OREANDA-NEWS. Fitch Ratings has published French sugar company Tereos Union de Cooperatives Agricoles a Capital Variable's (Tereos) Long-term Issuer Default Rating (IDR) of 'BB' with Stable Outlook. Fitch has also published its senior unsecured rating of 'BB' on Tereos Finance Group 1's EUR500m bond due 2020.

The IDR of 'BB' reflects Tereos's strong business profile that is offset by its weak credit metrics. The company's strong market position is supported by well-invested assets, access to some of the higher-yielding sugarbeet regions in Europe and diversification in terms of geography and raw materials processed. The cooperative ownership profile also contributes to Tereos's conservative financial policies.

The current low point in the price cycle of the world sugar market, which is compounded by a transition to a new pricing environment in the European Union, results in a challenging operating environment for the sector. Therefore the ratings factor in our expectation that Tereos's credit metrics will bottom out in the financial year ending March 2016 (FY16) before gradually recovering thereafter.

KEY RATING DRIVERS
Strong Business Profile
Tereos's IDR is underpinned by the company's strong business profile for the 'BB' category, both in operational scope and position in commodity markets with potential for long-term growth. At its core, Tereos is a top three player in the European sugarbeet industry. Due to its strong market shares and cost competitiveness, we expect the group to benefit from the post-2017 deregulated European sweeteners market. Geographic and product diversification as well as efforts to increase efficiency also support Tereos's business risk profile.

Successful Diversification: Sugarcane and Cereals
Tereos's diversification into the highly cost competitive Brazilian sugar market and into cereals through its 69%-owned subsidiary Tereos Internacional (TI; 55% of FY15 group EBITDA) should aid resilience against the current downward commodity cycle. The Brazilian sugarcane operations have benefited from a large capacity and efficiency investment programme, which Fitch expects to boost the unit's contribution to group EBITDA and cash flows.

The company's cereals unit revenues and profits (17% of FY15 group EBITDA) is exposed to muted performance over the next three years due to the challenging European sweetener and ethanol markets environment. However, the unit should see lower volatility as a result of the ongoing cost savings measures, improved raw materials and geographical diversification and an increased sales mix towards higher-margin products.

European Sugar Price Adjustment
Similar to other European sugar processors, Tereos's European sugarbeet business has suffered a sharp contraction. Its EBITDA more than halved between FY13 and FY15, following a steep decline in EU quota sugar prices largely linked to the intervention of the European Commission in 2013.

We believe the end of the European sugar quota regime in 2017 will cause quota sugar prices to converge towards international prices, which we expect to only marginally recover from their current low levels over the next two to three years as global stock-to-use ratios slowly decline. In this context, the 'BB' rating factors in our expectation that Tereos's consolidated EBITDA will decrease by approximately 40% to 50% between FY14 and FY16 (FY15 vs. FY14: down 38%).

European Sugar Export Cap
European sugar processors currently are unable to compensate low prices with increases in sales volumes due to stagnant European demand and regulatory constraints on foreign exports until September 2017. However, as the third-largest European sugarbeet player and one of the most efficient, once the cap is lifted, Tereos should benefit from its ability to source increased volumes of sugarbeet from some of the most efficient farmers in Europe and expand its sales volumes in Europe and via exports.

Expected Profit Trough
Tereos's underlying profitability, measured as readily marketable inventories (RMI)-adjusted EBITDA/gross profit (thus eliminating price fluctuations), should remain below 40% until at least FY17 due to volume constraints in its sugarbeet division. Beyond 2017, Tereos's profitability should benefit from management's ongoing initiatives to improve the group's competitiveness and, with the removal of the EU sugar regime, better flexibility on sugar beet prices as well as sugar production growth in Europe.

Beyond these considerations, Fitch believes that the extent of the recovery of the company's European and international EBITDA generation capacity remains partly reliant on the final configuration of the European sweeteners industry and the timing and pace of recovery in world sugar prices.

Weak Credit Metrics; Anticipated Improvement
We project Tereos's RMI-adjusted funds from operations (FFO) gross leverage to peak in FY16, at above 5.0x (FY15: 4.8x) as a result of reduced FFO and RMI value, in conjunction with limited scope for debt reduction. We also expect negative annual free cash flow (FCF) until FY17 as subdued profits would not be fully offset by an expected decline in capex driven by the end of the sugarcane and cereals investment cycles.

Although the expected deterioration would not be consistent with the current IDR, we expect Tereos's credit metrics to subsequently improve on a combination of a modest upturn in commodity prices, a strengthened business profile and an increase in sugar export volumes. We expect FCF to turn neutral to positive from FY18 and RMI-adjusted FFO gross leverage to decrease to below 4.0x in the same year, consistent with levels for a 'BB' rating.

