OREANDA-NEWS. Fitch Ratings has affirmed South African state-owned defence company Denel SOC Limited's (Denel) National Long-term rating at 'AAA(zaf)' and National Short-term rating at 'F1+(zaf)'. The Outlook is Stable.

The affirmation reflects continuing strong links between Denel and the state, mainly driven by the government's irrevocable and unconditional guarantee on ZAR1.85bn of Denel's ZAR3bn domestic medium term notes (DMTN). The group delivered strong operational performance for the financial year to 31 March 2015 (FY15) with an increase in international revenue diversification alongside a solid order book.

Despite the strong sovereign linkage and operational performance, potential negative pressures on the ratings include the management suspensions, increased leverage leading to a lower portion of government-guaranteed debt and the expiry of the government guarantee. We believe these risks are currently adequately managed by the group, but will closely monitor developments to ensure that any material changes to these do not warrant a negative rating action.

KEY RATING DRIVERS
Strong Sovereign Linkage
Denel's ratings are underpinned by the full state ownership and support from the state. The main driver for this is the explicit shareholder support Denel receives from the government guarantee for ZAR1.85bn of its issuance under its DMTN programme.

Strong Operational Performance
Operational performance for FY15 exceeded Fitch's expectations with revenue growth of 28% and profitability (Fitch-adjusted EBIT) margin improvement to 3.4% (FY13: 0.5%). Denel benefitted from increased export sales and weaker operating currency, which kept cost increases (notably other operating costs) well below revenue growth.

In FY15 the group benefitted from key landward projects moving from development phase to production, which provided about 15% of the revenue growth and we expect both Denel Land systems and Denel Dynamics to lead growth for FY16. (Fitch's calculation of EBIT differs from Denel's reported EBIT of ZAR335m (excluding associates' ZAR64m) in FY15 as we exclude other income of ZAR137m disclosed on Denel's income statement).

Solid Order Book
Denel delivered a healthy order book of ZAR35bn for FY15 (FY14: ZAR32bn), which represents an annual revenue cover of 6x. The order book, together with the further targeted opportunities of ZAR37bn (of which ZAR23bn are short- to medium-term) and collaborative partnerships in the Middle East, Southeast Asia and South America, underpin the group's forecast revenue growth assumptions.

Increased Leverage
On 28 April 2015 Denel concluded their acquisition of BAE Systems Land Systems South Africa for ZAR855m, which was funded through debt raised by the group. While the strategic rationale for the acquisition is clear, in that it broadens Denel's offering in landward systems, we expect the acquisition to result in a significant increase in debt for FY16, which is higher than our previous assumptions. We expect the resultant weaker credit metrics to deteriorate until FY17 when monetisation of the increased Land Systems capabilities and synergies will drive cash flow and deleveraging.

Guaranteed Debt Share to Fall
The expected increased leverage in FY16 is likely to significantly reduce the proportion of government-guaranteed debt to above 50% from FY16 from above 80% in FY15. While there has been no change to the support provided by the state (in terms of the guarantee provided), the significant decline in the guaranteed debt proportion is a negative rating factor. If this proportion declines to less than 50% this could lead to a reassessment in the alignment of Denel's ratings with that of the sovereign.

Expiry of Government Guarantee
The government guarantee of ZAR1.85bn of the ZAR3.0bn DMTN programme is due to mature on 30 September 2017. Management have indicated that they will engage with the shareholder over an extension of the guarantee during 2016 and we would expect this to be resolved ahead of the FY17 results. Although not currently expected by Fitch, failure to agree a timely extension of the guarantee could result in notching down Denel's rating from the sovereign rating or potentially rating Denel on a standalone basis.

Management Uncertainty
Fitch continues to assess the links between the state and Denel as strong despite the suspension of key executives (CEO, CFO and Company Secretary) in September 2015 pending an independent investigation. We believe the significant support provided by the government to the company is not questioned by this board decision and it is this support that underpins Denel's current ratings. We expect that the suspension will add uncertainty to existing governance limitations; however, the interim leadership is experienced, which is likely to limit the short-term implications of this decision.

Speculative Grade Standalone Rating
We believe that Denel's standalone credit profile remains below investment-grade with low levels of profitability, weak free cash flow (FCF) generation and high leverage metrics. The limited number of manufacturing platforms and low level of self-funded research continue to negatively impact Denel's operating profile and our view of the group's standalone credit profile.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Denel include:
-Partial year recognition of LSSA contribution in FY16, resulting in 80% increase of Land Systems revenues with an average of high-single digit growth thereafter;
-Mid-single digit revenue growth for the group as a whole (excluding LSSA impact);
-Slightly lower EBIT margins for FY16 and FY17 but higher thereafter, reflecting expected improvement for Dynamics and Land Systems; and
-Increased capex intensity for FY16 and FY17 to account for PMP plant renewal and LSSA acquisition, and moderating thereafter.

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
-Withdrawal of government support through the government inferring or explicitly indicating that it is no longer committed to Denel's long-term turnaround strategy and a failure to assist the company to operate as a going concern.
-A reduction in the government-guaranteed portion of Denel's debt to below 50%
-Indications that the government guarantee may not be renewed at expiry
-Weakening in government financial support, which would lead to Fitch assessing Denel on a standalone basis

LIQUIDITY
At end-FY15 Denel maintained sufficient liquidity, with ZAR1,909m of unrestricted cash balances (management maintains that cash, which is operationally ring-fenced for Hoefyster, remains available for debt service if required) and available facilities of ZAR909m (including a ZAR300 facility plus a USD50m facility) against short-term debt maturities of ZAR1,270m. We forecast negative FCF for FY16 of ZAR310m, largely driven by capex. There have been no changes to the government guarantee of ZAR1.85bn of the ZAR3bn DMTN programme.

The group is, however, heavily reliant on short-term funding, largely due to CP issuance. For FY16 we expect this short-term debt profile to remain similar (with a further addition of a two-year banking facility for the LSSA acquisition), but for it to improve to a longer maturity profile once the guarantee extension has been agreed.