OREANDA-NEWS. Fitch Ratings has placed Russian pig iron company OAO Koks Group's (KOKS) ratings on Rating Watch Negative (RWN) as follows:

- Long-term foreign currency Issuer Default Rating (IDR) of 'B' on RWN
- Short-term IDR of 'B' on RWN
- Long-term local currency IDR assigned at 'B', and placed on RWN
- Senior unsecured rating for Koks Finance Limited's Eurobond issues due in 2016 and 2018 of 'B' on RWN.

The RWN reflects the risk of KOKS's failure to repay short-term debt, which we consider unlikely, and the more likely risk that KOKS continues to maintain a liquidity position not commensurate with a 'B' rating. The former could result in a default; the latter a downgrade, probably to 'B-'. We understand the company is taking steps to address both risks and expect to resolve the RWN within the next six months once there is evidence of KOKS's progress on its Eurobond repayment and a successful short-term debt refinancing, resulting in a more comfortable liquidity ratio (2015E: 0.5x).

The ratings reflect KOKS's performance being largely in line with Fitch's expectations except for debt, which increased in 2015 due to the rouble's sharp devaluation against the US dollar. This raised end-2015 funds from operations (FFO) adjusted gross leverage to 4.5x, above our negative leverage guideline of 4.0x. Fitch expects that FFO adjusted gross leverage will reverse to 3.8x by end-2016 on the back of positive free cash flow (FCF) generation of RUB4.6bn, which will be used for deleveraging.

The ratings also incorporate KOKS' small size and limited operational diversification compared with other Russian steel companies. At the same time KOKS has a strong pig iron and coke market position and targets 100% self-sufficiency in iron ore and coking coal by 2020.

KEY RATING DRIVERS
Leverage Peak in 2015
As KOKS's reporting currency is the Russian rouble, a sharp fall of the currency against US dollar has inflated its US dollar-denominated debt (62% of total debt at end-2015), which caused its FFO gross leverage to rise to 4.5x at end-2015 from 3.6x at end-2014 despite the USD debt amount remaining unchanged. Fitch expects KOKS's leverage to decline to 3.8x by end-2016 as high profitability and positive FCF generation contribute to overall debt reduction.

Weak Liquidity
Fitch views KOKS's liquidity as weak, with a small cash position and reliance on revolving credit facilities (RCFs) to repay current maturities. The company has implemented two exchange offers to extend its Eurobonds' maturities to December 2018 from June 2016. As a result of the exchanges KOKS currently has two outstanding Eurobonds: USD201m (USD32m of which is on KOKS's balance sheet) maturing in 2018 and USD134m maturing in 2016.

KOKS's short-term bank debt was RUB22bn as of end-2015 (40% of total debt). Of this amount RUB17bn was RCFs, which Fitch expects to be rolled over in due course. This means KOKS will need to repay RUB5bn non-RCF debt and RUB10bn of Eurobonds (fell to RUB9bn during 1Q16 on stronger rouble) maturing in 2016. Fitch expects KOKS to have just sufficient liquidity for this repayment, including RUB4.1bn of cash, expected positive FCF of RUB4.6bn, a recently approved RUB4bn two-year credit line from Rosselhozbank and undrawn credit lines.

Therefore Fitch views KOKS's liquidity management as having weakened but expects it to improve with the new longer term facilities the company is currently considering.

Strong Profitability
KOKS's revenue increased 12% yoy in 2015 to RUB53bn, even though average USD-denominated export prices of pig iron declined 34% yoy. The fall in the rouble against US dollar has helped the company to partly offset the negative effect of softer prices. EBITDA grew 11% yoy to RUB13.5bn, partly driven by currency effect and partly by a structural change in costs as the company gradually ramped up coal production at its captive Butovskaya mine, hence reducing purchases from third parties.

Fitch expects further profitability improvement, driven by higher production of coal at captive mines - the operating Butovskaya mine (commissioned in 2014) and at Tikhova mine that is currently under development (to be commissioned in 2018).

