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Fitch Affirms United Confectioners at 'B'; Outlook Negative

March 23, 2015 | Fitch Ratings

Fitch Ratings-Moscow/Milan/London-20 March 2015: Fitch Ratings has affirmed Russia-based OJSC Holding Company United Confectioners' (UC) Long-term Issuer Default Rating (IDR) at 'B' and its National Long-term rating at 'BBB-(rus)'. Outlook is Negative. The agency has also affirmed the senior unsecured rating on OOO United Confectioners Finance's bond due April 2023 at 'B'/'RR4'.
The ratings reflect the company's heightened corporate governance risks and volatile operating margin as FX-driven increases in raw materials prices cannot be fully passed on to customers. The ratings remain supported by UC's leading position in Russia's confectionery market, moderate leverage and satisfactory operating cash flow generation capability.

The Negative Outlook captures potential continuation of the company's aggressive shareholder distributions and increasing loans to related parties, amid a challenging economic environment in Russia and the associated pressure on the company's core operations in 2015.

KEY RATING DRIVERS

Loose Corporate Governance Practices
Corporate governance issues remain a key credit risk, in particular with respect to aggressive distribution of cash outside of the group either in a form of dividends or loans to related parties. Lack of management independence and the portion of UC's cash kept at Guta Bank also demonstrate UC's dependence on its shareholder Guta Group, which caps rating uplift. We treat shareholder-friendly policies as potentially adversely affecting unsecured creditors.

Dividends and loans to related parties exceeded operating cash flows in 2013 and we believe this was repeated in 2014. Maintenance of cash distributions at elevated levels in 2015, despite expected deterioration in UC's cash generation ability due to weakening consumer sentiment and rouble devaluation, would mean a shift towards a more aggressive financial strategy of the group and could lead to a rating downgrade.

Subdued Consumer Sentiment
Fitch expects a decline in real disposable incomes in Russia to translate into subdued consumer sentiment in 2015-2016 and weaker demand for confectionery as demonstrated during the 2008/09 crisis. However, we expect any drop in UC's sales volumes to be limited to the low single digits in 2015, which should enable the company to outperform the market, which we expect to see a mid-single digit market contraction.

The company is well positioned to benefit from a substitution of demand for Ukrainian confectionery (currently banned). In addition, the company's focus on affordable sweets should help protect sales volumes as consumers trade down.

FX Risk Exacerbates Margin Volatility
UC's operating margins are volatile primarily as a result of swings in prices for major inputs, such as cocoa, sugar and other agricultural commodities, given the company's inability to enter into effective hedging. Following the sharp rouble devaluation since end-2014, we expect UC's operating profit margin to come under pressure in 2015-2016 due to the strong increase in in the rouble price of raw materials. This is despite our assumption that UC will be able to increase its selling prices above projected food inflation in 2015 and reflects the limited scope for passing on higher costs in a challenging consumer spending environment.

Moderate Leverage
We forecast that UC's funds from operations (FFO)-adjusted leverage should rise to around 2.9x-3.7x in 2015-2016 (2013: 2.5x) as a result of EBITDA margin deterioration, together with the maintenance of large shareholder distributions and loans to related parties. Although this leverage is still acceptable for the company's 'B' rating, a further and sustained hike in leverage, if not alleviated by reduced shareholder distributions and loans to related parties, could lead to further downward pressure on the IDR.

Leading Market Position
UC continues to hold leading positions in its core confectionery market segments of Russia, benefiting from its strong portfolio of nationally recognised brands. We believe that the company's focus on the medium price segment, high customer loyalty and wide distribution network covering the whole country will enable UC to retain its leading position in the Russian confectionery market over the medium term and display resilient revenue performance in the current environment.

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to negative rating actions include:
- Any material, sustained, deterioration in free cash flow (FCF) generation, combined with larger-than-expected distribution of funds to Guta Group or with operating underperformance
- Sustained FFO-adjusted gross leverage above 4x
- Net outflows in relation to loans to related-parties and dividends exceeding cash flow from operations minus maintenance capex

Positive: An upgrade is unlikely unless corporate governance practices improve. Future developments that may, individually or collectively, lead to the rating Outlook being revised to Stable include:
- Evidence of decreased distribution of funds to Guta Group, particularly in the event of weak cash flow generation
- Adequate liquidity

LIQUIDITY AND DEBT STRUCTURE

Liquidity is supported by RUB0.7bn of Fitch-adjusted unrestricted cash as of end-2014 and RUB4.9bn available bank lines relative to short-term debt of RUB2.1bn. Fitch acknowledges that liquidity issue may arise in 2016 in view of maturities of major revolving credit facilities. We believe that UC will be able to refinance these credit lines, although refinancing risk may increase if cash leakage to related parties and/or high dividends result in further leverage growth.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
-USD/RUB at around 60 for 2015-2017
-Decrease in sales volumes in the low single digits in 2015 and muted growth thereafter
-Double-digit revenue growth in 2015 supported by high inflation and the partial pass through of input cost increases, before slowing to high-single-digits in 2016-2017
-Decline in EBITDA margin to around 8.5% in 2015 as a result of higher raw materials prices (in turn due to the rouble devaluation)
-Capex around 3%-4% of revenue over 2015-2018
-Cash distributions outside of group perimeter (dividends or loans to related parties) equal to or slightly exceeding prior-year net profit

Company: United Confectioners Holding

Full company nameOJSC United Confectioners Holding Company
Country of riskRussia
Country of registrationRussia
IndustryFood industry

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