OREANDA-NEWS. Fitch Ratings has affirmed Ukraine-based grain trader and sunflower seed processor Kernel Holding S.A.'s (Kernel) long-term foreign and local currency Issuer Default Ratings (IDRs) at 'CCC'. Its National Long-term rating was upgraded to 'A-(ukr)' from 'BBB+(ukr)'. The Outlook for the National rating is Stable.

The ratings reflect political and economic uncertainty in Ukraine, where Kernel's assets and operations are mainly based, and which may threaten the company's financial flexibility and ability to meet its debt obligations. The company has a number of strong credit factors, including an export-oriented business model and a large portion of cash balances kept outside Ukraine. Nevertheless, we consider these factors are not sufficiently strong to justify rating the company above the Country Ceiling 'CCC', especially in light of its liquidity and refinancing risks.

Absent the current Country Ceiling constraint, the business and financial profile of Kernel would allow its ratings to return to the 'B' category.

The upgrade of the National rating reflects better-than-expected operating performance and material deleveraging achieved in FY15 (ended June 2015), as well as the generally stronger credit profile we now project for FY16-18.

KEY RATING DRIVERS

Country Ceiling Constraint
Kernel's IDRs remains constrained by Ukraine's Country Ceiling and local currency IDR of 'CCC', despite the group's strong credit profile with a high share of export revenue (92% in 9MFY15) and a large portion of cash held outside Ukraine. The large amount of short-term debt and insufficiency of offshore cash balances to cover the next six to 18 months of debt service do not provide enough support for the ratings to be above the Country Ceiling.

In addition, the reliance on domestically sourced inputs (grain and sunflower seeds) and on the country's infrastructure leaves Kernel highly exposed to the local economy and to the risk of imposition of regulatory constrains or higher fiscal burdens.

Record Margins in FY15
For FY15, we expect Kernel to have achieved a record EBITDA margin of above 17%, driven by a turnaround in farming operations and exceptionally strong crushing margins. While in FY16-FY18 the EBITDA margin is likely to return to normalised levels of 10%-11%, this should enable the company to generate operating cash flows of around USD130m-USD150mn annually, sufficient to cover both capex and planned dividend payments.

Strong Deleveraging
We expect a material reduction in Kernel's funds from operations (FFO) adjusted gross leverage to 1.7x in FY15 (FY14: 4.8x) as a result of strong operating performance, substantially ahead of Fitch's expectations. Assuming that capex will intensify from FY16, we project FFO adjusted gross leverage will remain at around 3.0x over the medium term, which is slightly higher the median for 'BBB' rating category based on Fitch's Commodity Processing and Trading Companies Navigator.

Moderate Diversification
As a sunflower seed processor and a grain trader, Kernel is focused only on few commodities, primarily sunflower oil and meal, corn, wheat and barley. In terms of sourcing geographies Kernel remains largely reliant on Ukraine, although some diversification benefit is provided from its Russian grain trading and sunflower seed processing operations (9MFY15: 16% of total revenue).

We see some risks of a contraction in Ukrainian harvest due to reduced sowing campaign financing over the next two years. At the same time, we believe Kernel would be able to manage such risks due to its leading market position and access to external liquidity, while other crushers and traders may face liquidity problems.

Asset-Heavy Business Model
Compared with global soft commodity processors and traders, Kernel operates on a stronger FFO margin of 7%-9%. The reason is Kernel's asset-heavy business model with substantial processing operations (relative to trading) and infrastructure assets as well as integration into farming. The group's asset structure and integration within operating segments allows the company to retain leading market positions in sunflower oil and grain exports and are positive for Kernel's credit profile.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for the issuer include:
- Weak international soft commodity prices over the medium term
- EBITDA margin up to 17% in FY15 and returning to 10%-11% thereafter
- Stable dividends at USD19.9m over FY16-FY19
- Capex not exceeding 4% of revenues over FY16-FY19
- M&A spending not exceeding USD50m p.a.
- No material reduction in VAT reimbursements related to exports
- Cancellation of Ukraine's special VAT regime for agricultural producers from 2016 (relevant for the farming segment), despite that the government has not announced plans to do so
- Adequate liquidity

RATING SENSITIVITIES

Positive: An upgrade of the local currency IDR is unlikely unless there is a sustained improvement in the operating environment. An upgrade of the foreign currency IDR is contingent on Ukraine's Country Ceiling being revised higher.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- A liquidity shortage caused by limited available bank financing of working capital investments or by refinancing at more onerous terms than expected.
- A severe shock from soft commodity prices, export restrictions, material reduction in VAT refunds or limited crop availability in Ukraine leading to material deterioration of Kernel's credit metrics.

LIQUIDITY

As of end-March 2015, Kernel's liquidity position was weak as Fitch-adjusted unrestricted cash balances of USD83m, and expected positive free cash flow were not sufficient to cover Kernel's short-term debt of USD463m. However, its liquidity position is supported by the recent renewal of pre-export and pre-crop financing facilities with a total maximum limit of USD645m, which should fully cover the company's working capital needs for FY16. Readily marketable inventories (RMI) could further support liquidity (Fitch-estimated RMI of USD222m as of end-March 2015).