OREANDA-NEWS. Fitch Ratings has revised the Outlook on Deutsche Bahn AG's (DB) Long-term Issuer Default Rating (IDR) to Negative from Stable and affirmed the IDR at 'AA'. The Short-term IDR has been affirmed at 'F1+'. Fitch has also affirmed Deutsche Bahn Finance B.V.'s senior unsecured rating at 'AA'.

The revision of the Outlook to Negative reflects DB's continued weaker than expected financial performance, with both funds from operations (FFO) net leverage and FFO fixed cover charge weaker than Fitch's negative rating sensitivities. This has been driven by declining market share, difficult competitive and economic conditions, operational challenges in 2014 and 2015, and increasing capex requirements. The weaker financial metrics are mitigated by DB's strong standalone business profile as the largest European integrated passenger and freight transport provider with a dominant domestic market position.

If DB's 2015 out-turn remains weak and our financial expectations do not improve, Fitch is likely to downgrade the ratings by one notch.

DB's 'AA' rating incorporates a three-notch uplift from its 'A' standalone credit profile to reflect linkage with its sole shareholder, the Federal Republic of Germany (AAA/Stable/F1+) in accordance with Fitch's Parent and Subsidiary Linkage methodology.

KEY RATING DRIVERS
Continued Pressure on Standalone Rating
DB's standalone rating of 'A' is under pressure as a result of a decline in the company's financial performance over 2014 and 1H15, which is reflected in our revised projections. A negative shift in the company's business and operational profile has been caused by intense competition in the transport and logistics businesses, liberalisation of markets causing a decline in market share and regular operational issues, including strike action and weather-related interruptions leading to lost income and an increased cost-base due to wage increases.

This has resulted in DB's FFO adjusted net leverage rising to 4.7x for the full year to 2014, well above our negative rating guideline of 4.0x, and FFO fixed charge cover of 2.5x, below the negative rating guideline of at least 3.0x. Fitch forecasts that given the current regulatory and economic environment in which DB operates, it will be difficult for the company to quickly reduce leverage and increase fixed charge coverage and maintain a 'A' standalone rating.

Strong Parental State Support
The strategic importance of rail infrastructure and service to Germany's export-driven economy and the federal funding of the company's infrastructure capex and concession fees for regional transport services continue to underpin Fitch's view of strong links between DB and the sovereign.

Ongoing dividend payments ultimately limit the degree of state support incorporated into the ratings, although we note dividends were reduced to EUR200m in 2014, from EUR525m in 2013. Fitch would likely reassess the notching differential for state support in the event of a sale of a majority stake in DB and/or a separation of the network from the train operations.

Large Capital Expenditure Requirements
Under the latest agreement infrastructure funding agreement with the German government for the period 2015-19, (LUFV II), the government will continue to support DB in maintaining and developing the infrastructure of German rail. Over the five-year period, DB forecasts more than EUR50bn of capital expenditure, of which around two-thirds will be covered by government grants to the company.

We expect that the completion of major capital expenditure projects, such as the Stuttgart 21 project will in time result in better network performance, allow the company to compete more successfully in its domestic passenger market and also generate returns on future station and track charges, underpinning the strong business risk profile. While capex is potentially flexible to a degree, dividends may be more likely flexed to offset high capex.

Intense Domestic Passenger Competition
DB's long-distance train division's revenues and operating profits fell slightly in 2013 and 2014 as a result of intense competition, weather disruptions and strike action. In addition, lower fuel prices have resulted in higher car usage.

DB is also exposed to competition to renew its existing regional franchises, under the liberalisation of regional rail operations. We expect DB to lose further market share, likely to result in relatively flat revenues, although DB's strategy of retaining the more profitable contracts has led to improving margins and a gradual increase in operating profit.

Arriva Diversifies Operations
DB Arriva operates transport services outside of Germany and accounts for around 10% of group revenue and profit. This offers DB a degree of diversity away from the relatively mature German market that is being liberalised to the cost of DB as the incumbent operator. Over FY14, revenue has grown reflecting the start of new contracts, while margins have remained relatively stable.

Fitch expects DB Arriva to continue to make further bolt-on acquisitions, compete for transport contracts outside Germany and be an increasingly important contributor to DB's revenue and profits in the long term.

Logistics Still Under Pressure
DB's freight and logistics divisions operate in a highly cyclical and competitive environment which is strongly correlated to GDP dynamics. These divisions account for 50% of group revenues but only around 17% of group profits, demonstrating the highly competitive and low margin nature of the industry.

The subdued European economic environment suggests than future near-term growth will be difficult. However, Fitch expects a small degree of margin improvement as DB implements cost-efficiency measures and the weak euro continues to drive Germany's export market.

Infrastructure and Services Stable
Both the services (DB Services) and infrastructure (DB Netze) elements of DB have remained relatively stable over the past two years, underpinning the group's strong business profile. The Services division has maintained level revenues over the past year with a slight increase in margin, and Fitch expects a small increase in demand for the service as DB gradually expands its own rolling stock fleet.

The higher margin track and station elements of Netze are likely to grow with investment, as new capacity initiatives are likely to result in higher train volumes, run by both DB and other train operating companies. However, Fitch expects a small decline in the DB Netze Energy segment due to the liberalisation of the rail energy supply market and ongoing low wholesale electricity prices.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for DB include:
- Continued strong links with the German government
- Increased gross capex along with higher grants from the German government
- Operating leases adjusted to debt using a blended 6.0x multiple
- High competition in passenger transport to reduce volumes and margins
- Logistics to remain competitive but with limited growth
- Infrastructure to continue with higher margins and relatively stable earnings

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
Fitch sees limited rating upside in the absence of explicit debt guarantees from the federal government for a substantial part of its debt. We may consider raising the standalone rating if DB's financial profile improves substantially to FFO net adjusted leverage below 3.0x on a sustained basis, and FFO fixed cover charge of better than 4.0x. However, we view this as unlikely based on current capex plans and business outlook.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- FFO adjusted net leverage above 4.0x and FFO fixed charge cover below 3.0x on a sustained basis. Fitch would consider tightening these guidelines where DB's business profile has weakened substantially, including an increase in exposure to more volatile market segments such as the company's freight forwarding & logistics businesses.
- A downgrade of Germany below 'AA'.
- The degree of state support may also be re-assessed where there is a marked reduction in the government's funding of capex and/or material increases in dividends which lead to significant deterioration in credit metrics.
- Deconsolidation of the network as the business provides stability of revenues and compensates for the more volatile businesses of freight forwarding and logistics. This could arise if directives are passed leading to full ownership unbundling of rail infrastructure from public transport, although this would not happen until 2021 at the earliest.

LIQUIDITY
Strong Liquidity and Access to Funding
At 30 June 2015, short-term liquidity comprised EUR2.8bn of unrestricted cash (end 2014: EUR4.0bn) and EUR4.1bn of undrawn committed bank facilities, comfortably covering short-term debt. Fitch expects continuing negative free cash flow due to high capex to reduce available cash. However, DB has ready access to debt markets as it is a well-established and regular issuer in the domestic and international capital markets, with frequent benchmark size issues.