OREANDA-NEWS. Fitch Ratings has assigned O'KEY LLC's upcoming RUB5bn bond under its RUB25bn programme an 'B+(EXP)' expected rating, with a Recovery Rating of 'RR4' and an expected National Long-term rating of 'A(rus)(EXP)'.

The assignment of the final rating is subject to the receipt of final documentation conforming to information already received.

The notes are rated at the same level as O'KEY's Issuer Default Rating (IDR) of 'B+', reflecting the absence of subordination to other unsecured debt issued by the group.

The planned five-year RUB5bn senior unsecured bond is expected to be issued by O'KEY LLC, with a guarantee by the holding company O'key Group SA (O'KEY) and a suretyship of JSC Dorinda, the group entity that owns real estate and long-term lease rights. These notes rank junior to O'KEY's RUB5bn secured debt instruments. The bond will also benefit from a put option in one year.

The proceeds will be used to refinance part of O'KEY's short-term debt (RUB12.4bn at 2014-end) and capex. Consequently, there will not be a material increase in gross or net debt as a result of the bond issue.

KEY RATING DRIVERS

Recovery Assumptions
Fitch assumes that given the group's large scale of operations and strong market position in the Russian food retail market, the prospect of recoveries for noteholders, given default, would likely be based on a "going concern" basis. In Fitch's bespoke recovery analysis for the company, a distressed multiple of 5.0x and an embedded value (EV) of RUB39bn are assumed. Fitch's distressed EV analysis implies a post-restructuring EBITDA of RUB7.8bn

Recoveries Capped
Based on Fitch's estimated enterprise valuation in a distressed sale scenario the resulting recoveries on the proposed notes would equate to a Recovery Rating of 'RR1' (91% - 100% recovery given default) although the assigned recovery is capped at 'RR4' (31%-50% recovery prospects given default) given the Russian jurisdiction based on the agency's country-specific treatment of Recovery Ratings. Therefore, there is no notching of the notes from O'KEY's IDR.

Bond Issuance Programme
O'KEY has a registered bond programme with a total value of RUB20bn (post placement of the RUB5bn issue), including five tranches (RUB3bn-5bn) of five-year maturity each. Should the company consider a placement of additional bond issues from the programme these bonds are likely to be rated at the same level as the group's IDR.

Weaker Credit Metrics
Gross funds from operations (FFO) adjusted leverage weakened to 4.2x in 2014 from 3.1x in 2013 following a large increase in debt raised for expansionary capex. Given the planned launch of the new convenience store format, together with the accelerated store openings in 2015-16, we expect gross FFO adjusted leverage to remain between 4.0x and 4.4x for FY15 to FY18, albeit still commensurate with the ratings. Similarly, we project FFO fixed charge cover will deteriorate to around 2.0x (FY14: 2.3x), given increased cost of debt.

Change in Management Team
In 2014, the company underwent a few major changes in its management team. Tony Maher was appointed the company's Chief Executive Officer in February 2014, succeeding Patrick Longuet who had been with O'KEY for the past seven years. Also, a new Commercial Director, Angelo Turati, was appointed in October 2014. Although these individuals come with vast industry experience and have in-depth knowledge of the Russian market, we believe there are execution risks in managing step changes to the company's strategy, which include modifying the logistics operations amid a challenging trading environment.

Tougher Retail Competition in Russia
O'KEY will face more intense competition from major market players, who have also aggressive expansion plans and have identified hypermarkets as one of their target areas of growth. We believe that this further expansion from competitors will translate into pressure on operating margins for all retailers, particularly as they use pricing as a factor to attract consumers whose spending power should remain subdued in 2015.

Expansion into New Regions
Although O'KEY has been successful in one of the most competitive regions in Russia (St. Petersburg - 42% of group sales in 2014), there are execution risks embedded in its expansion plans into other regions in Russia where consumer purchasing power and infrastructure are less developed. In addition, O'KEY will be launching its new convenience store format, which we expect will negatively impact group profit margin in 2015 before improving in 2016.

Negative Free Cash Flow
We project that O'KEY will be able to finance more than 50% of its capex with internally generated cash flows. However, we expect O'KEY to show negative free cash flow (FCF) over the next four years, averaging 4% of net sales per annum, due to its large expansion programme and a dividend pay-out of up to 25% of group net profit. This is mitigated by O'KEY's proven access to both bank and capital markets and its ability to obtain trade creditors' financing for its working capital as sales continue to grow.

Key Russian Hypermarket Operator
The group's positioning in the fast-growing hypermarket format enables O'KEY to capture the structural shift towards modern food retail chains in Russia. The group has shown reasonable resilience during the 2008/9 economic downturn. In addition, operating performance in terms of sales per sq m compares positively against other food retailers: RUB272,000 for O'KEY vs. RUB246,000 for X5 Retail Group and RUB277,000 for Lenta for 2014.

RATING SENSITIVITIES

Negative: Future developments that could lead to a negative rating action including, including the Outlook being revised to Negative, are:
- A sharp contraction in like-for-like sales growth relative to peers
- Material failure in executing its expansion plan
- EBITDAR margin erosion to below 9% (FY14: 9.9%)
- FFO-adjusted gross leverage remaining above 4.5x on a sustained basis
- Deterioration of liquidity position as a result of high capex and weakened capital market in the country

Positive: Future developments that could lead to a positive rating action are
- Solid execution of its expansion plan and positive like-for-like sales growth relative to peers
- Maintaining current market position in Russia's retail sector
- Ability to maintain the group's EBITDAR margin of at least 9.5%-10%
- FFO-adjusted gross leverage below 3.5x on a sustained basis
- FFO fixed charge coverage around 2.0x on as sustained basis

LIQUIDITY AND DEBT STRUCTURE

At end-2014 about 60% of O'KEY's debt was long-term (RUB19bn) while most of the remainder was short-term under one-year revolving credit facilities for which the company has a consistent track record of annual renewal. Combined with strong operating cash flow expected in FY15 we believe that liquidity sources are sufficient both for debt servicing and for financing O'KEY's expansion plans.

The latest bonds issue will improve headroom under the company's undrawn credit facilities. Available unrestricted cash totalled RUB5.4bn as of end-2014 and undrawn committed credit facilities amounted to RUB5.6bn as of end-2014.