OREANDA-NEWS. Fitch Ratings has affirmed French-based electrical distributor Rexel SA's (Rexel) Long-term Issuer Default Rating (IDR) at 'BB' and Short-term IDR at 'B'. The Outlook is Stable. Fitch has also affirmed Rexel's senior unsecured rating at 'BB' and its EUR500m commercial paper programme at 'B'.

Rexel's ratings reflect the balance of the company's fairly low-risk business profile as a worldwide leading distributor of electrical products and its weak financial profile. Fitch takes a positive view of the ongoing diversification of group sales outside of mature Europe and towards higher added-value products. Although this is currently affecting margins, it should enhance revenues and profitability over the longer term. Due to remaining uncertainty over the pace of profit recovery, maintaining strong cash flow conversion and a conservative financial policy are key to deleveraging towards levels consistent with the current ratings by 2016.

KEY RATING DRIVERS

Timid Sales Recovery
Organic sales rebounded 1.1% in 2014, following two years of decline. This reflects a strong recovery of the US market (25% of group's 2014 sales) and a milder recovery in Europe, where growth continued to be dragged down by key markets such as France (33% of 2014 European sales).

Fitch conservatively forecasts organic sales growth in the low single digits over the next three years mainly due to likely persistent weaknesses in several core European markets and, to a lesser extent, the negative impact of low oil and copper cable prices (together representing approximately 18% of group 2014 sales).

Operating Margin Pressure
Rexel's EBITDA margin fell to 5.5% from 6.1% between 2012 and 2014. This reflected tough market conditions in higher-margin Europe (6.3% EBITA margin) and concomitant recovery in lower-margin North America (34% of 2014 group sales, 4.6% EBITA margin), negative mix effect from lower-margin projects and operating investments to streamline the group's cost structure.

Fitch expects mild margin recovery towards 5.8% in 2017, supported by low organic sales growth and management's initiatives to optimise group gross margin and the operating cost structure. In addition, completing the announced divestment of certain less profitable businesses and potential economies of scale from acquisitions should support profitability. However, Fitch believes greater margin enhancement remains reliant on a stronger market recovery in Europe.

Free Cash Flow Critical
Fitch expects pre-dividend free cash flow (FCF) margin to remain above 2% in the next three years, a healthy level for the current ratings. Rexel has demonstrated its ability to remain cash flow-generative throughout economic cycles, due to low capital intensity and the countercyclical nature of its working capital needs, combined with tight management.

In 2013-2014 the group maintained a high level of FCF despite a drop in EBITDA, due to resilient cash flow conversion and shareholder support, with 72% of dividend payments made through shares over this period. Fitch expects management to maintain strict financial discipline, supporting average annual FCF generation of EUR240m over the next three years.

Financial Flexibility, M&A Appetite
Rexel's business model is geared towards growing via acquisitions, as opposed to capex. This enables continuing positive FCF generation but makes the pace of deployment of resources for growth less predictable. Overall, Fitch positively views Rexel's acquisition strategy as it should lead to improved product and geographic diversification as well as a higher operating margin (through economies of scale).

However, maintaining a prudent financial policy, which includes a flexible approach towards allocating resources between M&A and cash dividends to cap total cash outlays in a given year, remains a critical safeguard for the ratings. In its 2015-2017 rating case, Fitch has assumed EUR300m acquisition spending and 50% of dividends paid in shares per annum.

Weak Credit Metrics
Rexel's 2014 lease-adjusted FFO net leverage (taking into account EUR959.6m readily available cash) was high at 5.2x and slightly above our negative rating guideline of 5.0x. This high leverage results from high acquisition spending in 2012, followed by two years of difficult economic conditions and initiatives to diversify the group's business model, all resulting in lower profitability.

Under Fitch's current assumptions (mild top-line recovery and a strict financial policy in terms of M&A and shareholder distribution), Rexel should be able to regain some rating headroom from 2015 with lease-adjusted FFO net leverage falling back below 5.0x in 2016. The profile of future acquisitions in terms of spending within the boundaries described above and with potential for group profitability enhancement will be important for sustained deleveraging.

LIQUIDITY AND DEBT STRUCTURE

Liquidity was healthy as of 31 December 2014 with EUR1,160m of cash on balance sheet, of which Fitch considers EUR960m readily available. It is further underpinned by EUR1,060m undrawn committed bank facilities. Rexel also has access to various receivable securitisation programmes and a EUR500m commercial paper programme.

Following the 2013 refinancing Rexel has no major debt repayment before 2019.

KEY ASSUMPTIONS

-Annual sales growth in the mid-single digits driven by a slow recovery in organic sales and acquisitions
-EBITDA margin trending towards 5.8% in 2017 (2014: 5.5%)
-Limited acceleration of working capital outflows due to tight management
-Stable dividend pay-out at EUR0.75 per share, 50% paid in shares over 2015-2017
-Average annual FCF of EUR240m over 2015-2017
-Annual bolt-on acquisitions spending of EUR300m and marginal proceeds from divestments over 2015-2017
- Prepayment of the 7% EUR499m outstanding bond due 2018 in 1Q15

RATING SENSITIVITIES

Positive: We do not expect any positive rating action over the next three years as management's M&A policy - even though we believe it will reinforce the group's business profile and cash generation capacity in the longer term - should prevent any significant deleveraging. Nevertheless, future developments that could lead to positive rating actions include:
-FFO adjusted net leverage below 4.0x on a sustained basis and evidence of resilient profitability
- Continued strong cash flow generation, measured as pre-dividend FCF margin comfortably above 2%

Negative: Future developments that could lead to negative rating action include:
- A large debt-funded acquisition, or a deeper-than-expected economic slowdown with no corresponding increase in FCF (notably due to working capital inflow and dividend restriction) resulting in (actual or expected) lease-adjusted FFO adjusted net leverage above 5.0x for more than two years
- A contraction of pre-dividend FCF margin to below 2% as a result of weaker profitability and/or a less tightly managed working capital
-A more aggressive shareholder-friendly stance leading to an erosion of FCF margin to below 1%.