OREANDA-NEWS. Fitch Ratings has upgraded Peugeot SA's (PSA) Long-term Issuer Default Rating (IDR) to 'BB-' from 'B+' with a Positive Outlook and affirmed the senior unsecured rating at 'BB-'.

The upgrade reflects our projections that PSA's core automotive operations will remain profitable, following the improvement of their operating margin to around breakeven in 2014, before adjustments for capitalised development costs, from negative 2.9% in 2013 and negative 3.9% in 2012. We also forecast free cash flow (FCF) margin to remain positive, between 1% and 3% through 2017. We believe that the group continues to face challenges, including weak demand in several emerging markets but this should be offset by the gradual recovery in Europe. Furthermore, PSA's significant work on its cost structure over the past couple of years has started to be successful and should mitigate the intense pricing pressure and continuous overcapacity in its domestic market.

The upgrade also reflects the absence of liquidity risks and the material decline in leverage in 2014 following EUR0.9bn in positive FCF combined with a EUR3bn capital increase. As a result, the group's funds from operations (FFO) adjusted net leverage fell to 1.6x at end-2014 from 4.9x at end-2013 and we expect further improvement towards breakeven by end-2017.

The Positive Outlook reflects our view that the group's financial metrics could be in line with the mid-range of the 'BB' category by end-2016. Further evidence that the improvement recorded in 2014 and expected in 2015 is sustainable in 2016 and beyond could lead to a further upgrade.

KEY RATING DRIVERS
Modest Sales Recovery
Fitch expects PSA's revenue growth to remain moderate in 2015-2016 as the group's strategy includes a smaller product range and lower discounts, which will hinder volume growth. In addition, we expect further adverse conditions in several markets including Latin America and Russia. However, this should be offset by the recent and upcoming renewal of key models, the gradual recovery of the European market as well as further growth and increasing market shares in China.

Progress in Restructuring
Strategic measures to streamline the product portfolio and profitably expand international operations have started to bear fruit. In Europe, we expect PSA's cash-preservation and cost-reduction measures to improve the cost base and hence boost profitability further in 2015 and 2016. We project PSA's automotive operating margin to increase further, towards 3% in 2017 from about breakeven in 2014 and negative 2.9% in 2013, before adjustments for capitalised development costs.

Recovering Profitability and FCF
We expect earnings to benefit from the improved cost structure and increasing sales in the next couple of years but to be challenged by further FX volatility, investments and adverse market conditions, particularly outside Europe. In 2015, we expect a positive impact from FX and raw materials to boost underlying margin progression.

FCF in 2014 was a robust EUR0.9bn, in sharp contrast with the cash absorption of EUR1.3bn in 2013 and EUR3.3bn in 2012. It was supported by the strengthening of underlying FFO, a substantial EUR1bn inflow from working capital improvements and controlled investments.

Lower Leverage
We expect leverage decline to come from further positive FCF, the creation of a joint venture with Santander releasing some equity from Banque PSA Finance (BPF) and the issue of warrants and the possible conversion of a convertible in 2016. This should offset an acceleration in capex and the potential resumption of dividends in the medium term.

Weak Competitive Position
Despite continuous recent improvement, PSA's sales remain biased toward the European market and the mass-market small and medium segments, where competition and price pressure are fiercest. Competition is also intensifying in foreign markets where PSA has diversified, including Latin America, Russia and China.

Capital Increase
The French state and Dongfeng Motor have become PSA's majority shareholders, in line with the Peugeot family, each with a stake of 14.1%. The capital increase has benefited the financial profile but the new shareholding structure may present some challenges to coordinate the potentially diverging interests of the various shareholders.

Sound Liquidity
Liquidity remains healthy, including EUR8bn of readily available cash for its industrial operations at end-2014, including Fitch's adjustments. In addition, committed credit lines of EUR3bn at PSA maturing in 2017 and 2019 and EUR1.2bn at Faurecia were undrawn at end-2014.

KEY ASSUMPTIONS
Fitch's key assumptions for 2015-2017 within our rating case for PSA include:
- Industrial operations' revenue up by 3% in 2015, growth moderating to about 1.5% in 2016 and accelerating thereafter.
- Auto operating margin increasing to more than 2% in 2015-2016 and reaching 3% by 2017.
- Capex to increase to about EUR3bn, no dividend paid in 2015-2016.
- Dividends paid by BPF of about EUR400m in 2015 and EUR500m in 2016 and by Dongfeng Peugeot-Citroen Automobile (DPCA) increasing gradually to just under EUR200m by 2017.
- Cash inflows of about EUR500m per year in 2015-2017 from the release of equity following the establishment of the JV with Santander.

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include
- Further diversification of sales.
- Automotive operating margins above 2% (2014: 0.2%, 2015E: 2.4%, 2016E: 2.3%).
- FCF above 1% (2014: 1.8%, 2015E: 0.9%, 2016E: 2.1%).
- FFO adjusted net leverage below 2x (2014: 1.6x, 2015E: 0.8x, 2016E: 0.1x).
- CFO/adjusted debt above 25% (2014: 28%, 2015E: 41%, 2016E: 53%).

Negative: Future developments that may, individually or collectively, lead to negative rating action include
- Inability to sustain positive automotive operating margins.
- Negative FCF.
- FFO adjusted net leverage above 3x.
- CFO/adjusted debt below 15%.