OREANDA-NEWS.  Fitch Ratings has placed Azerbaijan Railways Closed Joint-Stock Company's (ADY) Long-term Issuer Default Rating (IDR) of 'BBB-' on Rating Watch Negative (RWN).

The RWN reflects the uncertainty regarding the form and the amount of state support that will be available to the company at the time of expected drop in earnings, partially due to changes in the consolidated perimeter.

A State Programme for the Development of Railways over 2016-2020 (Programme) is being discussed by the government of Azerbaijan. While a large part of capex funding has been provided by the government, the new programme is yet to be approved and we expect authorities to adjust capital spending to lower oil prices. We may notch ADY's rating down from the sovereign rating if we think the support and links are weakening. Currently the company's rating is aligned with Azerbaijan's sovereign rating (BBB-/Stable).

We expect to resolve the RWN within six months.

KEY RATING DRIVERS
State Support Uncertainty
Fitch continues to apply a top-down rating approach to ADY with its Long-term IDR being aligned with that of the Azerbaijan's sovereign as Fitch considers the strategic, operational and to a lesser extent legal ties between the state and the company as relatively strong, according to the agency's Parent and Subsidiary Rating Linkage methodology. The strength of the ties is largely underpinned by ADY's high strategic importance to the national economy, including its position in the transport of export-bound oil products and oil as well as freight transit, which contribute significantly to Azerbaijan's economy.

We expect ADY's rating to continue to be related to the credit quality of the sovereign, but once approved, if the Programme implies less direct support in the form of capex funding, guarantees and weaker credit metrics for ADY, Fitch may reconsider the rating alignment and instead notch ADY's rating down from the sovereign rating. We expect more detail about the Programme and its approval in the next few months.

Negative Aspects of Corporate Governance
ADY's IFRS financial statements have been audited by a local audit firm. The company reported significant related party transactions (about 43% of revenues). ADY's standalone profile in the low 'BB' category includes the impact of corporate governance limitations. Significant changes to ADY group and consolidated perimeter may also contribute to a downgrade.

Exposure to International Movements of Liquid Cargo
ADY continues to be highly dependent on export/import and transit shipments with a high share of oil and oil products, with only marginal revenue coming from local freight shipments. Following a decline in freight transportation volumes during 1H15, we do not expect it to improve considerably over 2H15-2018, on the back of slowing economies across the region as well as increasing competitive pressure from pipelines for crude oil transportation. The impact of lower volumes on revenues and EBITDA will be partially offset by the Azeri manat devaluation in February 2015 as ADY's tariffs are set in CHF and denominated in US dollars.

New projects (including Baku-Tbilisi-Kars route to be commissioned by end-2016) should provide a boost to the volumes in the long term. We believe ADY will remain a freight-focused railway, with the passenger business remaining relatively small.

Negative FCF Expected
Fitch expects ADY to continue to generate positive cash flows from operations, albeit at a lower scale. Nevertheless its free cash flow (FCF) may continue to be negative owing to the ambitious capex programme. We anticipate the capex programme to continue to be at least partially state funded. However, ADY's investment programme and respective funding is currently under review and should be approved by the government over the next few months within the context of the new Programme.

Previously, the government funded or expected to fund about 48% of ADY's investment programme over 2012-2017 via loans borrowed by the government without recourse to ADY, as well as equity injections that we view as a sign of tangible support from the government. A significant change in capex funding may prompt Fitch to view the strength of state support for ADY as weaker.

Weaker Credit Metrics Expected
Fitch anticipates that ADY will remain 100% state owned in the foreseeable future. Despite the full ownership by the state, ADY's debt is not guaranteed by the government. At end-1H15 debt was relatively modest at AZN288m. We expect ADY's funds flow from operations (FFO) net adjusted leverage to deteriorate to above 1.6x at end-2015 from about 1x at end-2014 mainly on the back of revenue and EBITDA drop as a result of deconsolidation as well as lower transportation volumes. Further leverage increases will depend on the mix of capex funding envisaged in the Programme. Any significant external debt increase without state guarantees or other forms of state support (ie material equity injections) may result in ADY's rating being notched down from the sovereign rating.

FX-linked Debt
ADY's reported debt is subject to foreign currency fluctuations as almost all of its outstanding debt is denominated in USD. However, foreign currency exposure is offset by ADY's revenues as tariffs for freight export/import and transit that accounted for the majority of freight volumes are set in CHF and denominated in US dollars. In addition, ADY holds part of its cash in foreign currency. At end-1H15 about 90% of total cash and cash equivalents was in EUR, USD and CHF.

Low 'BB' Standalone Profile
Fitch views ADY's standalone credit profile in the low 'BB' rating category. The company's business profile continues to benefit from its monopoly position, relatively healthy EBITDA margin although this is expected to slightly deteriorate to about 44% in 1H15 from around 46% in 1H14, as well as the integrated nature of its business. However, ADY's small size compared with some other former Soviet Union railways and exposure to higher event risk stemming from its concentration on two key routes and geopolitical events constrain the standalone ratings. The expected weakening in credit metrics following EBITDA decline as well as negative free cash flow generation driven by the ambitious investment programme are also risks.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Freight transportation volumes to decline in 2015 by over 10%, flat volumes in 2016 and a low-single digit increase thereafter.
- Freight tariffs in local currency equivalent increase driven by the Azeri Manat devaluation in 2015 and a single-digit increase thereafter.
- Slight deterioration of EBITDA margin.
- Capex and state funding are being reviewed, we expect a decrease in both.

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- ADY's rating would be notched down from the sovereign rating if we view the company links with the government as weaker following the approval of the Programme and any other change in the group structure.
- Negative sovereign rating action driven, among other things, by the factors listed below would be replicated on ADY.

The ratings are on RWN. As a result, Fitch's sensitivities do not currently anticipate developments with a material likelihood, individually or collectively, of leading to an upgrade. Future developments that could, nonetheless, lead to positive rating action include:
- ADY's rating will continue to be aligned with the sovereign if the level of state support remains unchanged (ie ADY will continue to receive substantial equity injections for the large share of its investment programme or the state will provide guarantees for a large portion of the company's debt).
- If the sovereign rating of Azerbaijan is upgraded to 'BBB' or above, Fitch is unlikely to continue to fully align ADY's ratings with the sovereign unless the legal links with the state are perceived to have strengthened (ie through substantial direct guarantees of ADY's debt).

For the sovereign rating of the Azerbaijan, ADY's parent, the following sensitivities were outlined by Fitch in its rating action commentary of 28 August 2015:
The following risk factors individually, or collectively, could trigger negative rating action:
- A failure to adjust expenditure or revenue to the lower oil price environment, resulting in a draw-down of oil fund assets beyond 2015.
- A prolonged period of low oil prices.
- A regional geopolitical shock severe enough to disrupt Azerbaijan's economic or financial stability, such as a full-scale conflict over Nagorno-Karabakh.

The following risk factors individually, or collectively, could trigger positive rating action.
- An improvement in the budgetary position, beyond the measures currently envisaged, sufficient to increase Fitch's confidence in the longer-term sustainability of Azerbaijan's sovereign balance sheet strengths.
- Sustainable economic diversification, supported by reforms to improve governance and transparency.

LIQUIDITY
At end-1H15, ADY's cash and cash equivalents combined with unused credit facilities were sufficient to cover short-term maturities of around AZN89m. Fitch expected negative free cash flow driven by ADY's ambitious investment programme will add to funding requirements. We believe that ADY may postpone most of its capex plans in case of need. At end-1H15, ADY reported debt of AZN288m and the early LPN redemption was funded by a new external loan.