Fitch Affirms Ukraine's Lemtrans at 'CCC'
The ratings reflect Lemtrans' position as the largest private freight rail operator in Ukraine (CCC) with an estimated market share of about 20% in freight transportation in open wagons, but also consider its exposure to the operating environment in Ukraine. Although Lemtrans' direct exposure to conflict areas is limited, its major customers DTEK Holdings B.V. (DTEK, rated C) and METINVEST B.V. (Metinvest, rated RD) that accounted for about 90% of the company's revenue in 6M15, have significant share of assets in the conflict areas, which could undermine the operational and financial stability of Lemtrans. The ratings reflect Lemtrans' standalone profile.
KEY RATING DRIVERS
High Customer Concentration
Lemtrans' customer base remains highly concentrated as two main clients - DTEK and Metinvest - are responsible for over 90% of revenue adjusted for the pass-through infrastructure component (adjusted revenue) in 2014-6M15. Although customer concentration is higher than rated peers it is somewhat mitigated by both companies being part of the same holding company as Lemtrans, System Capital Management Limited (SCM). Further DTEK and Metinvest are two largest industrial companies in Ukraine that transport tens of millions of tons of coal, ore and metal products every year by rail and have agreed to prepayment terms with its customers that reduces non-payment risk.
Although DTEK and Metinvest reported decline in their output over 6M15-9M15 the effect on Lemtrans was smoothed by the increased share of transportation covered by Lemtrans in these companies' total transportation needs to about 90% in 6M15, from around 50%-75% in 2014. ArcelorMitall Kriviy Rih and YuGok - non-SCM group companies - cover the remaining revenue at 5% of adjusted revenue each in 6M15. Although Lemtrans is seeking to expand its customer base Fitch believes that at least over the medium term, DTEK and Metinvest will continue to dominate Lemtrans' revenues and volumes.
Political Uncertainty Remains
The political and economic environment in Ukraine remains unstable, although the conflict in the Donetsk and Lugansk regions has subsided. Lemtrans does not have any significant fixed assets in these regions; however, a large portion of cargo is located there, as both DTEK and Metinvest have a fairly significant share of assets in these areas. Political instability and military operations in Donetsk and Lugansk regions affected the customers of Lemtrans and may lead to operational and financial uncertainty especially if the conflict escalates.
Increase in Dividends
Lemtrans makes contributions to its shareholder in the form of dividends and other financial contributions that in 2014 amounted to UAH0.3bn. For 2015 the company expects these contributions to increase. Under the company's policy contributions to the shareholder must not exceed 50% of the company's trailing 2010-2015 net income. However, given the lower cash flow generation of the shareholder's main assets (DTEK and Metinvest) we are assuming a 100% dividend pay-out ratio in 2016-2018 vs. management's expectation of 50%.
Tariffs Increase
From 1 February 2015 Ukrzaliznitsia (UZ, rated C) increased the tariff for cargo transportation by 30% for all freights except coal for which tariff was increased by 10% plus another 18.2% from 1 April 2015. These tariffs, along with the cargo operators' margins, are passed on to customers. Lemtrans is not directly affected by the increase in tariffs of UZ, as it passes all tariffs through to its customers.
The depreciation of hryvna, on the other hand, has positively affected the revenue of Lemtrans, as the company's tariffs are linked to UAH/USD exchange rate and provide a natural hedge for its foreign currency debt (mostly leases).
FX-linked Debt
At end-1H15 Lemtrans reported debt of UAH3.4bn, including finance lease (97%) and loan (3%) from a related party bank, First Ukrainian International Bank (FUIB). Lemtrans is subject to foreign currency risk as all of its debt is either linked to RUB or USD exchange rates (finance lease) or denominated in USD (bank loan). However, foreign currency risk is mitigated by natural hedge as the majority of Lemtrans' tariffs are linked to the USD/UAH exchange rate, and by some foreign currency cash holdings.
