Fitch Revises UCL Rail and Freight One Outlook to Stable; Affirms at 'BB+'


29 Nov 2016 12:12 PM


Fitch Ratings-Moscow/London-29 November 2016: Fitch Ratings has affirmed the Long-Term Foreign-Currency Issuer Default Ratings (IDRs) of UCL Rail B.V. (UCLR) and its key 100% subsidiary JSC Freight One at 'BB+' and revised the Outlook to Stable from Negative. A full list of rating actions is available at the end of this commentary.

The Outlook revision reflects our expectation that leverage will improve to levels commensurate with the current rating level within the rating horizon. We forecast Freight One's funds from operations (FFO)-adjusted net leverage to be slightly below 2.5x at end-2016 and beyond due to improving gondola rates, expected scrap proceeds from the sale of old rail fleet and zero dividends.

KEY RATING DRIVERS
Improving Market Fundamentals
The forecast modest Russian GDP growth will support freight rail transportation volumes, which, coupled with gradual rail fleet disposals following the ban on use of old rail fleet from 2016 and low fleet production, will continue to support gondola rate growth in 2017, although at a slower pace than in 2016. This should boost the revenue of rail operators with a significant share of gondola cars, like Freight One. We expect JSC Russian Railways' tariff growth to be lower than in 2016, about inflation, which should support rail operators' margins, as empty-run costs are the major contributors to their total operating costs.

Mixed Impact from Ban on Old Fleet Use
The ban on use of old rail fleet from 2016 prompted disposal of railcars and helped reduce their oversupply on the market, boosting gondola use daily rates, which had been stagnating in recent years. This is positive for rail operators. Freight One expects to write off a material part of its fleet over 2016-2019. Nevertheless, we expect the company to retain its market share either through operating leases, as in 2016, or the purchase of additional railcars in the coming years. Our rating case also includes RUB8.5bn of scrap proceeds from sale of old rail fleet in 2016, and more, although significantly below this level, in 2017-2019.

Lease-Adjusted Credit Metrics
We consider the increased proportion of operating leases in 2016 in response to the ban on use of old rail fleet a temporary measure rather than a long-term strategy shift. We expect the company to return to fleet acquisitions, partially substituting the leased fleet as market conditions improve. Therefore we expect the share of the fleet under operating leases will remain small and in line with the historical average.

Fitch treats rail fleet operating lease rentals as a debt-like obligation and applied a 4x multiple (instead of the standard 6x multiple in Russia) to capitalise the related costs, reflecting the flexibility of operating-lease contracts, which can be dissolved at relatively short notice and the company's demonstrated ability to manage lease costs to match the stage of the business cycle. Fitch would revise the multiple to 6x if the company permanently shifts its strategy towards having a significant and steady share of operating leases from its historical practice of using leases for a number of small and specific business opportunities.

Deleveraging Under Way
Freight One continues to deleverage. Its net debt position decreased to RUB58bn at end-2015 from RUB106bn at end-2012 and we expect it to fall further by end-2016. As we expect the company to partially substitute the leased fleet with owned fleet as the market environment improves, we expect it to increase capex to about RUB22bn on average over 2017-2019. Our rating case also includes the proceeds from old rail fleet sales for scrap and zero dividends. Therefore we expect FFO-adjusted net leverage to drop below 2.5x on average over 2016-2019. This leverage expectation supports the Outlook revision.

Focus on Service Contracts
The competition between rail operators has intensified in recent years. Rail operators including Freight One have entered medium- to long-term service agreements with their key customers to increase the visibility of cash flows. Under these agreements Freight One is responsible for transporting 25%-100% of its customers' freight. The company generates about 60% of total revenue under these contracts. The agreements' tenor ranges from two to seven years. However, Freight One remains exposed to volume risk as some contracts fix only the percentage of the customers' cargo volumes, but not actual volumes.

