OREANDA-NEWS. Fitch Ratings has affirmed Russia-based food retailer O'key Group S.A.'s (O'key) Long-term foreign and local currency Issuer Default Ratings (IDRs) at 'B+'. Fitch has also affirmed LLC O'key's senior unsecured debt at 'B+'/'A(rus)' with a Recovery Rating of 'RR4'. The National Long-term rating has been affirmed at 'A(rus)'. The Outlook is Stable for all issuer Long-term ratings.

The affirmation reflects Fitch's view that O'key will maintain stable credit metrics in the medium-term despite projected weaker profitability for 2016-2017 due to the launch of a new discounter format and subdued consumer sentiment. Fitch views positively the recent changes in strategy toward less capital-intensive hypermarket openings, focusing on operating efficiencies and the acceleration in discounter format openings in 2016-2017. As a result, we expect O'key's free cash flow (FCF) generation ability to improve compared with previous expectations.

The ratings continue to reflect O'key's strong positioning in the hypermarket food retail segment in Russia, high profit margins and customer loyalty owing to a strong brand. This is balanced with temporary stretched credit metrics expected in 2015, albeit still in line with its ratings, as a result of weak consumer and the competitive environment. The ratings also reflect execution risks around the expansion of the group's new discounter format following further changes in senior management during 2015.

KEY RATING DRIVERS
Early Signs of Improvement
In response to the difficult trading environment in the Russian retail sector, O'key has adapted its product assortment and pricing policy during 2H14 and 1H15. Based on its 3Q15 results, O'key saw early signs of improvement in LFL footfall (-0.4% in 3Q15 vs. -5.2% in 2Q15). Fitch expects LFL sales growth should stabilise from end-2015. More importantly, we consider that changes in product mix and price proposition, together with its strong brand and customer loyalty, should help protect LFL sales in 2016 and 2017.

Change in Management
During 2015 the company saw another set of management changes. Heigo Kera was appointed as Chief Executive Officer and Chairman in April 2015, succeeding Tony Maher who had been with O'key since February 2014. Fitch considers that Mr. Kera has strong knowledge of the company and the market as he has been on the Board of Directors of O'key since 2010 and was first employed by shareholders in 2000 as a consultant where he was responsible for O'key's modern chain concept.

Other appointments included new heads of store formats, supplies, logistics and marketing. Although these individuals come with vast industry experience and have in-depth knowledge of the Russian market, we see execution risks in the company's strategy, which include expanding the discounter format in a challenging trading environment.

Tough Operating Environment
Fitch expects limited improvement in O'key due to the tough operating environment in 2016. O'key will face more intense competition from major market players. This will translate into downward pressure on operating margins, especially if the Russian consumer environment remains subdued and price-sensitive.

Fitch also expects the discounter format will negatively impact group profit margin in 2016 before improving in 2017 once O'key achieves some critical mass in this channel.

Stretched Credit Metrics
In 2014, O'key's leverage increased sharply due to higher capex while revenue growth decelerated to 9% from 18.8% in 2013 and EBITDA margins fell to 7.4% from 7.8% during the same period. Despite material reduction in capex in 2015 and 2016, Fitch expects funds from operations (FFO) adjusted gross leverage will remain close to the upper end of but within the agency's 4.5x guidance for negative rating action. This is due to lower EBITDA resulting from the launch of the new format in 2015, which is expected to generate losses in the first two years of operations. Fitch expects O'key to be able to navigate through this difficult period and deleverage toward 4x by 2018.

In addition, increased rents associated with the discount channel, together with high financing costs due to high interest rates prevailing in Russia will translate into weak FFO fixed charge cover just above 1.5x in 2015 before improving towards 1.7x by 2017.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for O'key include:
- Revenue to have increased 6% in 2015, and growth accelerates to 10%-13% pa over 2016-2019, driven by discounter format openings.
- EBITDA margin at 6.3% in 2015-2016 (2014: 7.4%) mostly due to losses incurred by the new discounter format, but also due to pressure from increased competition. Gradual recovery from 2017 onwards to 7%.
- Capex at 6% of revenue and lower at 3%-4% over 2017-2019, reflecting fewer store openings.
- Negative FCF margin of 4% in 2015 (2014:-8%) with neutral FCF from 2016 onwards.
- Dividend payout ratio of 25%.
- Adequate liquidity.

RATING SENSITIVITIES
Negative: Future developments that could lead to a negative rating action including but not limited to the Outlook being revised to Negative, are:
- Continued contraction in LFL sales growth relative to peers and failure in executing its expansion plan
- EBITDAR margin erosion to below 9% sustainably (2014: 9.9%)
- FFO-adjusted gross leverage above 4.5x on a sustained basis;
- FFO fixed charge coverage contracting to below 1.7x on a sustained basis
-Deterioration of liquidity position as a result of high capex and weakened financing conditions in the country.

Positive: Future developments that could lead to a positive rating action include:-
- Solid execution of its expansion plan with faster revenue growth from improved LFL sales and accelerated store expansion, while preserving its market position and financial discipline
- Ability to maintain the group's EBITDAR margin of above 9.5%
- FFO-adjusted gross leverage below 3.5x on a sustained basis;
- FFO fixed charge coverage around 2.0x on a sustained basis.

LIQUIDITY
Available cash totalled RUB3.1bn and undrawn committed credit facilities amounted to RUB12.3bn as of 20 December 2015, which is sufficient to cover RUB4.3bn of short-term debt maturing in 2015 and 2106. At 20 December 2015 87% of O'key's debt was long-term (RUB29bn) and most short-term debt maturities were revolving credit facilities. In addition, O'key has a bond programme with a total value of RUB25bn, including six tranches (RUB3bn-5bn) of five-year maturity each. Three tranches have been issued.