OREANDA-NEWS. Fitch Ratings has downgraded Yanzhou Coal Mining Company Limited's (Yancoal) Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'B' from 'BB-'. The Outlook remains Negative.

Simultaneously, Fitch has downgraded the rating on the USD1bn dual-tranche notes issued by Yancoal International Resources Development Co., Ltd and guaranteed by Yancoal to 'B' from 'BB-', with a Recovery Rating of 'RR4'; and the rating on the US dollar senior perpetual capital securities issued by Yancoal International Trading Co., Ltd and guaranteed by Yancoal to 'B' from 'B+', with a Recovery Rating of 'RR4'.

The downgrade of Yancoal's IDR and maintenance of a Negative Outlook reflect weakening in short-term liquidity, sustained high leverage (FFO-adjusted net leverage of 10x at end-2015) arising from challenging coal-mining industry conditions and higher-than-expected capex. Yancoal's capital expenditure is likely to remain elevated in the next three to four years, which together with our expectations of sustained weak thermal coal prices, will result in negative free cash flows and constrain the company's ability to improve its financial position meaningfully.

The company has increased its reliance on short-term on-shore debt funding in 2015. A significant increase in the share of short-term debt in its capital structure would raise liquidity risks. In addition, there is limited headroom under the Recovery Ratings of 'RR4' - weaker cash generation or increased secured debt could prompt a downgrade of the Recovery Ratings, and thus the ratings on the senior unsecured debt.

Yancoal's 'B' IDR is underpinned by its good access to banking and capital markets as a provincial state-owned enterprise, and its strong market position within the Chinese coal-mining sector, which supports its near-term liquidity. We do not factor in any specific uplift from the provincial government in its ratings currently.

KEY RATING DRIVERS

Sustained Weak Coal Prices: Yancoal's average realised coal selling price dropped 20% in 2015 due to weakness in the China and Asia-Pacific seaborne coal markets. Fitch does not expect further significant price declines because producers sector-wide are suffering losses while China and Indonesia are taking steps to reduce capacity. However, in China, the central government's efforts to reduce capacity in the coal industry have yet to have a material impact. Fitch believes a significant price rebound is unlikely in the short term due to weak demand in China, and still an over-supplied seaborne thermal coal market.

Large Capex: Yancoal is maintaining high capex to increase production capacity, mainly in Inner Mongolia and Australia, with the aim of raising coal output from mines with higher margins. The company's total capex in 2015 rose 83% to CNY9.9bn. Yancoal plans to continue investing substantially in Inner Mongolia and Australia, as well as in its coal chemical, equipment manufacturing and power generation segments, although the company has a good level of flexibility in its non-maintenance capex. The company's maintenance capex is around CNY2bn-3bn annually. If the company chooses to continue to investing heavily, free cash flow will remain negative, which will hamper its ability to deleverage in the next three to four years.

Continued Cost Cutting: Yancoal has been reducing costs to cope with the adverse market conditions since 2013. In 2015, Yancoal's average production cost fell by 17% per tonne due to production process optimisation and labour cost cuts. Fitch expects a good portion of these cost-cutting measures to be sustained in the short to medium term. However, with most of its cost-cutting options already exploited, the room for further cost reduction is limited. Yancoal continues to be among the best performing coal miners in China on a cost and gross margin basis.

Liquidity Weaker; Adequate in Near Term: Yancoal's total debt maturing within one year more than doubled to CNY24bn at end-2015 from CNY11bn at end-2014. The company's total CNY23bn cash on hand at end-2015 (end-2014: CNY20bn) and its good access to multiple funding sources provide some liquidity support, but the buffer has shrunk significantly. Refinancing needs would also be considerable in 2017 with CNY2.2bn of bonds and CNY1.5bn of unsecured term loans maturing, on top of its secured borrowings. In addition, the company's FFO interest coverage weakened to 2.0x in 2015 (2014: 2.1x and 2013: 3.3x) with lower operating cash generation and high indebtedness. While we expect the company to continue to benefit from its state ownership in accessing domestic funding sources, any increase in funding costs will significantly affect its financial flexibility.

Linkages with Parent: Yancoal is 56.6% owned by Yankuang Group Corporation Limited (Yankuang), which is wholly owned by the Shandong State-owned Assets Supervision and Administration Commission (SASAC). Yankuang is also one of the two dominant coal producers within Shandong SASAC. Fitch has not provided any explicit rating uplift to Yancoal for any implied support from the Shandong government. However, the IDR considers enhancement to its liquidity from good access to domestic funding sources because it is majority-owned by the Shandong government.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Yancoal include:
- Coal price to remain flat in 2016, and recover by around 5% a year in 2017 and 2018
- Coal production cost to fall by 10% in 2016, reflecting further reduction in labour costs; and remain stable going forward
- Coal production in the Inner Mongolia and Australia mines to reach a total 40-50 million metric tonnes by 2018-2019; older mines' production to reduce by 5% a year
- Capital expenditure of around CNY7bn-10bn a year over 2016-2018 for coal mines in Inner Mongolia and Australia, and for coal chemical projects

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to a revision in the Outlook to Stable include:
- FFO interest coverage above 2.0x (end-2015: 2.0x) on a sustained basis
- An improvement in the company's liquidity position, including maintaining of a cash position that can comfortably cover its short-term debts
- Stabilisation of coal prices
- Evidence of tangible support from the provincial government

Negative: Future developments that may, individually or collectively, lead to a downgrade of the rating include:
- Weakened access to external funding sources
- Continued increase in short-term obligations that further weaken the liquidity profile
- Substantial reduction in the cash position against short-term debt
- FFO fixed-charge coverage sustained below 2x
- In addition, an increase in secured debt, a significant increase in overall indebtedness or a further weakening of operating performance, can lead to lowering of the Recovery Ratings, and thus, the ratings on the company's senior unsecured debt