Russia-Based European Bearing Corp. 'BB-' And 'ruAA-' Ratings Affirmed; Outlook Stable
September 10, 2014 Standard & Poor's
PARIS (Standard & Poor's) Sept. 8, 2014--Standard & Poor’s Ratings Services said today that it affirmed its 'BB-' long-term corporate credit rating and 'ruAA-' Russia national scale rating on Russia-based engineering company OJSC European Bearings Corporation (EPK). The outlook remains stable.
The affirmation reflects our view that low debt will help EPK to maintain healthy credit ratios, despite our expectation of somewhat lower EBITDA in 2014 and 2015 on the back of weaker end markets. It also reflects our forecast of adequate liquidity--with Russian ruble (RUB) 1.4 billion of cash covering RUB1 billion of short-term debt--and positive discretionary cash flow due to moderate capital expenditure (capex) and no planned shareholder distributions.
Standard & Poor’s takes into account that current geopolitical risks may lead to a sudden and significant deterioration of EPK’s end markets in Russia. Standard & Poor’s has therefore revised our assessment of EPK’s financial risk profile downward to "intermediate" from "minimal" despite our base-case forecast that debt to EBITDA will remain below 1x.
Standard & Poor’s continues to assess EPK’s business risk profile as "weak," constrained by its narrow geographical focus. The company derives more than 90% of its total revenues in Russia, while the rest stems mostly from the other countries in the Commonwealth of Independent States (CIS). In addition, EPK faces weakness in several of its key end markets, which are the rail, auto, and industrial segments. In 2013, the company reported a significant decline in most of its markets apart from its special sector, which serves Russian aerospace and defense. The rail segment will experience further weakness in 2014 as a result of new Russian government regulations. These will lead to old railcars being written off, potentially causing EPK to lose some volumes from the servicing contracts. So far, sales to the Russian aerospace and defense industry have been the most profitable and didn’t decline in 2013, but Russia’s growing budget deficit may constrain funding for the sector. This could have an indirect impact on EPK's performance in this segment.
Our business risk assessment also reflects EPK's exposure to cyclical end markets, its concentrated customer base, the small size of its operations, and the less-advanced nature of its products compared with those of international peers, which means EPK lacks a technological competitive edge.
These factors are partly mitigated by EPK's good competitive position in Russia and the high barriers to entry in EPK's domestic markets, notably aerospace and defense. EPK also provides more than three-quarters of the rolling stock bearings used by the dominant national railroad operator Russian Railways JSC. Another supporting factor is the group's healthy adjusted EBITDA margin due to the significant (albeit reduced) contribution of aerospace and defense. Standard & Poor’s forecasts the margin from this segment to stay above 20% in 2014 and 2015.
Our base-case scenario for EPK over 2014 and 2015 assumes:
• Flat or very low GDP growth for Russia in the rest of 2014 and 2015.
• Single-digit revenue decline in 2014 and 2015, based on weakening conditions in the Russian bearings market. Standard & Poor’s forecasts a decline in rail, auto, and industrial segments for EPK.
• EBITDA margins of about 20%-24% in 2014 and 2015 (thanks to the high contribution of EPK's aerospace and defense-related operations) despite rising operating costs and increased pricing pressures.
• Capex of about RUB1.2 billion in 2014 and RUB500 million in 2015 due to the ongoing modernization program at EPK's Saratov plant, with relatively low maintenance capex.
• No shareholder distributions planned.
Based on these assumptions, Standard & Poor’s arrives at the following credit measures:
• Debt to EBITDA of about 0.5x;
• Funds from operations (FFO) to debt of more than 100%; and
• Free operating cash flow of about RUB1 billion;
Although EPK's management currently doesn’t expect any shareholder distributions, Standard & Poor’s still sees a risk of significant dividend payouts or large investments in other of the main shareholders' spheres of interest financed via raising debt at EPK--as happened in 2012, when the company provided a loan of RUB2.5 billion to its shareholders that was repaid through the company’s dividend. Standard & Poor’s therefore sees a risk that leverage may increase compared to our base-case scenario--although Standard & Poor’s considers that this risk has reduced. Standard & Poor’s reflects this with a one-notch downward adjustment to the rating (previously two notches) for our financial policy modifier (see "Ratings Score Snapshot").
Standard & Poor’s assesses EPK’s liquidity position as "adequate," in accordance with our criteria. This reflects our forecast that company’s sources of liquidity will cover its uses by comfortably more than 1.2x in the 12 months from June 30, 2014. Standard & Poor’s also anticipates that the liquidity sources will exceed liquidity uses even if EPK's EBITDA was 15% short of our expectations.
Standard & Poor’s understands that EPK doesn’t currently plan to extend its revolving credit facility with Sberbank that matures in 2015. Therefore, Standard & Poor’s doesn’t consider it as a source of liquidity in our calculation. This is mitigated by EPK’s liquidity cushion, positive cash flow generation, and comfortable debt repayment schedule.
EPK’s credit agreements with Sberbank and Commerzbank have a number of maintenance covenants tested at least twice a year. Standard & Poor’s expects EPK to maintain ample headroom under these covenants over the next 12 months.
Standard & Poor’s forecasts the following principal sources of liquidity over the next 12 months:
• About RUB1.4 billion in cash and cash equivalents;
• About RUB0.6 billion available under the committed export line maturing in beyond 2018; and
• FFO in excess of RUB2 billion.
Over the same period, Standard & Poor’s forecasts the following principal liquidity uses:
• Short-term debt of RUB1 billion as of June 30, 2014;
• Capex of about RUB1.2 billion; and
• Potential working capital volatility and outflow of about RUB0.5 billion.
The stable outlook reflects our expectations that EPK’s operating performance will weaken only moderately and its EBITDA margin will remain at about 20% or above. It also factors in our forecast of continued low leverage, adequate liquidity, and positive discretionary cash flow generation.
Standard & Poor’s could lower the rating on EPK if weaker end markets in Russia cause the company's performance to weaken, with negative discretionary cash flow leading to weaker liquidity.
Standard & Poor’s could also lower the rating if the company made a significant shareholder distribution in the current environment, leading to much higher leverage.
Standard & Poor’s does not foresee potential for an upgrade of EPK in the medium term, given Russian country risks and EPK’s limited scale and geographic diversification.
Company — European Bearing Corporation
Full nameEuropean Bearing Corporation