OREANDA-NEWS. Fitch Ratings has affirmed Russia-based Joint Stock Company Federal Passenger Company's (FPC) Long-term Issuer Default Rating (IDR) at 'BB+' with Negative Outlook. A full list of rating actions is available at the end of this commentary.

The ratings continue to be driven by FPC's strong ties with state-owned parent, JSC Russian Railways (RZD, BBB-/Negative), and its domestic monopoly in long distance rail. FPC is dependent on subsidies and given its important public function in providing affordable long-distance rail transportation, Fitch expects FPC to continue to benefit from considerable operational and financial support from both RZD and the Russian Federation (BBB-/Negative).

The Negative Outlook mirrors RZD's Outlook, which in turn reflects that of the Russian Federation. Rating actions on RZD are likely to be replicated in FPC's ratings with a one notch differential.

KEY RATING DRIVERS

One Notch below RZD's IDR
FPC's Long-term IDR continues to be notched down by one level from that of RZD in accordance with Fitch's Parent and Subsidiary Rating Linkage Methodology given the company's strong legal, operational and strategic ties with RZD and, indirectly, with the state. The strong ties are evidenced by RZD's 100% direct ownership of FPC, its control over FPC's strategy, and inter-dependency of operations.

FPC holds a monopoly in long-haul rail transportation and continues to receive sizeable subsidies (RUB23.3bn in 2014) from the federal budget in compensation for state-regulated below-cost tariffs. RZD in 2014 contributed new equity to FPC of RUB12.8bn, comprising RUB8.3bn assets and RUB4.5bn cash; however, we note that the capital injection was accompanied by dividend payment of RUB4.1bn from FPC.

FPC is considered a principal subsidiary according to the terms of RZD's eurobonds documentation, as its revenue equals to 10.3% of RZD's total revenue and, as a result, meets the 10% threshold. Therefore, FPC's obligations could be captured within RZD's cross default provision. However, Fitch has not aligned FPC's ratings with RZD's owing to the absence of explicit guarantees and also because FPC's revenue could fall below the 10% threshold.

Highly Dependent on Subsidies
FPC receives subsidies in compensation for insufficient state-regulated tariffs. Excluding subsidies, FPC is deeply loss-making, generates material negative free cash flows (FCF) and is economically unviable on a standalone basis. FPC's unregulated business is not sufficiently profitable or cash-generative to offset losses generated by its regulated business.

While losses incurred at the EBITDA level (excluding subsidies) have narrowed over 2010-2014, Fitch expects EBITDA will remain under pressure given minimal increases in passenger numbers, combined with continued pricing and inflationary cost pressures. Fitch expects management to optimise revenues and to cut some costs through increased staff productivity and asset efficiency, but these alone are unlikely to enable FPC to become financially self-sufficient.

Subsidies do not always compensate the company for operating losses, which can arise where costs are higher than those expected by the state. Fitch expects the state to continue adjusting subsidies where revenue shortfall cannot be met through tariff increases, as was the case in 2014. However, there is no formal retrospective adjustment procedure. Adjustments are at the government's discretion and subject to federal budget constraints.

'B' Category Standalone Rating
Fitch assesses FPC's standalone rating at the 'B' category. The company's inability to generate sustainable operating cash flows, without shareholder support, places the ratings under pressure. This is due to limited passenger growth, as well as pricing and inflationary cost pressures. Funds from operations (FFO) lease-adjusted gross leverage of close to 3x in the medium-term and FFO fixed charge cover of below 3x are commensurate with the 'B' rating category.

The regulatory framework and tariff-setting mechanisms for the company's regulated business are less transparent and predictable than some international peers'.

FFO Lease-Adjusted Leverage and Coverage
Fitch adjusts FPC's FFO leverage and coverage credit metrics for locomotive payments to more accurately compare FPC with rail peers such as Deutsche Bahn AG ('AA'/Stable) and PKP Intercity S.A. ('BBB'/Stable), which purchase their locomotives. Lease payments relating to the use of locomotives are capitalised using a 5x lease multiple, instead of the 8x multiple usually used for Russian rail companies. The lower multiple reflects the flexibility of these locomotive payments. FPC only pays for the use of locomotives when the locomotive is in operation. Payments do not have specific tenors or contracts typical of ordinary leases.