DERIVATION SUMMARY
Freight One is the leading nationwide commercial rolling stock operator in Russia, with an estimated market share of about 16% at end-2016. It is followed by Globaltrans Investment Plc (BB/Stable), which has about 8% based on rail transportation volumes. Rail operators' business is exposed to volatile economic drivers affecting transported volumes and freight rates. Like Globaltrans, Freight One operates under long-term contracts with major customers. However, its rail fleet is older and therefore it is more exposed to the ban on use of old rail fleet introduced at end-2015. Freight One expects to write off a material part of its rail fleet over 2016-2018 and partially replace it with leased-in fleet.

Freight One will maintain the largest fleet in operations among private rail operators.

UCL Rail's ratings are equalised with those of Freight One, as the latter is the sole contributor to the group's revenues and earnings following a reorganisation in 2015.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Domestic GDP decline of 0.5% in 2016 and 1.3%-2% growth over 2017-2019
- Inflation to grow at 7% in 2016 and 5%-6% over 2017-2019
- Freight prices to grow at about or slightly lower than inflation rate
- Capex in line with company's guidance for 2016 and our expectation of RUB22bn on average over 2017-2019 to substitute the recent increase of rail fleet under operating lease with the owned railcars
- Rail fleet size under operations in line with management expectations
- Scrap proceeds in line with management expectation for 2016 of RUB8.5bn and more, although significantly below this level, over 2017-2019.

RATING SENSITIVITIES
Positive: Future Developments That May, Individually or Collectively, Lead to Positive Rating Action
- A sustained decrease in FFO lease-adjusted net leverage below 1.5x and FFO fixed charge coverage of above 3.5x
- Sustained stronger economic growth and infrastructure improvements
- Diversification of the customer base and lengthening of contract duration with volume visibility with key customers

Negative: Future Developments That May, Individually or Collectively, Lead to Negative Rating Action
- FFO-adjusted net leverage above 2.5x and FFO fixed charge coverage below 2.5x on a sustained basis, due to weak industrial activity in Russia and weaker-than-expected operating results, larger capex or dividend payments or failure to execute asset disposals as planned
- Unfavourable changes to the Russian legislative framework for the railway transportation industry

LIQUIDITY
At end-1H16 Freight One had RUB12bn of cash and cash equivalents and bank deposits, which is sufficient to cover the company's short-term maturities of about RUB6bn. Freight One also had unused credit facilities of RUB49bn, mainly from VTB, Alfa-Bank (BB+/Negative) and Promsvyazbank and we expect the company to be free cash flow positive. Freight One does not pay any commitment fees under unused credit facilities, which is common practice in Russia.

Freight One's outstanding debt of RUB61bn at end-1H16 was mostly raised in roubles. Debt of RUB19bn was secured by pledge of rail fleet. At end-1H16 rail fleet with balance value of RUB33bn (about 32% of total assets) was either pledged under loan agreements or used as a security under finance lease agreements. But the company still had a significant share of unencumbered assets, which leaves significant asset value for senior unsecured creditors.

FULL LIST OF RATING ACTIONS
UCL Rail
Long-term foreign currency IDR affirmed at 'BB+'; Outlook revised to Stable from Negative
Short-term foreign currency IDR affirmed at 'B'
Foreign currency senior unsecured rating affirmed at 'BB+'
Long-term local currency IDR affirmed at 'BB+'; Outlook revised to Stable from Negative
Short-term local currency IDR affirmed at 'B'
Local currency senior unsecured rating affirmed at 'BB+'
National Long-term rating affirmed at 'AA(rus)', Outlook revised to Stable from Negative

Freight One
Long-term foreign currency IDR affirmed at 'BB+', Outlook revised to Stable from Negative
Short-term foreign currency IDR affirmed at 'B'
Foreign currency senior unsecured rating affirmed at 'BB+'
Long-term local currency IDR affirmed at 'BB+', Outlook revised to Stable from Negative
Short-term local currency IDR affirmed at 'B'
National Long-term rating affirmed at 'AA(rus)', Outlook revised to Stable from Negative
Local currency senior unsecured rating affirmed at 'BB+'

Contact:
Principal Analyst
Dmitry Doronin
Analyst
+7 495 956 9984

Supervisory Analyst
Oxana Zguralskaya
Director
+7 495 956 7099
Fitch Ratings CIS Ltd
26 Valovaya Street
Moscow 115054

Committee Chairperson
Josef Pospisil
Manging Director
+44 20 3530 1287

Media Relations: Julia Belskaya von Tell, Moscow, Tel: +7 495 956 9908, Email: julia.belskayavontell@fitchratings.com; Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@fitchratings.com.

