OREANDA-NEWS. Fitch Ratings has assigned Russian retailer Lenta LLC's recently issued RUB5bn bonds a senior unsecured rating of 'BB-'/'RR4' (Recovery Rating) and a National senior unsecured rating of 'A+(rus)'.

Similar to its rouble bonds issued in August 2015, Lenta's new bonds do not feature an irrevocable public offer (akin to a put option) from holding company Lenta Ltd. However, Fitch does not consider these bonds structurally subordinated to other senior unsecured obligations as Lenta LLC is the major operating company within the group, generating 100% the group's revenues and EBITDA and holding close to 100% of the group's assets.

The bond is rated in line with Lenta's Long-term local currency IDR of 'BB-' (which is on Positive Outlook) as prior-ranking debt, represented by a secured loan, is less than 2x (estimated at 0.2x in last 12 months to June 2015) of group EBITDA and we expect the debt mix to remain unchanged over the medium term.

KEY RATING DRIVERS

Average Recoveries for Unsecured Bondholders
The bond rating reflects average recovery expectations in case of default. We have not applied any notching to the senior unsecured rating compared with the Long-term IDR as prior-ranking debt constitutes less than 2x of group EBITDA - the maximum threshold under Fitch's criteria before triggering subordination of unsecured creditors. The company's debt composition has improved substantially after the refinancing of a VTB loan this year as secured debt fell to RUB4.6bn at end-June 2015 (0.2x EBITDA) from RUB37.7bn at end-2014 (1.8x).

Russia's Leading Hypermarket Operator
Lenta's Long-term IDR reflects the company's moderate market position and scale, as Russia's sixth-largest food retailer and third largest large-format operator (after Auchan and Metro) as measured by 2014 sales. Lenta's current small size (EBITDAR of EUR439m in 2014) is mitigated by the company's consistent market share gains, strong growth opportunities and low competition compared with developed markets due to the fragmented nature of the Russian food retail market. A successful execution of its growth strategy will likely strengthen Lenta's market position and scale in the 'BB' rating category.

Limited Format Diversification
Fitch expects the company to remain focused on its hypermarket format over the medium term, with supermarkets accounting for less than 10% of sales by 2018 (2014: 3%). At the same time, Lenta's wide geographic diversification across Russian regions and a continued reduction in reliance on the St. Petersburg market is positive for the credit profile. St Petersburg is one of the most competitive markets in Russia, and accounted for 27% of sales in 2014.

Robust Margins
Lenta has a strong track record of fast revenue growth, driven by both like-for-like (LFL) sales growth and new store roll-outs, while maintaining a strong EBITDA margin. However, our rating forecasts factor in a moderate decline in EBITDA margin to 10%-10.8% (2014: 11.1%) over the medium term as a result of increasing operating lease expenses and gross margin sacrifices to support its price-led business model. These profitability metrics, however, will remain strong compared with Russian and European food retail peers.

Subdued Consumer Sentiment
Hypermarket operators are usually exposed to the high cyclicality of their business. However, Lenta's focus on promotions and its low share of non-food sales in revenues will enable the company to maintain LFL sales growth in the current period of weak consumer spending as customers trade down. We expect this consumer behaviour will prevail in 2015-2016. Erosion of consumer purchasing power should also facilitate customer migration from traditional retail to federal retail chains, such as Lenta.

Low Leverage
Fitch expects Lenta's funds from operations (FFO) adjusted gross leverage to decrease to 3.1x in 2015 (2014: 3.9x), after its holding company Lenta Ltd raised RUB12.6bn net secondary public offering proceeds in March to repay debt and fund expansion at Lenta. Although we expect free cash flow (FCF) to remain negative over the medium term due to planned high capex, further deleveraging to 2.8x-2.9x (FFO adjusted gross leverage) will be supported by growing operating cash flows and maintenance of a negative working capital position. We expect Lenta to fund 70%-80% of capex for 2016-2018 with internally generated cash flows.

Strong Interest Coverage Metrics
Lenta's FFO fixed charge cover (2014: 2.6x) is strong relative to Russian peers as a result of a high proportion of self-owned selling space, which leads to low operating lease expenses. We expect FFO fixed charge coverage to remain strong for the ratings, despite increased cost of funding and planned growth of leased space due to new supermarket openings.

LIQUIDITY AND DEBT STRUCTURE

At end-June 2015 unrestricted cash of RUB12.1bn, together with available committed undrawn credit lines of RUB7.3bn, were sufficient to cover expected negative FCF and RUB16.3bn short-term debt.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
- Annual revenue growth of close to 30% driven by high single-digit LFL sales growth (driven both by footfall and average shopping basket growth) and selling space CAGR of 20% over 2015-2018
- EBITDA margin decreasing to around 10%-10.8% as a result of increasing share of leased space in store portfolio and margin sacrifices
- Capex at around 9%-11% of revenue
- No external dividends paid by Lenta Ltd funded by Lenta LLC.
- Neutral to negative FCF margin
- No large-scale debt-funded M&A

RATING SENSITIVITIES

Negative: Future developments that could lead to a revision of the Outlook to Stable include:
- Slowdown in store roll-outs, deterioration in LFL performance relative to close peers, reflecting a challenging operating environment, or materialisation of execution risks in its growth strategy.
- No evidence of sustained deleveraging based on FFO adjusted gross leverage (2014: 3.9x).

Future developments that could lead to a downgrade include:
- A sharp contraction in LFL sales growth relative to close peers along with material failure in executing expansion plan.
- EBITDA margin erosion to below 7%.
- FFO-adjusted gross leverage above 4.5x on a sustained basis.
- FFO fixed charge cover below 2.0x (2014: 2.6x).
- Deterioration of liquidity position as a result of high capex, worsened working capital turnover and weakened access to local funding.

Positive: Future developments that could lead to positive rating action include:
- Solid execution of expansion plan and LFL sales growth relative to peers leading to improved market position in Russia's food retail sector.
- Maintaining EBITDA margin at around 9%.
- FFO-adjusted gross leverage below 3.5x on a sustained basis.
- FFO fixed charge coverage of 2.5x on a sustained basis.