Fitch Affirms Russia's O'Key at 'B+'; Outlook Stable
16 Jan 2017 7:28 AM
Fitch Ratings-Moscow-16 January 2017: Fitch Ratings has affirmed O'Key Group S.A.'s (O'Key) Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) at 'B+'. Fitch has also affirmed LLC O'Key's senior unsecured debt at 'B+'/'A(rus)' with a Recovery Rating of 'RR4'. The National Long-Term Rating has been affirmed at 'A(rus)'. The Outlook is Stable for both IDRs and National Long-Term Rating.
The ratings reflect the small scale of O'Key as the seventh-largest food retailer in Russia. Nevertheless it retains a healthy position in the Russian hypermarket segment and a strong brand, especially in its home St. Petersburg region, one of the largest retail markets in Russia with strong consumer purchasing power.
The ratings also reflect temporarily weaker credit metrics projected for 2016-2017, albeit still in line with its ratings, as a result of heightened competition in the market and start up-losses at its new hard discounter format. The Stable Outlook is predicated on the group's financial headroom increasing from 2018 as the EBITDA margin improves.
KEY RATING DRIVERS
Challenging Trading Environment
Competition is intensifying in the Russian food retail market as consumer spending remains weak, while large players continue consolidating the market with rapid store roll-outs.
As O'Key is only the seventh-largest food retailer in Russia and has modest expansion plans for its core hypermarket format, we expect it to continue to sacrifice some gross margin to withstand competition. We project a reduction in gross margin to below 23% over 2016-2019 (2015: 23.6%). This is despite some support from improved purchasing terms due to a strengthened commercial team and increased procurement from regional suppliers, as well as a decrease in supply chain costs following the construction of a new warehouse in 2016.
Scaling Back Discounter Roll-Outs
O'Key has scaled back plans for its new hard discounter (Da!) openings over 2017-2019. Slower growth of the store base will postpone the format achieving breakeven to 2018 from the previously expected 2017. Therefore the group's EBITDA margin should remain under pressure in 2016-2017 before recovering in 2018 when the new format should gain critical mass.
Our projections also assume that sales density at hard discounters should catch up with industry averages. Nevertheless, the ratings continue to incorporate execution risks around the expansion of the group's new format, as O'Key balances the need to expand the format to gain critical mass with meeting profitability targets.
EBITDA Margin under Pressure
Fitch expects O'Key's EBITDA margin to decline to 5.7% in 2016 and remain around this level in 2017 (2015: 6.1%) due to a mild decline in gross margin and losses in growing discounter operations. Our expectation of recovery of the EBITDA margin to 6.2% in 2018-2019 is based on the discount stores breaking even and lower staff costs partly offsetting the gross margin decrease.
Slow Revenue Growth
We expect O'Key's revenue to grow 7% per annum over the medium term (2015: 7%), which is the lowest among public Russian food retailers, but high by European standards. This is based on 5% annual sales growth in O'Key's core hypermarket and supermarket formats, which in turn is driven by new store openings. We however conservatively assume close-to-zero like-for-like (LfL) sales growth over the medium term due to the competitive market environment.
Positively LfL sales growth should be supported by O'Key's strong brand, continued assortment adjustments towards cheaper goods and private label, and by a gradual recovery in non-food sales.
Credit Metrics Consistent with Ratings
We expect O'Key's funds from operations (FFO)-adjusted gross leverage and FFO fixed charge coverage to weaken in 2016-2017 before recovering in 2018 as EBITDA margin improves, while capex remains moderate at 3%-4% of sales. We expect FFO adjusted gross leverage to fall to 3.7x by 2019 (2015: 4.1x), which is conservative for the industry but consistent with the rating given O'Key's weaker-than-peers business profile.
However, weak financial performance for example due to delays in achieving profitability for its discounter format or greater-than-expected margin attrition not offset by other cash preservation measures, resulting in permanently impaired credit metrics could put negative pressure on the rating or outlook.
The rating differential between O'Key (B+/Stable) and its Russian peers X5 (BB/Stable) and Lenta (BB/Stable) stems from the company's weaker business profile due to its smaller scale and market position, more limited growth prospects as well as more volatile margins and LfL sales performance. Leverage is slightly higher than its peers, although we expect some deleveraging in the next three as the expanding discount format begins to generate operating profits.
Fitch's key assumptions within our rating case for the issuer include:
- Revenue growth of, 7% per year supported by 5% revenue growth in hypermarket and supermarket formats and discounter format openings.
- EBITDA margin decreasing to 5.7% in 2016-2017, before recovering to above 6% in 2018 as discounter format breaks even in 2018
- Capex at 3%-4% of revenue over 2016-2019, reflecting fewer store openings.
- Dividends of around RUB1.3bn per year.
Future developments that may, individually or collectively, lead to a negative rating action include:
- Continued contraction in LfL sales growth relative to peers and failure in executing its expansion plan;
- EBITDA margin erosion to below 5.5% on a sustained basis (2015: 6.1%);
- FFO-adjusted gross leverage above 4.5x on a sustained basis (2015: 4.1x);
- FFO fixed charge coverage below 1.7x on a sustained basis (2015: 1.7x);
- Deterioration of liquidity as a result of weaker internal cash flow generation or worsened access to external funding.
Future developments that may, individually or collectively, lead to a positive rating action include:
- Solid execution of its expansion plan with faster revenue growth from improved LfL sales and accelerated store expansion, while preserving its market position and financial discipline;
- Maintaining EBITDA margin above 6.5%;
- FFO-adjusted gross leverage below 3.5x on a sustained basis;
- FFO fixed charge coverage around 2.0x on a sustained basis.
At end-October 2016 O'Key's liquidity was adequate as cash balances of RUB2.6bn and undrawn committed credit facilities of RUB5.9bn were sufficient to cover short-term debt of RUB5.4bn and expected negative free cash flow for 2017.
Anna Zhdanova, CFA
+7 495 956 2403
+44 20 3530 1155
Fitch Ratings Limited
30 North Colonnade
London E14 5GN
+44 20 3530 1069
Media Relations: Julia Belskaya von Tell, Moscow, Tel: +7 495 956 9908, Email: email@example.com; Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: firstname.lastname@example.org.
Summary of Financial Statement Adjustments -
Cash: We have adjusted available cash at end-2015 to reflect restricted cash of RUB1.5bn needed for seasonal changes in working capital requirements.
Leases: Fitch has adjusted end-2015 debt by applying a multiple of 6.0x of yearly operating lease expense related to long-term assets (RUB4,728m for 2015).
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.
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
National Scale Ratings Criteria (pub. 30 Oct 2013)
Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 21 Nov 2016)
Dodd-Frank Rating Information Disclosure Form
Copyright © 2017 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