Adequate Financial Flexibility
Tereos's weak credit metrics is partially mitigated by adequate financial flexibility. The latter is supported by strict financial discipline in shareholder distributions and M&A spending, adequate liquidity management and healthy RMI-adjusted FFO fixed charge cover throughout the downward commodity cycle.

Since the recent downturn in sugar prices, cooperative owners have demonstrated their financial support to Tereos by accepting a sharp reduction in price complements (which Fitch treats as dividends) to EUR5m paid cash in FY15 from EUR57m in FY14. We assume these will remain subdued so long as sugar prices are low.

Tereos's weak internal liquidity score, defined as unrestricted cash + RMI + accounts receivables divided by total current liabilities (0.7x at FYE15), is compensated by comfortable access to diversified sources of external funding. We expect Tereos's RMI-adjusted fixed charge cover to reach a low point in FY16 at 3.7x (TI: 3.2x). These levels remain comfortable for the rating.

Parent-Subsidiary Linkage
Despite limited but growing operational and financial integration, Tereos France's (TF) and Tereos's influential control as well as their legal and strategic ties with TI are very strong, making the parent and its subsidiary intrinsically linked. The development of TI has been promoted by Tereos's cooperative owners through their financial support. This signals a strategy to allocate resources towards international diversification while enabling greater resilience against increasingly volatile commodity markets.

Senior Unsecured Rating Aligned with IDR
The 2020 EUR500m senior unsecured notes issued by Tereos Groupe Finance 1 are guaranteed on an unsecured basis by Tereos, and are therefore subject to structural subordination not only to debt at TF but also at the TI level. TI's debt is non-recourse to TF's assets; therefore we exclude it from the amount of debt ranking above the senior unsecured notes in the payment waterfall in case of default.

However, due to cross-default provisions linking together the debt of TI's subsidiaries, TI, TF and Tereos, Tereos's senior unsecured notes' rating depends not only on TF's and Tereos's probability of default and the potential level of debt ranking ahead of them, but also on TI's probability of default.

Average Recovery Prospects
Due to the strong linkages between TF, Tereos and TI, the senior unsecured notes rating is derived from the consolidated group's IDR of 'BB'. Usually, for issuers rated in the 'BB' category (a transitional territory between investment-grade and highly speculative), prior-ranking debt constituting 2x-2.5x EBITDA indicates a high likelihood of subordination and lower recoveries for unsecured debt.

Although we expect a sharp fall in EBITDA from the sugarbeet business, we believe the level of senior secured (or other form of prior-ranking) debt leverage at TF is unlikely to rise beyond 2.0x within the next three years. We believe TF (or Tereos) is unlikely to increase its debt to support other group entities. In addition, existing committed debt ranking ahead of the senior unsecured notes relates to TF's EUR400m revolving credit facility (RCF), which exclusively funds working capital needs throughout the year. Based on historical intra-year working capital needs, average intra-year outstanding RCF amounts are unlikely to rise beyond 2.0x TF's EBITDA. Therefore the senior unsecured notes are rated at the same level as the group's IDR.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Further decrease in revenues in FY16 mainly driven by falling European sugar prices and weakening of the Brazilian real against the euro.
- Profit trough (EBITDA margin around 8.5%) in FY16, and gradual improvement thereafter.
- Annual capex at between EUR300m and EUR350m.
- Low price complements (dividends) paid to cooperative members so long as sugar prices stay low.
- Mildly negative FCF annually over FY15-FY17; consistently positive from FY18.

RATING SENSITIVITIES
Positive: Future developments that could lead to positive rating actions include:
- Strengthening of profitability (excluding price fluctuations), as measured by RMI-adjusted EBITDAR/gross profit, reflecting reasonable capacity utilisation rates in the sugarbeet business and overall increased efficiency
- At least neutral FCF while maintaining strict financial discipline
- FFO gross leverage (RMI-adjusted) consistently below 3.5x at Tereos group level and 4.0x at TI level.

Negative: Future developments that could lead to negative rating action include:
- Inability to sustainably maintain cost savings derived from its efficiency programmes or excessive idle capacity in different market segments, leading to RMI-adjusted EBITDAR/gross profit remaining weak
- Inability to return to a level of approximately USD0.5bn consolidated FFO (FY15: USD422m) and to improve profitability and cash flow generation
- Reduced financial flexibility reflected in FFO fixed charge cover (RMI-adjusted) below 3.0x,
- FFO gross leverage (RMI-adjusted) sustainably above 4.5x at Tereos group level (5.0x at TI level).