Partial Self-Sufficiency
Currently KOKS is over 100% self-sufficient in coke, 71% in iron ore and 50% in coking coal. With the commissioning of Tikhova mine in 2018 and further production ramp-up at the recently commissioned Butovskaya mine, KOKS expects to achieve 100% self-sufficiency in coking coal by 2018. With Tikhova mine already operating the company will be a rare producer of high quality ZH-grade coking coal. The commissioning of the iron ore deposit at Kombinat KMA Ruda in 2020 will bring KOKS's self-sufficiency in iron ore to 100%.

Strong Position in Pig Iron
KOKS is the world's largest exporter of merchant pig iron and top producer of merchant coke in Russia. In 2015 it controlled 15% of the world's pig iron exports and 29% of total CIS pig iron sales. KOKS accounted for 25% of total coke sales in CIS. The company is geographically diversified in its pig iron sales with a strong presence in markets such as North America (38% of total sales), Europe (29%), Turkey and The Middle East (25%) and Asia (8%). KOKS specialises in commercial pig iron, which is used in automotive, machinery and tools industries requiring high quality of pig iron (low content of sulphur and phosphorus). With its new de-sulphurising machine KOKS intends to raise the share of premium pig iron in total sales up to 50% in 2016 from 28% in 2014.

Tula-Steel Project
Along with its two partners, DILON Cooperatif U.A. (DILON) and LLC Steel, KOKS is developing an up-to-RUB35bn steel project in Tula Region. All three partners are ultimately controlled by the Zubitskiy family. At present LLC Steel and DILON control the Tula-Steel project through an equity interest of 66.7% and 33.3% respectively. KOKS has no control, no legal ties or debt recourse and does not consolidate the project in its financial results. It has only provided a RUB7bn loan due 2023 to the project and may provide a further up to RUB8bn depending on its partners' contribution. The project has obtained RUB20bn eight-year project financing from Gazprombank. If the project incurs unexpected cost overruns it will require KOKS to contribute the shortfall, together with its partners (unlikely until 2018), which may negatively affect its leverage metrics.

A 2mtpa steel plant is expected to be commissioned in end-2017 with expected ramp-up in 2018. The steel plant will produce high quality specialty steel to be used in the machinery and automotive industries. As the plant will be fed with pig iron produced by KOKS's subsidiary Tulachermet, the steel project should integrate seamlessly into KOKS's business model.

KOKS may consider consolidating the steel project, provided the project's leverage becomes moderate. However, cash outflows to Tula-Steel that are materially above our expectations or the project's consolidation into KOKS's financial results may create leverage and rating pressure. Consolidating the project may also create a significant secured debt layer affecting the recoveries of senior unsecured bondholders.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Average export pig iron price decline of 15% in 2016 with mid-single digit recovery after 2016
- Further ramp-up at Butovskaya coal mine and commissioning of Tikhova coal mine in 2018
- Average RUB/USD 75 in 2016 with gradual rouble appreciation towards 58 in 2019
- Cost inflation at 8% in 2016, declining to 5% thereafter
- Capex to moderate to below RUB5bn and no dividends until 2019
- RUB6bn funding contribution to non-consolidated Tula-Steel in 2016-2017

RATING SENSITIVITIES
Positive: Fitch does not expect any rating upgrade at this stage.

Future developments that may, individually or collectively, lead to the ratings being affirmed include:
- Positive FCF across the cycle leading to FFO adjusted gross leverage below 4x on a sustained basis;
- FFO fixed charge cover above 4x on a sustained basis (4.8x at end-2014);
- Improved liquidity with the liquidity ratio reverting to above 1.0x.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Failure to repay short-term debt including Eurobonds due 2016, although considered unlikely, could result in a multi-notch downgrade
- Failure to improve KOKS's liquidity position could result in a downgrade, most likely to 'B-'
- Cash outflows to Tula-Steel project that are materially above our expectations;
- Significant market deterioration, capex overruns or Tula-Steel project consolidation causing FFO adjusted gross leverage to remain above 4x after 2016;

LIQUIDITY
KOKS's liquidity continues to rely on undrawn committed short-term facilities and the company's ability to roll over already drawn funds in due course. Fitch expects KOKS to have just sufficient liquidity to repay 2016 maturities, with RUB4.1bn of cash, expected positive FCF of RUB4.6bn, a recently approved RUB4bn two-year credit line from Rosselhozbank and undrawn credit lines.