015/2016;
--No land sales have been forecasted.

RATING SENSITIVITIES
USJ's inability to substantially improve its cash to short-term coverage ratio in the coming months could lead to a negative rating action. An upgrade is unlikely in the short term. In the medium to long term, a sustainable increase in international sugar and domestic ethanol prices leading to improvements in USJ's liquidity and allowing deleveraging, could trigger a positive rating action.