OREANDA-NEWS. Fitch Ratings has affirmed Russia-based Evraz Group SA's (Evraz Group) and holding company Evraz plc's (Evraz) Long-term Issuer Default Rating (IDR) at 'BB-'. The ratings of Evraz's 82% owned subsidiary, Russian coal company OAO Raspadskaya, have also been affirmed at 'B+'. The Outlook on all ratings is Stable. Evraz Group's senior unsecured rating of 'BB-' has also been affirmed. A full list of Evraz Group ratings is available at the end of this commentary.

The rating affirmation reflects Evraz's proven ability to generate positive free cash flow (FCF) through the steel market cycle. This was again demonstrated in 1H15, when despite challenging market conditions, Evraz's financial performance remained strong (USD992m EBITDA, 19% EBITDA margin). We expect this trend to continue in 2H15, assisted by the favourable foreign exchange impact on rouble-denominated costs.

Fitch expects that the company will continue using a significant portion of its FCF for further debt reduction. Funds from operations (FFO) adjusted gross leverage was reduced to 3.5x in 2014 from 5.2x in 2013. Despite the expectation of further absolute debt reduction in 2015 the company's FFO leverage will increase to 3.9x due to market-related drop in EBITDA in the current difficult market environment. Thereafter, leverage metrics should show a downward trend although will remain higher than its main Russian peers.

KEY RATING DRIVERS

Rouble Devaluation Boosts Earnings
Difficult market conditions impacted Evraz's financial performance in 1H15 (15% decrease in EBITDA yoy due to 28% fall in revenues). However, EBITDA margin in 1H15 rose to 19% (+3 points yoy), assisted by the favourable foreign exchange impact on rouble-denominated costs. Overall costs decreased 31% yoy or USD1.6bn, mostly due to RUB/UAH devaluation but also to cost efficiency measures. Fitch expects this trend to continue in 2H15, resulting in USD1.8bn EBITDA and USD650m-USD700m FCF. We expect that the company will use a significant portion of this (USD350m-USD400m) for further debt reduction.

Mixed Outlook for Key End-Markets
Evraz's key domestic Russian end-markets are construction (34% of 1H15 production volumes) and railway products (8%). Around 50% of Russian production is exported in the form of semi-finished products. The near-term outlook for the Russian construction market is weak with forecasts of a 15% yoy fall in demand in 2015. Actual Evraz volumes to date supplied to the construction market have seen a 10% decline. Demand for railway products was also negatively impacted (-31%) following a drop in demand from Russian railcars producers and slower rail sales to other CIS countries (ex. Russia).
Demand for rails in Russia was stable, with only a 5% yoy decline, supported by steady demand for maintenance from Russian Railways.

In contrast, demand for railway products in North America remains robust. Among other North American markets the order book for large diameter energy pipes remains solid, while - in line with its competitors - Evraz's OCTG sales continue to suffer from an inventory overhang in the market and the substantial reduction in capex by E&P companies.

Challenging Price Environment
The significant decline since 3Q14 in steel input costs (iron ore, coking coal and energy prices) and more evidence of deteriorating demand from China have put steel prices under pressure globally. Separately, the negative outlook for the Russian economy (sanctions, oil prices, etc) has triggered a steep depreciation of the rouble, hurting domestic steel products' prices in dollar terms (prices of Evraz's domestic finished products dropped 24% on average in 1H15 yoy). Fitch expects this dynamic to continue in 2H15 (in line with 1H15) despite higher price inflation as a result of the weaker rouble.

Raspadskaya Ratings Linked to Evraz
Stronger ties between Evraz plc and Raspadskaya developed after Evraz increased ownership to 82% in January 2013. The companies have since merged several support departments, such as treasury, logistics and other operations to increase synergies. Evraz also refinanced all of Raspadskaya's bank debt in 3Q13. Evraz remains a top-three offtaker for Raspadskaya, which plays a crucial part in Evraz's integration into coal. Despite these factors a one-notch differential remains appropriate and reflects the absence of formal downstream corporate guarantees for Raspadskaya's debt from Evraz.

High Raw Material Self-Sufficiency
Evraz Group benefits from high self-sufficiency in iron ore and coking coal, including supplies of coal from its subsidiary Raspadskaya. Consequently, it is better placed across the steel market cycle to control the cost base of its upstream operations than less integrated Russian and international steel peers. The cash cost of slab production at Evraz's Russian steel mills is estimated to have fallen by around 50% in absolute terms since 2012, reflecting a combination of operating cost efficiencies and the fall in value of the rouble, which have enabled the company to maintain full plant capacity utilisation.

Corporate Governance
We regard Evraz's corporate governance as reasonable compared with its Russian peer group, but we continue to notch down the rating by two notches relative to international peers. This notching-down factors in our view of company-specific corporate governance practices but also the higher-than-average systemic risks associated with the Russian business and jurisdictional environment.

KEY ASSUMPTIONS

-USD/RUB exchange rate: 63 in 2015, 60 in 2016 and 2017
-Slight decrease in steel sales volumes in 2015 (-2.6%), progressive recovery thereafter (+1% in 2016 and +2.4% in 2017 and 2018)
-Steep decrease in coal sales volume in 2015 (-8%), steady growth thereafter (+2% in 2016-2018)
-Sharp decrease in prices of steel products and coal in 2015 (-22% for steel and -13% for coal), steady increase thereafter
-USD587m capex in 2015, USD600m each in 2016 and 2017
-No dividends payments in the forecasted period, no share buybacks

RATING SENSITIVITIES
Evraz plc/ Evraz Group SA

Positive: Future developments that could lead to positive rating actions include:
-Further absolute debt reduction with FCF; FFO gross leverage moving sustainably below 3.0x
-FFO-adjusted net leverage sustained below 2.5x
-Sustained positive FCF
-Operational performance in Russia remaining within expectations including the Russian construction market declining 10% 2015 and being flat in 2016

Negative: Future developments that could lead to negative rating action include:
- FFO-adjusted gross leverage above 4.0x by end-2016 or sustained above 3.5x
- FFO-adjusted net leverage sustained above 3.0x
- Persistently negative FCF
- Failure to extend debt maturities falling due in 2017 and 2018

OAO Raspadskaya

Positive: Future developments that could lead to positive rating actions include:
-Stronger operational and legal ties with Evraz, including a corporate guarantee of Raspadskaya's debt, which could lead to the equalisation of the companies' ratings.
-A positive rating action on Evraz plc, which could lead to a corresponding rating action on Raspadskaya.

Negative: Future developments that could lead to negative rating action include:
-Evidence of weakening operational and legal ties between Evraz and Raspadskaya
-A negative rating action on Evraz plc, which could lead to a corresponding rating action on Raspadskaya.

FULL LIST OF RATING ACTIONS

Evraz Group SA
- Long-term foreign currency IDR affirmed at 'BB-'; Stable Outlook
- Short-term foreign currency IDR affirmed at 'B'
- Senior unsecured rating affirmed at 'BB-'

Evraz plc
- Long-term foreign currency IDR affirmed at 'BB-'; Stable Outlook
- Short-term foreign currency IDR affirmed at 'B'

OAO Raspadskaya
- Long-term foreign currency IDR affirmed at 'B+'; Stable Outlook
- Short-term foreign currency IDR affirmed at 'B'
- Long-term local currency IDR affirmed at 'B+'; Stable Outlook
- Senior unsecured rating affirmed at 'B+'/RR4
- National long-term rating affirmed at 'A(rus)'; Stable Outlook.