OREANDA-NEWS. Fitch Ratings has downgraded China-based Honghua Group Limited's (Honghua) Long-Term Issuer Default Rating (IDR) to 'B-' from 'B', with Negative Outlook. The oil rig producer's senior unsecured rating has also been downgraded to 'B-' from 'B', with a Recovery Rating of 'RR4'.

The downgrade reflects the deterioration of the company's financials in a sharp industry downturn. The company did not manage to unlock cash from working capital as revenue dropped dramatically. Margin also declined, which further pressured cash flow.

The Negative Outlook reflects our view that the industry outlook remains uncertain. The company's liquidity might come under more pressure if the downturn persists.

KEY RATING DRIVERS

Weaker-than-Expected Results: Honghua's 2015 results were much weaker than Fitch estimated as market conditions continued to deteriorate. Honghua's revenue declined 46.0% to CNY4.2bn in 2015. EBITDA fell 56% to CNY310m. Its EBITDA margin narrowed to 7.3% from 9.1% in 2014. Its core land drilling rigs segment recorded operating losses in 2H15 while its offshore drilling rigs and engineering services segments were unprofitable at the operating level.

Revenue, Margin Decline in Downturn: Honghua's core business segment has been badly hit by the decline in oil prices. Its revenue from land drilling rigs and related parts plunged as downstream clients scaled back capex and operating activities. The operating margin of these two segments was not as resilient as expected through the cycle - the margin almost halved to 6.2% in 2015 from about 12.0% when oil prices were buoyant. The poor financial profile would limit Honghua's investment in new technology and R&D activities, which would hurt its long-term market position.

Challenges in New Businesses: Honghua's diversification into offshore drilling rigs and engineering services has not been successful so far. The offshore market is likely to be more volatile than the onshore market due to the higher cost structure in general, which would put a new player like Honghua at a disadvantage. The company posted a CNY137m operating losses in 2015 for this segment. Honghua's engineering services segment also had operating losses of CNY163m, due to the decline in daily rates.

Debt Remains High: Honghua's net working capital to revenue ratio surged to 75% in 2015 (2014: 29%), indicating it is increasingly difficult to collect receivables. As a result, Honghua did not reduce debt as much as we expected during the industry downturn. Net debt remains at CNY3.1bn (2014: CNY3.1bn) and the net debt to EBITDA ratio surged to 10x (2014: 4.3x).

Adverse Operating Environment: The continued fall in global oil prices has negatively affected the oil and gas value chain. As major producers scale back on capex and operating activities, Honghua's order book is shrinking and its margin is under pressure. We expect the weak operating environment to persist. Hence, Honghua's business performance is unlikely to rebound to the previous peak in the next 12-18 months.

Liquidity Still Adequate: Honghua has CNY2.3bn of debt due within one year. Meanwhile, it has CNY1.6bn of cash on hand and CNY11.4bn in unused banking facilities. It has also received approval to issue not more than CNY1.5bn in short-term debt facilities in the domestic capital market. The company pared capex and is gradually reducing its working capital needs, it should be able to generate positive free cash flow. Overall, we believe Honghua has sufficient financial resources and access to meet its liquidity needs.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Honghua include:
- Revenue to stabilise from 2017 onwards
- Working capital requirement to decrease following the falling revenue
- Margin for core operating segments to remain stable
- Operating cash flow in non-core operating segments to turn positive after 2017

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Weakened liquidity, including challenges in rolling over short-term debt
- Sustained revenue decline and margin pressure
- Sustained negative free cash flow generation

Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- The company avoids breaching negative rating guidelines over the next 12-18 months.