Summary of Financial Statement Adjustments -
Operating leases of rail fleet: Fitch adjusted Freight One's/UCLR's debt by adding 4x the annual operating lease expense related to rail fleet of RUB1.2bn in 2015. The multiple was lowered to 4x from 5x used in previous years. The decrease follows the revision of the multiple for Russia from 8x to 6x. The remaining operating lease expenses were capitalised using 6x multiple.

Additional information is available on www.fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary.

Applicable Criteria
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
Parent and Subsidiary Rating Linkage (pub. 31 Aug 2016)

Additional Disclosures
Dodd-Frank Rating Information Disclosure Form
Solicitation Status
Endorsement Policy


ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTPS://WWW.FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE AT WWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE, AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE CODE OF CONDUCT SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.
Copyright © 2016 by Fitch Ratings, Inc., Fitch Ratings Ltd. and its subsidiaries. 33 Whitehall Street, NY, NY 10004. Telephone: 1-800-753-4824, (212) 908-0500. Fax: (212) 480-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. In issuing and maintaining its ratings and in making other reports (including forecast information), Fitch relies on factual information it receives from issuers and underwriters and from other sources Fitch believes to be credible. Fitch conducts a reasonable investigation of the factual information relied upon by it in accordance with its ratings methodology, and obtains reasonable verification of that information from independent sources, to the extent such sources are available for a given security or in a given jurisdiction. The manner of Fitch’s factual investigation and the scope of the third-party verification it obtains will vary depending on the nature of the rated security and its issuer, the requirements and practices in the jurisdiction in which the rated security is offered and sold and/or the issuer is located, the availability and nature of relevant public information, access to the management of the issuer and its advisers, the availability of pre-existing third-party verifications such as audit reports, agreed-upon procedures letters, appraisals, actuarial reports, engineering reports, legal opinions and other reports provided by third parties, the availability of independent and competent third- party verification sources with respect to the particular security or in the particular jurisdiction of the issuer, and a variety of other factors. Users of Fitch’s ratings and reports should understand that neither an enhanced factual investigation nor any third-party verification can ensure that all of the information Fitch relies on in connection with a rating or a report will be accurate and complete. Ultimately, the issuer and its advisers are responsible for the accuracy of the information they provide to Fitch and to the market in offering documents and other reports. In issuing its ratings and its reports, Fitch must rely on the work of experts, including independent auditors with respect to financial statements and attorneys with respect to legal and tax matters. Further, ratings and forecasts of financial and other information are inherently forward-looking and embody assumptions and predictions about future events that by their nature cannot be verified as facts. As a result, despite any verification of current facts, ratings and forecasts can be affected by future events or conditions that were not anticipated at the time a rating or forecast was issued or affirmed.
The information in this report is provided “as is” without any representation or warranty of any kind, and Fitch does not represent or warrant that the report or any of its contents will meet any of the requirements of a recipient of the report. A Fitch rating is an opinion as to the creditworthiness of a security. This opinion and reports made by Fitch are based on established criteria and methodologies that Fitch is continuously evaluating and updating. Therefore, ratings and reports are the collective work product of Fitch and no individual, or group of individuals, is solely responsible for a rating or a report. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of any security. All Fitch reports have shared authorship. Individuals identified in a Fitch report were involved in, but are not solely responsible for, the opinions stated therein. The individuals are named for contact purposes only. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. Ratings may be changed or withdrawn at any time for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax-exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from US$10,000 to US$1,500,000 (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2000 of the United Kingdom, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers.
For Australia, New Zealand, Taiwan and South Korea only: Fitch Australia Pty Ltd holds an Australian financial services license (AFS license no. 337123) which authorizes it to provide credit ratings to wholesale clients only. Credit ratings information published by Fitch is not intended to be used by persons who are retail clients within the meaning of the Corporations Act 2001