Fitch Downgrades Honghua to 'B'; Outlook Negative
The downgrade reflects deterioration in Honghua's profitability and cash flow generation during the difficult operating environment for the oil and gas sector in 1H15. Its rapidly declining revenue has led to shrinking operation scale. The non-core offshore and service business segments continued to be unprofitable. As a result, EBITDA fell sharply by 62% yoy in 1H15. We expect its FFO-adjusted net leverage to remain above 4x and its FFO fixed-charge coverage at 1x-2x for the next 12-36 months.
The Negative Outlook reflects low visibility of the oil and gas industry trough, which could lead to further weakening in the Honghua's operations. In addition, counterparty risks could delay the deleveraging process and lead to short-term liquidity pressure.
KEY RATING DRIVERS
Adverse Operating Environment: The continued fall in global oil prices has negatively affected the oil and gas value chain. As major producers scale back on capex and operating activities, Honghua's operation is challenged by both shrinking order book and margin pressure. We expect the weak operating environment to persist. Hence, Honghua's business performance is unlikely to rebound to the previous peak in the next 12-18 months.
Weak Demand for Land Rigs: Sales of Honghua's land drilling rigs declined by 45% yoy in 1H15, with sales primarily sustained by replacement demand. Parts and components sales fell by 30% with operating margin squeezed to 0.5% in 1H15 from 5.1% in 1H14, which was worse than we expected. Overall, these two core segments accounted for 94% of the total revenue in 1H15. Given muted new demand, we expect new orders to stay at a low level.
Unprofitable Non-Core Business: The offshore drilling rig segment continued to post operating losses in 1H15. Honghua has yet to establish itself in this market. Fitch believes it will be difficult for this segment to break even in the medium term, given the intensifying competition and tough operating environment for its downstream clients. Meanwhile, the oil and gas engineering services segment is likely to continue to record operating losses as the rates continue to decline.
Liquidity Not an Immediate Concern: Honghua's working capital requirements will decrease significantly over time as its overall business operation scales back rapidly, , though at a slower pace than the decrease in revenue. The cash freed up from the reduction in working capital would then help Honghua meet immediate liquidity needs. However, this would be jeopardy if its clients extend their payment cycles or fail to meet their obligations.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Honghua include:
- Revenue to stabilise from 2017 onwards
- Working capital requirement to reduce significantly following the falling revenue
- Margin for core operating segments to remain stable
- Non-core operating segments to maintain positive operating cash flow
RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, result in negative rating action include:
- Further material decline in revenue on a sustained basis
- Negative free cash flow generation on a sustained basis
- Increasing pressure on liquidity
Positive: Future developments that may, individually or collectively, result in the rating Outlook being revised to Stable include:
- The company avoids breaching negative rating guidelines over the next 12-18 months
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