Domestic Monopoly
FPC is strategically important to Russia given its monopoly in long-distance passenger rail transportation, with a share of over 90% of long-haul passenger transportation in 2014. The importance of FPC's rail network is further illustrated by the country's significant geographical size and extreme climate conditions. In certain areas, inadequate motorway and aviation infrastructure often means FPC's rail network is the only form of transportation available. Further plans to develop high speed rail have been postponed owing to the current difficult economic environment in the country.

Increasing Airline Competition
The share of airline traffic in long-haul passenger transportation increased to 46% in 2014 from 33% in 2010. While air travel is likely to pose a continuing and increasing threat, FPC is likely to remain the main carrier of long-haul passengers over the medium-term as Russia does not currently have adequate airport infrastructure to accommodate increasing demand.

Weakening Credit Metrics
Fairly high capex of about RUB19.4bn on average over 2015-2017 will result in continuing negative FCF. As a result, net debt/EBITDA is likely to rise to around 1.4x by 2018 from 0.4x in 2014. However, this would still be well below the external covenant of net debt/EBITDA of 3.0x. We do not expect the company to scale back its capex plans, as the company's assets are rather old.

Volumes under Pressure
Passenger turnover continued to decline in 2014 and 1H15 (by 11.6% yoy and 11.4% yoy respectively) mainly due to deterioration of the Russian economy, declining purchasing power of population as well as cancellation of unprofitable trains. The unregulated segment declined by 14% yoy in 2014 compared with 7% in regulated segment. As a result, the share of the regulated segment in total passenger turnover rose to 62% in 2014 from 59% in 2013.

In the medium term we expect rail passenger turnover volumes to remain under pressure on the back of a drop in real income, increasing support of air transport from the state as well as growing competition from air and motor transport.

RATING SENSITIVITIES

Negative: Future developments that could lead to negative rating action include:
- A downgrade of RZD's ratings, assuming the parent links do not strengthen at the same time.
- Evidence of weakening ties with RZD (and indirectly the state) including but not limited to reduced financial support in the form of insufficient subsidies, tariffs or equity injections such that net debt/EBITDA exceeds 1.5x.

Positive: Future developments that could lead to positive rating action include:
- RZD's Outlook being revised to Stable or a positive change in RZD's ratings, unless FPC's links with RZD weaken.
- Guarantees by RZD of a substantial portion of FPC's debt, which would imply stronger legal ties with RZD.

For the rating of RZD, the following sensitivities were outlined by Fitch in its rating action commentary of 1 March 2015:
Negative: Future developments that could lead to negative rating action include:
- Fitch expects to continue aligning RZD's IDR with Russia's, given the strength of government links. Therefore, Fitch is unlikely to downgrade RZD before downgrading Russia. However, sustained FFO net adjusted leverage above 3.5x and FFO fixed charge coverage below 4x may be negative for RZD's ratings unless further evidence of state support is provided.

Positive: Future developments that could lead to positive rating action include:
- A positive change in Russia's rating may be replicated in RZD (up to BBB level), unless its links with the State weaken

LIQUIDITY AND DEBT STRUCTURE

At end-2014 FPC had cash of RUB10.7bn, which comfortably covered short-term debt of RUB2.6bn as well as most of the 2015 negative FCF of around RUB10bn (as calculated by Fitch). However, these cash financing requirements are largely expected to be funded by additional debt and not through existing cash balances. The company also has undrawn credit facilities of RUB19.3bn. FPC does not pay commitment fees for these facilities, which is a common practice in Russia. Fitch does not include them in its liquidity analysis.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
- Domestic GDP decline of 3.5% in 2015 and growth of 1%-1.5% in 2016-2017 and inflation of 11.2% in 2015 and 6%-8% over 2016-2017
- Passenger turnover deterioration of about 2%-9% over 2015-2018
- Tariff growth below CPI level
- Capital expenditure and subsidies in line with management's forecasts

FULL LIST OF RATING ACTIONS

Long-term foreign currency IDR affirmed at 'BB+' with Negative Outlook
Long-term local currency IDR affirmed at 'BB+' with Negative Outlook
Short-term foreign currency IDR affirmed at 'B'
Short-term local currency IDR affirmed at 'B'
Long-term National Rating affirmed at 'AA+(rus)' with Stable Outlook.