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.

DERIVATION SUMMARY
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.

KEY ASSUMPTIONS
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.

RATING SENSITIVITIES
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.

LIQUIDITY
Adequate Liquidity 
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.

Contact:

Principal Analyst
Anna Zhdanova, CFA
Associate Director
+7 495 956 2403

Supervisory Analyst
Jean-Pierre Husband
Director
+44 20 3530 1155
Fitch Ratings Limited
30 North Colonnade
London E14 5GN

Committee Chairperson
Pablo Mazzini
Senior Director
+44 20 3530 1069

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 -
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.

Applicable Criteria
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)

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


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