Fitch Downgrades Zalagh Holdings to 'B(mar)'; Stable Outlook
The downgrade of the National long-term rating to 'B(mar)' follows sharply weaker-than-expected 2014 financial results, due to circumstances that were largely outside of management's control, such as congestion at the main port of Casablanca affecting its grain trading activities and oversupply in downstream turkey slaughtering. The downgrade also reflects our expectation that the pace of recovery will be gradual, thereby leading to a financial leverage that, if maintained, would result in the capital structure being unsustainable. This could drive further negative rating actions, including a change in the Outlook to Negative.
The Stable Outlook captures our view that, at this point in the industry cycle, Zalagh should be able to demonstrate stronger results supported by growing volumes, its large investments underway and its efficiency plan. However, infrastructure bottlenecks and disruptive competition down the value chain will continue to lead to a volatile earnings profile.
Despite the rating downgrade, near-term liquidity is supported by continuing access to bank financing, the bond placement and private placement in 4Q14 and, more recently, by the equity injection by Seaboard Corporation (MAD176.2m equivalent to USD18.2m) for around 12% of Zalagh shares, which served to strengthen the balance sheet.
KEY RATING DRIVERS
Worse-than-Expected Market Conditions
Zalagh was impacted in 4Q14 by bottlenecks in the port of Casablanca (leading to unexpected higher costs at its commodity trading business Graderco) and record low gross margins in its slaughtering unit due to strong increase of turkey production (eg. day-old poults) and imports in Morocco.
While we expect port infrastructure to continue to weigh on trading activities in 2015, Zalagh has started to pass on increased costs to customers; therefore we expect a gradual improvement in trading profitability towards the end of 2015 and more strongly in 2016.
Intact Business Model
Zalagh's asset-heavy business model remains intact despite competition from players in certain business lines characterised by low-to-moderate barriers to entry such as turkey slaughtering. As inefficient competitors are forced to exit driven by unattractive profitability, Zalagh should emerge in a stronger position and start to benefit from greater scale and efficiencies derived from investments (around cumulative MAD400m from 2013 and expected until 2016) in trade and animal feed as well as further down the value chain.
Mixed Business Risk Profile
Zalagh is considered a price-taker in the international commodity markets that trade in US dollars, although it is largely a price-setter in animal feed domestically given its leading position. Transactional FX mismatch is expected to grow as Zalagh expands its feed operations domestically, but this is mitigated by its proven pass-through mechanisms, and by most of its debt being in domestic currency.
Competition is more acute in slaughtering and meat processing as seen in 2014. However, Zalagh's key competitors are not self-sufficient in procurement and, hence are more exposed to raw materials price volatility and sharp supply/demand imbalances in the poultry sector than Zalagh.
We expect opportunities for further penetration of poultry production and demand. However, supply/demand balance will remain volatile as production remains largely disorganised in Morocco. Also, any potential benefit from market growth is subject to local regulation changes in favour of integrated poultry producers such as Zalagh.
No Significant Deleveraging before 2017
Zalagh's leverage at end-2014 was high with readily marketable inventories (RMI)-adjusted funds from operations FFO gross leverage of around 20x, which was above levels compatible with the previous rating. While we expect some improvement in 2015, we expect financial leverage to remain elevated due to further deteriorating (or highly volatile) cash flows under our rating case projections.
In the absence of further cash preservation measures, for example, lower capex or dividend outlays, or if the market recovery takes longer-than-expected, Fitch will view the leverage profile as unsustainable.
Weak Liquidity despite Equity Injection
Zalagh has sufficient liquidity at the consolidated level, but is weighed down by its downstream activities. Fitch expects free cash flow (FCF) to remain negative in 2015 due to high capex (which however can be scaled back in case of need). The recent equity contribution of MAD176m will also support near-term liquidity that was further bolstered by the MAD350m bond issued and MAD125m private placement in 4Q14, allowing for greater funding diversification. Zalagh expects to receive around MAD180m in VAT refund (butoir TVA) from the government over three years.
Overall, the company's Fitch-defined unrestricted cash balance and estimated liquid inventories plus receivables (RMI) as of end-December 2014 amounted to around MAD650m, along with undrawn revolving credit facilities of MAD600m. Considering the recent equity injection, available liquidity is just sufficient to cover short-term maturities of MAD1.6bn in 2015 (primarily represented by rollover of working capital lines).
