October 26, 2016 | Cbonds
Fitch Ratings has revised the Outlook on Russia-based vodka producer PAO Synergy's (Synergy) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to Stable from Negative and affirmed the IDRs at 'B+' and the National Long-Term Rating at 'A-(rus)'. A full list of rating actions is shown at the end of this commentary.
The revision of the Outlook reflects our expectation that the improvements in the company's operating performance in 1H16 should be sustainable and lead to a strengthening in its credit metrics, in turn ensuring larger headroom under the 'B+' rating.
The ratings are underpinned by Synergy's leading position in the Russian alcoholic beverages market, which is supported by a portfolio of national and regional brands as well as a more developed distribution platform and larger scale of operations than most competitors. The ratings are also supported by our expectations that Synergy's leverage will remain conservative, balancing its weak coverage metrics and lower profit margins than industry peers.
KEY RATING DRIVERS
Clampdown on Illegal Market
The performance of duty-paying vodka producers in Russia, including Synergy, was hit in 2015 by a stiffening of competition from illegal vodka producers, which benefited from consumers shifting to cheap vodkas priced at the minimum allowed level. However, at the beginning of 2016 the government took further action against illegal production, which led to a sharp contraction in sales of illegally produced spirits. As a result, Synergy's sales volumes went up by 18% yoy in 9M16 and even exceeded its results for 9M14.
Rebound in Illegal Production Unlikely
We do not believe a revival in illegal production is likely as government measures were tough and some of them are yet to deliver results. We therefore project growth in Synergy's sales volumes at 18% and 8% in 2016 and 2017, respectively. Our projections also factor in the weakness of one of Synergy's major competitors Roust, which should enable Synergy to increase its sales more than the market in 2016-2017.
Recovery in EBITDA
Synergy's EBITDA grew by 42% in 1H16 after two years of declines on the back of higher sales volumes and reduced selling and administrative expenses as a proportion of revenues. Assuming further volume growth and selling price increases slightly below CPI, we project an EBITDA of RUB3.7bn in 2016 (2015: RUB2.5bn) with a moderate further improvement in 2017.
Trade Laws Profit Neutral
We do not assume any favourable impact on Synergy's profits from trade law amendments introduced in July 2016, which capped the amount of discounts, bonuses and other fees that suppliers may pay to a retailer. Due to the strong and growing bargaining power of major modern retail chains in Russia, we conservatively expect any lower fees to be balanced by lower selling prices.
We project Synergy's FFO adjusted leverage at around 3.5x over 2016-2019 (2015: 3.6x), which is commensurate with the 'BBB' median for alcoholic beverages companies. Synergy's conservative leverage compensates for its relatively weak FFO fixed charge coverage and profit margins compared with international peers. We project FFO fixed charge cover to remain below the 'B' rating category median of 2.0x in 2016-2019, despite improved profit generation and gradually decreasing borrowing costs in Russia. This is due to our expectation that as Synergy's production volumes grow, the company will pay more fees for bank guarantees needed to obtain excise stamps.
Synergy's product diversification has been gradually improving over the past five years, though it remains heavily exposed to the Russian vodka market. The production of brandy and "infusions" and imports of alcoholic beverages altogether accounted for 33% of its alcohol segment revenues in 1H16 against 21% in 2012. We expect however further scope for product diversification will now be limited to the expansion of own production of brown spirits. These projections do not assume any new contracts for distribution of third-party brands.
Sales Mix Change Weighs on Margins
The increase in the contribution of imported spirits to total sales is diluting Synergy's EBITDA margin. We do not expect any recovery in its margin to the mid-teen levels of 2011-2013, but we view this strategy which leverages Synergy's distribution platform as beneficial in terms of enhancing the company's market position, top-line growth and business diversification.
Average Recovery Prospects
Fitch considers Synergy's two rouble bond issues (RUB4bn in total) structurally subordinated to the rest of the group's debt as bonds are issued by the holding company and not guaranteed by operating companies. However, average recoveries in case of default are supported by Fitch's going-concern valuation approach. As a result, the rating Fitch has assigned to the rouble bonds is in line with Synergy's IDR of 'B+'.
Synergy has smaller scale and narrower geographic and product diversification than international spirits producers, which translates into lower profitability. At the same time, the 'B+' rating is supported by the company's leading market position in Russia, strong brand portfolio and conservative capital structure.
The operating environment in Russia contributes to a lower rating for Synergy relative to global peers, in line with our criteria.
Fitch's key assumptions within our rating case for the issuer include:
- Excise duties stable in 2016 and increasing to RUB523 (+5% yoy) per litre of ethanol in 2017; no increases thereafter, as per the Russian tax code.
- 18% and 8% growth in sales volumes of own spirits in 2016 and 2017 respectively; stable in 2018-2019.
- Around 30% increase in revenues from distribution of imported brands in 2016; stable thereafter.
- Annual net selling price increases slightly below CPI.
- Reduction in marketing and distribution fees to retailers offset by respective decrease in selling prices in 2017, causing no impact on EBITDA.
- EBITDA margin improving to 10.0% in 2016 (2015: 8.2%) and 10.3% in 2017 but gradually decreasing below 10% by 2019.
- Around RUB3.5bn outflow under working capital in 2016; improvement in working capital turnover in 2017 due to trade law amendments.
- No dividends or share buybacks.
- Capex at around RUB1bn per year.
Future Developments That May, Individually or Collectively, Lead to a Positive Rating Action
An upgrade is unlikely in the coming two years, given the company's geographic concentration on one competitive market and its small size compared with larger industry peers. However, it could be considered should this change, and subject to:
Increasing diversification towards a higher share of non-vodka products and/or growing share of exports in its profits;
FCF turning and remaining positive, with EBITDAR margin of around 15%;
FFO-adjusted leverage below 3x and FFO fixed charge coverage above 2x on a sustained basis;
An enhanced liquidity profile, including a smaller proportion of short-term debt and a stronger liquidity buffer derived from cash balances and committed bank facilities.
Future Developments That May, Individually or Collectively, Lead to a Negative Rating Action
Deterioration in FFO-adjusted leverage sustainably above 4.0x and of FFO fixed charge coverage ratio below 1.5x.
Persistently negative free cash flow (FCF) not mitigated by asset disposal or equity injections.
Contraction of EBITDAR margin sustainably to below 10%.
Regulatory changes or rebound in illegal production in the Russian spirits sector that may put more pressure on the company's sales and profitability.
Weak Liquidity: As at 23 September 2016 Synergy's cash balances of RUB1.1bn and committed undrawn credit lines were insufficient to cover short-term debt of RUB5.1bn and expected negative free cash flow. However, the company has a record of debt refinancing, which it maintained in the difficult trading environment in 2015, and it has good access to the Russian bond market, as evidenced by issuance in 2015 and 2016.
FULL LIST OF RATING ACTIONS
- Long-Term Foreign-Currency IDR affirmed at 'B+'; Outlook is revised to Stable from Negative.
- Long-Term Local-Currency L IDR affirmed at 'B+'; Outlook is revised to Stable from Negative.
- National Long-Term Rating affirmed at 'A-(rus)'; Outlook is revised to Stable from Negative.
- Local-currency senior unsecured rating affirmed at 'B+'/RR4.
- Local-currency senior unsecured rating of rouble bond issued in May 2016 (4B02-05-55052-E) assigned at 'B+'/RR4.
Company: Beluga Group
|Full company name||PJSC Beluga Group|
|Country of risk||Russia|
|Country of registration||Russia|