OREANDA-NEWS. Fitch Ratings has affirmed UK-based National Express Group Plc's (NEX) Long-term Issuer Default Rating (IDR) and senior unsecured ratings at 'BBB-'. The Outlook on the Long-term IDR is Stable.

The affirmation reflects NEX's stable operating performance for 2014, which was in line with Fitch's expectations. NEX's ratings reflect the company's continued strong position in the Spanish and UK coach and bus markets as well as the US school bus markets. The company is well diversified relative to peers, with operations in local bus, school bus, coach and rail markets in the UK, Spain and Germany in Europe and the US in North America.

NEX's leverage is high for the rating (measured on a Fitch-adjusted funds from operations (FFO) basis) as a result of a large acquisition in 2012 and changes in its UK businesses. We expect the company's ability to consistently produce positive free cash flow along with a robust fixed-charge cover and a reduction of leverage to support the ratings.

KEY RATING DRIVERS
Solid Business Profile
NEX has a degree of diversity in terms of both geographical markets (UK, US, Spain, Germany, Morocco and Bahrain) as well as the sectors it operates in, including local buses, school buses, coach and rail. This mix of operations allows the company to take advantage of more consistent contract-based markets, such as US school buses and UK rail, offsetting the more cyclical markets, such as coach markets in the UK and Spain.

Stable Operating Performance
Group revenue was slightly below forecast in 2014 due to NEX's largest two divisions, North America and Spain, experiencing difficult operating environments. However, operating profit for 2014 remained stable, increasing by 0.1%, as the UK Bus and UK Coach division experienced improved margins (by 70bps and 90bps respectively) resulting in an overall 10bps increase in Group margins. Both revenue and operating profit for 2014 slightly increased on a constant currency basis (by 2% and 4% respectively), reflecting the strengthening of sterling against the euro and US dollar.

High Leverage for Ratings
For FY2014, the company's FFO adjusted net leverage was 3.7x, which was comparable with FY2013 but weaker than the agency's forecast for 2014 by around 0.2x. This weakness was primarily due to higher restricted cash adjustment for the new c2c rail franchise. NEX's FFO adjusted net leverage in FY2014 was above Fitch's negative rating guidance of 3.0x on a sustained basis. Fitch forecasts that NEX's leverage will trend towards 3.0x over the next four years as a result of an improving operating environment and continued cost efficiencies taking effect. The company's 'BBB-' rating is supported by this forecast reduction in leverage, FFO fixed charge cover being well above the minimum guidance of 2.5x and Fitch's expectation of consistent positive free cash flow generation.

Stable North American Earnings
NEX earns approximately 30% of its operating profit from the North American school bus and transit division. Revenue from this division fell by 4% in 2014 but actually improved 1.2% yoy on a constant currency basis. This small improvement was a result of improved pricing on contracts and the effects of first-time contributions from recent bolt-on acquisitions. The operating margin declined by 0.1% driven by cost savings and improved terms on new and existing contracts not fully offsetting the USD6m impact of difficult weather conditions in 1H14.

The contract-based nature of NEX's North American divisions provides steady and consistent cash flows, and we view this division as an important contributor to the company's overall performance. We forecast NEX to have stable contract churn rates, with fuel costs benefiting from hedging or contractual pass-through. We forecast low-single digit growth of operating profit in the short to medium term as the company looks to further expand this division through future bolt-on acquisitions.

Strong Competition in Spain
NEX's largest division is its Spanish operations, which contributed 37% of group operating profit in 2014. Revenue in this division fell by 5% and the operating margin dropped by 3% in 2014 compared with 2013 as a result of continued difficult economic conditions, aggressive intercity competition from rail and industrial action in 1H14. However on a local currency basis revenue was flat, reflecting a number of contract renewals and wins in Spain, and solid growth in the division's Moroccan market.

Stable UK Bus and Coach
The UK bus and coach businesses have been performing well, driven by moderate pricing growth, continued volume growth and benefit from cost savings offsetting inflationary pressures. The key risk for the UK bus business is the potential for franchising of regional markets following the expected devolution of transport powers to regional authorities. Franchised bus businesses typically have 200-400bps lower operating margins compared with NEX's existing UK bus business. While franchising would also likely reduce the revenue risk, this would be rating negative in our view, as historically the underlying revenue profile has been quite stable. However, this is a medium-term risk as the process of potential devolution followed by franchising will likely take two to five years.

Growing Rail Business, Limited Cash Benefit
NEX's rail business could grow significantly with any further wins in the UK or German rail market. NEX currently operates the Essex Thameside rail franchise in the UK and the RME franchise for regional rail in Germany. NEX is bidding for the East Anglia franchise in the UK and intends to bid for regional rail contracts in Germany. Due to the bidding and start-up costs, we expect the operating profit contribution from the rail division to decline significantly in the near term. Under the franchise contracts, the parent company's ability to receive cash from the rail franchise is limited to dividends. We do not expect NEX's existing and any new rail franchise to pay dividends in the near term.

RATING SENSITIVITIES
Positive: Future developments that could lead to positive rating action include:
- FFO adjusted net leverage consistently below 2.5x (FYE14: 3.7x)
- FFO fixed charge cover consistently in excess of 3.0x (FYE14: 3.2x)
- Continued sustainable positive free cash flow

Negative: Future developments that could lead to negative rating action include:
- We expect FFO adjusted net leverage to trend towards 3.0x. A reversal of this trend may result in negative rating action
- FFO fixed charge consistently below 2.5x
- Negative free cash flow

LIQUIDITY AND DEBT STRUCTURE
Adequate Liquidity
As at 31 December 2014, reported unrestricted cash and cash equivalents were GBP80.9m and undrawn credit facilities were GBP416m, compared with short-term debt obligations of GBP26.7m. The company has a healthy debt maturity profile with no significant maturities until 2017 when its seven-year GBP350m bond falls due. NEX also amended and extended its GBP400m revolving credit facility to a GBP416m facility due in November 2019 from July 2018. Free cash flow is expected to be neutral to positive in the near term, providing further support for NEX's ratings.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- UK bus and UK coach - steady organic growth in revenue and small margin improvement due to ongoing cost structure efficiencies
- North America - significant growth in 2016 and 2017 as the company makes bolt-on acquisitions
- Spain coach and bus - steady organic growth until 2016 when significant contract renewals occur at expected lower margins, resulting in a drop of operating profit in 2017
- UK Rail - profit to turn negative as bid costs moved above the profit line, no further franchise wins or losses expected and gradual steady growth as German rail profitability improves
- Dividends to remain above GBP50m as the company continues its policy of paying a dividend that is covered approximately twice by its non-rail earnings