OREANDA-NEWS. Fitch Ratings has affirmed Chinese leading steelmaker Baosteel Group Corporation's (Baosteel Group) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDR) and senior unsecured rating at 'A-'. The Outlook is Stable.

Fitch has also affirmed Baoshan Iron & Steel Co. Ltd's (Baosteel) Long-Term Issuer Default Rating (IDR) of 'A-' with Stable Outlook. The company's senior unsecured rating and the outstanding senior unsecured US dollar notes issued by Bao-Trans Enterprises Ltd (Bao-Trans), a wholly owned subsidiary of Baosteel, have also been affirmed at 'A-'.

Baosteel's ratings are equalised with those of its parent Baosteel Group due to their strong operational and strategic linkages. Baosteel on a standalone basis is more reflective of a 'BBB+' credit profile.

KEY RATING DRIVERS
Potential State Support: The ratings are notched up a level from Baosteel Group's standalone 'BBB+' rating to reflect moderately strong linkages with the Chinese state (A+/Stable), in line with Fitch's Parent and Subsidiary Linkage criteria.

Steel is necessary for the industrialisation and urbanisation of China, and Baosteel Group is among China's key steel companies spearheading high-tech steel product development. As the largest and financially strongest steel enterprise held by the State-owned Assets Supervision and Administration Commission of the State Council, Baosteel Group is strategically important in China's drive to develop its steel industry. As a result, the Chinese government can be expected to support the company, should the need arise.

Most Resilient Chinese Steelmaker: The ratings reflect Baosteel Group's strong financial profile despite a difficult environment for the steel makers in China. The decline in apparent consumption (sum of production and imports, and minus exports) and capacity overhang resulted in lower revenue and profit in the industry in 2014 and 2015. Fitch expects Baosteel's metal spread (gross profit per tonne of steel product sold) to improve to CNY410-420 in 2015 and 2016 on the back of higher plant efficiency, cost reduction measures and economies of scale at its new Zhanjiang plant. The company's metal spread decreased to CNY388 in 2014 from CNY454 in 2013.

Over the long term, Fitch expects Chinese steel demand to be underpinned by the country's urbanisation and rising sales of consumer durables and automobiles. Baosteel Group supplies 50% of the domestic auto industry's demand for cold-rolled steel sheets.

Strong Focus on R&D: Baosteel Group's continued investment in R&D for new product launches is one of the key contributors to its leading position in carbon steel in China. The company spends about 2% of its revenue a year on R&D, usually in collaboration with its major customers to make products that suit their needs along the value chain. This allows the company to establish a long-term customer base and better prices, a trait hard to replicate by competitors.

Capex Drives Leverage: Fitch expects Baosteel Group to incur total capex of CNY51bn in 2015-2016, most of which is driven by the construction of its Zhanjiang steel plant (with annual crude steel capacity of 8.75 million tonnes). Phase 1 of the plant commenced production in October 2015, and it will be followed by phase 2 in June 2016. Capex will taper off significantly from 2017, after which fast deleveraging will take place.

Financial Flexibility Offsets Leverage: Baosteel Group's substantial financial assets of close to CNY79bn and its cash balance of CNY38bn at the end of 2014 provide strong backup liquidity in times of need, mitigating the impact from its increased leverage. Fitch expects Baosteel Group's FFO-adjusted net leverage to rise to around 4.5x in 2015 (2014: 3.3x). If Fitch includes about 75% of the available-for-sale financial assets that are marked to market in its calculation of FFO-adjusted net leverage, the figure is likely to rise to around 2.8x in 2015 (2014: 2.1x). About CNY52bn of the group's available-for-sale financial assets at end-2014, of were marked to market.

Baosteel Financially Stronger: Baosteel maintains a stronger financial profile relative to domestic and global peers, as well as its parent. It remains the most profitable Chinese steel producer in absolute terms as well as based on metal spread. Baosteel has the strongest financial position among leading global steel producers. In 2014, FFO net leverage for Baosteel was 3.2x, Baosteel Group's was 3.3x, and other rated peers recorded an average of 3.9x.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Gradual increase of metal spread to around CNY410-420 in 2015-2016
- Total capex of CNY51bn in 2015-2016, sustained capex of CNY15bn-18bn thereafter

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- substantial improvement in the steel industry via consolidation and easing raw material constraints
- improved business profile in terms of product leadership across more industries and geographic expansion while maintaining a strong financial profile
- consistent free cash flow generation

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- weakened linkage with the state
- sustained decline in metal spread (gross profit per ton of steel product sold) below CNY400;
- FFO-adjusted net leverage, including adjusted financial assets, exceeding 2.5x on a sustained basis.