At end-1H15 63% of total cash and cash equivalents (or UAH443m) was kept in USD, EUR and RUB. However, with leases denominated in foreign currencies a steep, sustained UAH weakening against the USD and RUB as well as revision of the company's tariff policy could weaken Lemtrans' credit metrics and put its ratings under pressure.
Strong 1H15 Results
In 1H15 Lemtrans reported revenue of UAH3.6bn, a 33% growth year-on-year. This was driven by a 44% revenue increase from freight transportation in its own rail fleet, which represented over 80% of total revenue. This was mainly due to an increase in infrastructure tariffs and to the hryvna depreciation, as the company's tariffs are tagged to the UAH/USD exchange rate.
The company's ability to keep most of the costs below inflation, which Fitch forecasts at 48% in 2015, led to a stable EBITDA margin at 28% in 1H15. However, we do not expect the company will be able to keep the costs sustainably below inflation, which we forecast to moderate to about 10%-16% over 2016-2017 and we therefore forecast the EBITDA margin to drop from the current level in 2016-2018.
Negative FCF Expected
Fitch expects Lemtrans to continue generating solid cash flow from operations (CFO) of around UAH520m on average over 2015-2018; however, free cash flow (FCF) is likely to turn negative over 2015-2018, due to the company's ambitious investment plans for this period and our assumption of increasing dividends. Fitch expects Lemtrans to rely on new borrowings to finance cash shortfalls. However, Lemtrans' capex programme is fairly flexible.
Capex Driven Leverage Increase Expected
At end-2014 Lemtrans reported fund from operation (FFO) adjusted gross leverage of 2.3x, down from 4.2x at end-2013. This was mainly driven by an increase in transportation volumes of DTEK and Metinvest, hryvna depreciation and lower tax payments, following large cash tax prepayment in 2013.
Lemtrans expects to spend UAH1.5bn on average annually over 2015-2018 vs UAH726m on average over 2011-2014 to replace part of aging fleet of UZ and to maintain its leading market position. We expect capex to be partially debt (lease)-funded. This is likely to increase FFO adjusted gross leverage to over 4.0x in 2016-2018. However, most of the capex is related to the acquisition of a new rail fleet and modernisation, meaning it can be postponed in case of need.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Lemtrans include:
- Tariff growth slightly below inflation for 2016-2018, which Fitch forecasts at 10%-16%.
- Transportation volumes to grow in line with GDP in 2016-2018, which Fitch forecasts at 1%-2%
- Inflation driven cost increase over 2016-2018
- Increasing dividends payments
- Capex above the historical averages for 2011-2014
RATING SENSITIVITIES
Negative: Future developments that could lead to negative rating action include:
- Further deterioration of the liquidity position resulting in difficulties for the company to service its debt;
- Disruption of the company's or its main customers' operations, undermining the company's operational and financial stability or customer's credit profile;
- Further significant hryvna depreciation without tariff increases resulting in material weakening of Lemtrans' credit metrics;
- Higher-than-expected dividend payments and contributions to the shareholder, which would result in a weakening of credit metrics.
Positive: Future developments that could lead to positive rating action include:
- Improvement of the macro-economic environment and of the company's liquidity position;
- Improved customer diversification and cargo mix and stronger credit profile of key customers. However, given Ukraine's dependence on coal mining and steel production these changes are not likely over the medium term.
LIQUIDITY
At end-1H15 reported cash and cash equivalents stood at UAH705m, which are insufficient to cover upcoming short-term maturities of UAH912m, comprising UAH583m of finance lease and UAH329m of bank borrowings. Lemtrans does not have any open credit lines. We expect Lemtrans' CFO to be positive, but liquidity will depend on capex, which has been moderate so far this year, and on dividend pay-out. We expect liquidity to remain tight.
Lemtrans' liquidity position is weakened by its high exposure to domestic banks. At end-1H15 over 86% of cash was deposited at local banks, mostly at First Ukrainian International Bank (FUIB). Although management views cash at a related party bank as unrestricted, for our projections we assume a portion of cash held at the Ukrainian banks as restricted, due to their low credit quality and related-party status.
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