OREANDA-NEWS. August 10, 2015.  Fitch Ratings has upgraded Peugeot SA's (PSA) Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'BB' from 'BB-'. The Outlook on the Long-term IDR is Stable.

The upgrade reflects the continuous improvement of PSA's profitability and cash generation, its low leverage and our expectations that this strengthening is sustainable. This improvement is illustrated by the better-than-expected 1H15 automotive operating margins (5% in 1H15, up from 0% in 1H14 and 0.2% in 2014), and free cash flow (FCF) margins (9.3% in 1H15, up from 5.1% in 1H14 and 1.8% in 2014).

While we believe that 2H15 and 2016 operating and FCF margins will be weaker than those reported in 1H15, notably because of seasonality, we expect credit metrics to remain commensurate with a 'BB' rating in the foreseeable future, due to the structural improvement of the cost base.

We view PSA's business profile as solidly positioned in the 'BB' rating category although the group remains reliant on Europe and is of a fairly modest size compared with global peers. In particular, PSA has limited potential for synergies on a standalone basis and a strong need for external alliances, notably to lower development costs in a cost- and asset-intensive industry.

The Stable Outlook reflects the headroom in the ratings and incorporates a moderate weakening of automotive profitability in 2H15 and 2016. We acknowledge the group's significant and rapid progress in implementing its turnaround strategy and lowering its breakeven point. However, we also believe that the competitive environment will intensify further as most of PSA's global competitors are also streamlining their cost structures and enhancing their product offering, therefore maintaining pressure on PSA's volume, pricing and need to ramp up investments. A sustained positive track record in maintaining profitability and cash generation will be crucial to considering another upgrade.

KEY RATING DRIVERS

Progress in Restructuring
Strategic measures to streamline the product portfolio and profitably expand international operations as well as cash-preservation and cost-reduction measures have reduced the breakeven point and will support profitability. We project PSA's automotive operating margin to increase to more than 3% in 2015 from about breakeven in 2014 and negative 2.9% in 2013, before adjustments for capitalised development costs.

Recovering FCF
FCF was robust at EUR0.9bn in 2014 and EUR2.7bn in 1H15, in sharp contrast with the cash absorption of EUR1.3bn in 2013 and EUR3.3bn in 2012. It was supported by the strengthening of underlying funds from operations (FFO), substantial EUR1bn and EUR0.9bn inflows from working capital improvements in 2014 and 1H15, respectively, and controlled investments. We expect a reversal of working capital and higher capex to absorb FFO in 2H15 but project FCF margin to remain solid at 1.5%-2% in 2015 and 2016.

Lower Leverage
We expect adjusted net leverage to decline to less than 1x at end-2015 and about breakeven by end-2017 from 1.6x at end-2014 and 4.9x at end-2013, driven by positive FCF, the creation of a joint venture with Santander releasing some equity from Banque PSA Finance, the issue of warrants and the conversion of a convertible by early 2016. This should offset exceptional restructuring expenses, the impact of accelerated capex and the potential resumption of dividend in the medium term.

Modest Sales Recovery
We expect revenue growth to be supported by on-going market recovery in Europe. However, the Chinese market, PSA's largest market, is decelerating sharply and we expect further adverse conditions in several markets including Latin America and Russia. Longer-term, the group's strategy includes a smaller product range and lower discounts, which could hinder substantial volume growth.

Weak Competitive Position
Despite continuous recent improvement, PSA's sales remain biased toward the European market and the mass-market small and medium car segments, where competition and price pressure are fiercest. Competition is also intensifying in foreign markets to which PSA has diversified, including Latin America, Russia and China.

Capital Increase
The French state and Dongfeng Motor have become majority shareholders of PSA, in line with the Peugeot family, each with a stake of 13.75%. The capital increase has benefited the financial profile but the new shareholding structure may present some challenges to coordinate the potentially divergent interests of the various shareholders.

KEY ASSUMPTIONS

- Industrial operations' revenue up by more than 5% in 2015, and 2.5%-3% in 2016-2017;
- Auto operating margin increasing to about 3% in 2015-2016 and increasing towards 3.5% in 2017;
- Capex to increase to about EUR3bn;
-No dividend paid in 2015-2016;
- Cash restructuring costs of about EUR2bn over 2015-2017.

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include
- Larger scale and further diversification in sales, combined with a sufficient track record or confidence that the company can meet the following quantitative guidelines:
- Automotive operating margins above 3% (2014: 0.2%, 2015E: 3.2%, 2016E: 2.9%)
- FCF above 1.5% (2014: 1.8%, 2015E: 1.8%, 2016E: 1.5%)
- FFO adjusted net leverage below 1x (2014: 1.6x, 2015E: 0.7x, 2016E: 0.1x)
- Cash flow from operations (CFO)/adjusted debt above 40% (2014: 28%, 2015E: 46%, 2016E: 53%)

Negative: Future developments that may, individually or collectively, lead to negative rating action include
- Automotive operating margins below 2%.
- FCF below 1%.
- FFO adjusted net leverage above 2x.
- CFO/adjusted debt below 25%.

LIQUIDITY AND DEBT STRUCTURE

Liquidity remains healthy, including EUR10bn of readily available cash and securities for its industrial operations at end-1H15, including Fitch's adjustments. In addition, committed credit lines of EUR3bn at PSA maturing in 2017 and 2019 and EUR1.2bn at Faurecia maturing in 2019 were undrawn at end-2014.