OREANDA-NEWS. Fitch Ratings has downgraded Chinese chemical company Shanghai Huayi (Group) Company's (Huayi) Long-Term Issuer Default Rating (IDR) and senior unsecured rating to 'BBB-' from 'BBB'. The Outlook is Negative.

Fitch has also downgraded the rating on the US dollar senior unsecured notes issued by Huayi Finance I Ltd to 'BBB-' from 'BBB'. The notes are unconditionally and irrevocably guaranteed by Huayi Group (Hong Kong) Limited, a 100% owned subsidiary of Huayi, which has granted a keepwell deed and a deed of equity interest purchase undertaking (EIPU) to ensure the issuer and guarantor have sufficient assets and liquidity to meet their obligations.

Huayi's ratings are derived from its revised standalone credit profile of 'BB', which was previously assessed at 'BB+', plus a two-notch uplift to reflect moderate to strong linkages with the Shanghai Municipal Government.

The downgrade reflects weakening of the company's credit profile with high levels of earnings volatility, depressed industry outlook and deterioration of the company's credit metrics. The Negative Outlook reflects low visibility of potential earnings recovery as well as elevated capex, which might put more pressure on its credit profile.

KEY RATING DRIVERS

Margin Volatility; High Leverage: Fitch expects Huayi's credit metrics to remain weak in 2015 with FFO-adjusted net leverage likely to rise to 5.8x from 4.3x in 2014. This will mainly be driven by lower profitability due to persistent industry overcapacity and weaker economic activity in China. We also expect Huayi's operating EBITDA margin to shrink to less than 4% in 2015 from 5.0% in 2014, which is consistent with a weaker business profile. Huayi is exposed to the industry's cycles because most of its end-users are in the truck and construction businesses in China, although the current downturn has been exacerbated by the current economic slowdown and industry overcapacity.

In calculating margins and leverage in 2014, Fitch adjusted depreciation to CNY2.1bn from the reported CNY6.9bn to take into account changes in the depreciation method after Huayi's subsidiary Shanghai Chlor-Alkali Chemical Co., Ltd. started using a new corporate planning software. Unadjusted operating EBITDA margin and FFO-adjusted leverage were 12.5% and 1.7x, respectively.

Capex Drives Leverage: Fitch does not expect significant improvements in the company's credit metrics as the company is committed to CNY4bn-6bn in annual capex, mainly for expanding capacity in truck tires, advanced and special chemicals, even though the outlooks for the construction and truck industries in China are subdued. However, Fitch expects the gradual recovery of crude oil prices from 2016 and beyond to result in some improvement in company's margins and top-line growth.

Government Linkages Intact: Huayi's linkages with the Shanghai Municipal Government continue to be moderate to strong and its rating continues to include a two-notch uplift to reflect these ties. Huayi is the sole chemical enterprise under Shanghai's State-owned Assets Supervision and Administration Commission (SASAC), and it undertakes scientific research projects in advanced materials for sectors including national defense, large aircraft and alternative energy. The Shanghai government has also demonstrated its support for Huayi by making several asset injections and providing annual government subsidies.

Regional Concentration: Huayi's businesses are concentrated in Shanghai, with only modest exposure to neighbouring provinces in eastern China. However, this is in line with Huayi's strategy to remain close to the main consuming markets, which are located in eastern and southern China, for the ease of transportation of chemicals.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
-Revenue and gross profit margin to see slight improvement from 2016 and beyond mainly on selling price recovery
- Capex of CNY4bn in 2015, CNY5.2bn in 2016, CNY6bn in 2017 and CNY5bn in 2018
- Inflow of CNY3.7bn of equity financing in December 2015

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Weakening of linkage with Shanghai SASAC
- FFO-adjusted net leverage sustained above 5.0x
- EBITDA margin sustained below 5%

Positive: The Outlook may be revised to Stable if the company avoids reaching the negative rating guidelines.