OREANDA-NEWS. Fitch Ratings has affirmed JSC National Company Kazakhstan Temir Zholy's (KTZ) Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB'. The Outlook is Negative. Kazakhstan Temir Zholy Finance B.V.'s senior unsecured rating has also been affirmed at 'BBB'.

The affirmation reflects our expectation that the government of Kazakhstan (foreign currency IDR BBB+/Stable/F2) would provide sufficient tangible support for KTZ to repay or service its liabilities, despite insufficient tariff increases for 2016-2020 and a rapid deterioration of KTZ's standalone creditworthiness. The Outlook could be revised to Stable if the government implements tangible support measures alleviating ongoing pressure on KTZ's liquidity and standalone credit profile.

The devaluation of the Kazakh tenge to USD has increased the tenge valuation of KTZ's financial liabilities, weakening the company's leverage metrics. At the same time, a long-term tariff increase below expected inflation is likely to squeeze margins and reduce operating cash flow generation. We have lowered our assessment of KTZ's standalone profile to 'B+' as a result.

KEY RATING DRIVERS
Ratings Driven by State Support
We apply a top down approach to the ratings of KTZ from those of the government, reflecting strong strategic and operational ties with the state but also the absence of significant explicit guarantees or cross-default provisions. KTZ's ratings are one-notch lower than those of Kazakhstan based on our expectation that the government would provide sufficient and timely tangible support for KTZ to service its liabilities.

KTZ is fully state-owned (indirectly through the JSC National Welfare Fund Samruk-Kazyna (S-K; BBB+/Stable/F2). The company is strategically important to Kazakhstan (BBB+/Stable/ F2) as the monopoly owner/operator of the Kazakhstan rail infrastructure and provider of around half of freight and passenger transportation in the country. KTZ's tariffs are regulated and its investment plans approved and partially funded by the state, through equity injections and loans. The government also provides direct subsidies to the loss-making passenger business.

Multi-notch Weakening of Standalone Profile
A number of adverse developments in 2015 have eroded KTZ's financial ratios. These include a freight tariff freeze in 2015, a drop in freight turnover and a near 75% devaluation of the tenge against USD since August this year. As a result, we expect KTZ's funds from operations (FFO) adjusted gross leverage to increase to 6.4x in 2015 from 3.3x in 2014 and FFO interest coverage to fall to 3.0x from 6.2x. Given the challenging economic outlook in Kazakhstan and its neighbour Russia, and weaker growth prospects in China, we do not expect the company's leverage to recover to below 5.8x over the medium term, based on the latest tariff settlement.

The business profile continues to benefit from the company's monopolistic position, fairly diversified product and customer mix and balanced exposure to the domestic, transit and export markets. However, the weakening in credit metrics, particularly increased leverage, places considerable pressure on the company's underlying credit quality, which Fitch now assesses at 'B+'.

Freight Turnover Dips
KTZ's freight turnover (tonne kilometres) declined 6% in 2014 and is estimated by the company to fall a further 11%-12% in 2015. This is mainly due to reduced exports and slower transit cargo flows. The reduction in turnover is affecting KTZ through lower revenue and profitability due to an inflexible, predominantly fixed-cost base. The tenge devaluation may improve Kazakhstan's competitive position and trade flows, although Fitch expects a further moderate fall in freight turnover in 2016.

Tariff Increases Below Inflation
Freight and passenger tariffs were not raised in 2015 due to the government's concern about the adverse impact on the weakened national economy. This has affected KTZ's cash flow generation and financial profile.

In December 2015, the regulator approved a 4% annual mainline infrastructure tariff increase for KTZ for 2016-2020. Locomotive haulage tariff increases have yet to be confirmed, but the company expects a broadly similar increase. This is below the annual expected inflation rate of 7%. At the same time, the government has approved a reduction in KTZ's investment programme to KZT609bn for 2016-2020. This means that annual investment would reduce by up to 80% per year versus 2012-2014.

Although lower tariffs together with reduced capex could result in marginally positive free cash flow, it would have a negative impact on leverage due to lower FFO generation and margins. Overall, we estimate the tariff decision to increase FFO adjusted leverage by 0.8x on average in 2016-2018.

