Fitch Affirms Evraz at 'BB-'; off Watch Negative
September 15, 2016
Fitch Ratings has affirmed Russia-based Evraz Group SA's (Evraz Group) and holding company Evraz plc's (Evraz) Long-Term Issuer Default Ratings (IDR) at 'BB-'. Evraz's 82% owned-subsidiary and Russian coal company OAO Raspadskaya has also been affirmed at Long-Term IDR 'B+'.
All ratings have been removed from Rating Watch Negative (RWN), where they were placed on 24 March 2016.
The Outlook on all Long-Term IDRs is Negative. A full list of ratings is available at the end of this commentary.
The Negative Outlook reflects our view that the low steel price environment will persist until 2018, negatively impacting Evraz's profitability and credit metrics. This will keep the funds from operations (FFO) adjusted gross leverage high over the short- to medium-term at above 5.0x in 2016, 4.6x in 2017 and 4.4x in 2018. This compares with our previous expectation of FFO adjusted gross leverage not exceeding 3.5x over the next three years.
After steel prices hit bottom in early 2016 and the recovery seen so far this year we expect prices to remain flat for the full year. We see prices remaining stable in 2017, before recovering slightly in 2018.
Evraz's strong liquidity profile is a key consideration, and the ratings factor in Evraz's continued effort to manage debt maturities, reduce absolute debt levels and maintain sufficient cash, despite a challenging market environment. The company has refinanced most of its 2016-2017 maturities, liquidity is in excess of USD1bn and free cash flow (FCF) is being deployed for deleveraging. The company has also obtained an 18-month covenant holiday.
Using a rating-through-the-cycle approach, we believe the company's FFO adjusted gross leverage could trend lower towards 3.5x by 2018 if it accelerates its deleveraging with additional measures such as cost optimisation and asset sales or in the event of a faster-than- expected steel price recovery.
Evraz has little headroom for underperformance at the current rating level. Further negative rating action may result if steel prices fall below 2015 levels in the medium term or if FCF generation is negative or not used for debt reduction.
KEY RATING DRIVERS
Deleveraging despite Weak Financial Performance
Weak end-market conditions had a significant impact on Evraz's financial performance in 2015. Revenues were down 33% compared with 2014, due to a combination of materially lower product prices and lower production volumes. However, favourable foreign exchange impact on rouble-denominated costs and cost efficiency measures helped contain the drop in EBITDA margin to 16%, compared with 17.6% in 2014. 1H16 EBITDA margin was in line with 2015 results.
Nevertheless, results were materially below our base rating case expectations in September 2015, both in terms of leverage and profitability. Evraz reported USD1.4bn of EBITDA and 5.3x FFO adjusted gross leverage, compared with our forecasts of USD1.8bn and 3.9x. Fitch now forecasts FFO gross leverage at 4.6x-5.1x over the 2016-17 period, compared with 4.0x for 2016 and under 3.5x over the next three years.
Despite our forecast of continued financial pressure in the short- to medium-term, Evraz is on a deleveraging path and we expect the company to use FCF exclusively in 2016 for debt repayment. Around USD500m has been repaid in the year to date, and we expect another USD200m repayment before year-end using balance-sheet cash. This should bring total debt down to USD5.9bn at end-2016, from USD6.7bn at end-2015.
Prices to Remain Stable
Evraz's key domestic end-markets are construction (36% of 1H16 sales volumes), and railway products (9%), while about 46% of Russian production is exported in the form of semi-finished products. Russian GDP declined 3.8% in 2015, driving consumption and prices significantly lower. As a result, steel prices for construction and railway dropped 32% and 29%, respectively, at end-2015 and continued to decrease 19% and 17% in 1H16.
Despite signs of easing price competition among domestic long steel producers and improved demand, both of which resulted in the beginning of a price recovery in 2Q16, we do not expect domestic prices to recover to above 2015 average levels. This is because we see a strong correlation between the prices of oil and gas and the Russian economy, and therefore, in turn, with the steel market in general, and the construction and railway markets in particular. We do not believe that oil prices will recover enough this year to reverse the trend. Exports of semi-finished product followed the same trend in 2015, with prices down 33% at end-2015 and a further 31% in 1H16, primarily due to global steel oversupply resulting from slowing demand from China. Although export steel prices have since improved, Fitch expects, as with domestic steel prices, the recovery to remain within 2015's average levels.
Raspadskaya Ratings Linked to Evraz
Ties between Evraz plc and Raspadskaya strengthened after Evraz increased its ownership to 82% in January 2013. The companies have since merged several support departments, such as treasury, logistics and other operations to increase synergies. Evraz remains a top-three offtaker for Raspadskaya, which plays a crucial part in Evraz's integration into coal. Nevertheless, a one-notch rating differential remains appropriate and reflects the absence of formal downstream corporate guarantees from Evraz for Raspadskaya's debt.
Cost-competitive but Less Profitable than Peers
Evraz Group benefits from high self-sufficiency in iron ore of 89% and coking coal of 196%, including supplies of coal from its subsidiary Raspadskaya. Consequently, it is better placed across the steel market cycle to control the cost base of its upstream operations than less integrated Russian and international steel peers. Thus, the cash cost of slab production at Evraz's Russian steel mills is the lowest among Russian peers - USD162/t in 1H16 versus USD176/t for NLMK and USD199/t for Severstal.
However, in terms of EBITDA generation per ton Evraz has the lowest profitability among its peers. The company generated approximately USD70/t in 2015 compared with USD126/t for NLMK, USD141/t for MMK, and USD194/t for Severstal in 2015. Evraz has been more severely impacted by the drop in steel prices than its Russian peers, which is partly due to its exposure to the fragmented Russian construction market, and more specifically to the less value-added long steel product market. Competition in the long steel product market from a number of small/mid-size players has been fierce, leading to a drop in prices for rebars. Evraz's peers are mostly exposed to the more concentrated flat steel product market.
We regard corporate governance at Evraz as average compared with its Russian peer group. However, we continue to notch down the rating twice relative to international peers, due to higher-than-average systemic risks associated with the Russian business and jurisdictional environment.
Fitch's key assumptions within the rating case for Evraz plc/Evraz Group/Raspadskaya include:
-USD/RUB exchange rate of 69 in 2016, 68 in 2017 and 62 in 2018
-Steel sales volumes to fall 8% in 2016, flat in 2017 and progressively recover thereafter (5% p.a. in 2018 and 2019)
Coal sales volume to rise 9% in 2016, flat in 2017 and grow steadily thereafter (2% p.a. in 2018 and 2019)
-Decrease in prices of steel products and coal in 2016 (3% for steel and 9% for coal), and progressive increase thereafter
-USD375m capex in 2016, USD400m-USD500m thereafter
-No dividend payments or share buybacks up to 2018
Company — Evraz
Full nameEvrazHolding (Evraz Group Russia)