Excluding external sources of liquidity, Zalagh's internal liquidity (defined as unrestricted cash+RMI+account receivables divided by total current liabilities) is rather weak at around 0.6x but in line with the ratings.
Restricted Financial Flexibility
We expect RMI-adjusted FFO fixed charge cover (adjusted for the share of dividends paid by Zalagh used to service debt at Greenlight Holding - an acquisition vehicle used by the Chaouni family to acquire Zalagh's shares as part of a buyout in 2011) to remain weak at 0.7x for 2015 before rising towards 1.2x in 2017 if profits rebound as expected, and more in line with the ratings.
In our assessment we consider the related portion of dividends paid to the controlling shareholders as a fixed charge obligation of Zalagh as Greenlight Holding does not receive income from any other activities. Debt borrowed at Greenlight Holding does not feature any cross-default with Zalagh's own indebtedness.
Solid Local Market Position
Zalagh's ratings continue to reflect the group's strong position in agri-business in Morocco as the only fully integrated producer across the entire industry value chain. The group has fairly significant storage capacities throughout the country, allowing it to secure 22% of national imports of soft commodities, which is a key rating consideration.
KEY DRIVERS FOR THE BOND
Structural Subordination for Holding Creditors
The MAD350m bond issue is an unsecured, unguaranteed debt obligation of Zalagh. Bondholders do not have direct recourse to the main opcos' assets or profits but only an unsecured claim on intercompany loans in such opcos. The bond rating therefore reflects such structural subordination for bondholders relative to creditors at subsidiary level.
Weak Recovery Prospects
Under our bespoke recovery analysis, we consider that expected recoveries upon default would be maximised in a liquidation scenario rather than in a going-concern restructuring given Zalagh's large asset base. Taking into account the new debt structure post-bond issue and private placement, and following a strict payment waterfall, Fitch estimates that the recovery rate for the bond would fall within the 0-10% range, resulting in an instrument rating of 'CCC+(mar)', two notches below the National Long-term rating of 'B(mar)'.
Weak recovery prospects are exacerbated by the presence of sizeable senior or secured liabilities at opco level, which rank senior to holding company creditors.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Zalagh include:
-Volume growth to accelerate by 2017, driven by additional capacity investments in 2014, 2015 and 2016 but largely offset by weak pricing
- EBITDA margin to increase from current trough towards 6% and RMI-adjusted EBITDA/RMI-adjusted gross profit of 40% by 2017 (2014: 27%), resulting from stabilisation in market conditions and management's efficiencies plan
-Working capital to normalise in line with historical average
-Capex driven by capacities expansion within chick hatchery, pout and turkey broiler and animal feed capacity in 2015 and 2016 moving towards maintenance levels thereafter.
-Flat dividends of MAD72m per annum
-Liquidity supported by access to renewable bank lines
RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- Improvement in profitability measured as RMI-adjusted operating EBITDAR/ gross profit above 40%, together with FCF returning to break-even or positive territory, underpinning internal liquidity - defined as cash+RMI+accounts receivables divided by total current liabilities - of more than 0.5x (excluding committed bank lines).
- RMI-adjusted FFO fixed charge cover (including apportioned dividends to cover Greenlight's debt service) above 1.2x (2014: 0.7x)
- FFO adjusted leverage below 7.5x (RMI-adjusted FFO leverage below 6.5x) for more than two consecutive years
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Weak profitability (EBITDA margin under 3% or RMI-adjusted operating EBITDAR/ gross profit below 30%) along with recurring negative FCF, reflecting a longer-than-expected market recovery or continuing large working capital or capex outlays necessitating increasing external financing.
- Weak internal liquidity of less than 0.5x (excluding available bank lines).
- RMI-adjusted FFO fixed charge cover (including apportioned dividends to cover Greenlight's debt service) of 1.0x or lower on a sustained basis.
- FFO adjusted leverage of more than 11x (RMI-adjusted FFO leverage greater than 10x) for more than two consecutive years, reflecting an increasingly unsustainable capital structure.
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