Capex and Cost Optimisation
KTZ is applying a number of cost-cutting initiatives to mitigate the negative impact of the tariff freeze and slower turnover. These led to a 16.6% reduction in operating costs in 1H15. The company has also reduced its capex plan to KZT654bn for 2015-2018. Although these measures are credit positive in the short term, it may be difficult to contain longer-term cost increases.

Negative Impact of Tenge Devaluation
The tenge has lost around 75% of its value versus USD since the government moved to a floating exchange rate in August 2015. KTZ is vulnerable to currency exchange rate swings due to the currency mismatch between its earnings and debt. At end-September 2015, 59% of its gross debt was denominated in foreign currency (mainly USD) versus only 20% of revenue (mainly transit, CHF-denominated). Most of the costs and capex are tenge-denominated.

The company plans to reduce the proportion of foreign-currency denominated debt by issuing tenge-denominated bonds. We have yet to see whether sufficient tenge liquidity will be made available by the authorities. Financial hedging of KZT/USD risk has historically been limited to monitoring exchange rates and maintaining a portion of cash in USD.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for KTZ include:
-Average freight tariff increase of 4% in 2016-2018 versus inflation rate of 7.5%.
-A continuing 6% decline in freight turnover in 2016, before reversing to 1.5% and 2.5% growth in 2017 and 2018, respectively.
-KZT16.6bn average annual proceeds from privatisation of minority stakes in non-core subsidiaries in 2015-2018.
-Continued loss compensation in the passenger division via state subsidies.
-Total capex of KZT654bn in 2015-2018.
-15% cash dividend pay-out ratio.
-State equity injections for selected investment projects of KZT68.3bn in 2015 and KZT36.4bn in 2016.
-Average interest rate for new borrowings of 8%.
-KZT200bn local bond issuance in 2016, used for foreign currency-denominated debt repayment; this significantly improves KTZ' foreign currency risk exposure.
-Continued tenge depreciation to 375 KZT/USD by end-2018.

RATING SENSITIVITIES
Positive: The Outlook is Negative and we currently do not anticipate an upgrade. However, future developments that could nonetheless lead to positive rating actions include:
- An upgrade of Kazakhstan's rating may be replicated for KTZ, unless its links with the state weaken.

A revision of KTZ's Outlook to Stable would be contingent on evidence of tangible state support in the near term, including but not limited to equity injections alleviating balance sheet pressure, liquidity support for May 2016 Eurobond repayment and assistance in minimising foreign currency risk exposure.

Negative: Future developments that could lead to negative rating action include:
- A downgrade of Kazakhstan's rating would be replicated for KTZ.
- Weakening of state support provided to KTZ.

For the sovereign rating of the Kazakhstan, KTZ's ultimate parent, the following sensitivities were outlined by Fitch in its rating action commentary of 30 October 2015:

The following risk factors individually, or collectively, could trigger negative rating action:
- Policy mismanagement and/or prolonged low oil prices leading to a weakening in the sovereign external balance sheet.
- Renewed weakness in the banking sector, which leads to contingent liabilities for the sovereign.
- A political risk event.

The following factors, individually or collectively, could result in positive rating action:
- Moves to strengthen monetary and exchange rate policy.
- Steps to reduce the vulnerability of the public finances to future oil price shocks, for example, by reducing the non-oil deficit, currently estimated at more than 9% of GDP.
- Substantial improvements in governance and institutional strength.

LIQUIDITY
KTZ's liquidity adequacy is contingent on covenant renegotiation and waivers. At end-1H15 the company had KZT58.2bn of cash and equivalents and KZT80bn of available credit facilities versus short-term debt repayments of KZT124.6bn. Additionally, negative free cash flow is expected to add to funding requirements around KZT110bn.

The available credit facilities of KZT80bn at end-1H15 included a USD300m syndicated loan from EBRD and a number of banks, committed specifically for the refinancing of USD350m eurobond falling due in May 2016. Due to the tenge devaluation, the company no longer expects to meet the financial covenants set in this facility and is renegotiating the planned financing package. Covenant renegotiation becomes more challenging as the tenge continues to devalue.

Additionally, the company is renegotiating the covenants on some of its existing debt (the overall exposure close to KZT150bn). Should the company not be successful in its covenant re-negotiations, Fitch expects the state to step in with timely financial support.