September 13, 2012 / 2:56 PM / 5 years ago

TEXT-Fitch rates O'KEY Group S.A.

Sept 13 - Fitch Ratings has assigned Russia-based food retailer O‘KEY Group S.A. (O‘KEY) a foreign and local currency Long-term Issuer Default Rating (IDR) of ‘B+'. Fitch has also assigned O‘KEY a National Long-term Rating of ‘A-'(rus). The Outlooks are Stable. The ratings reflect the group’s strong domestic position in the regional food retail market and in particular in the fast growing hypermarket segment in Russia. The group enjoys strong profitability at the high-end of the leading food retailers. The ratings also reflect the group’s relative lower scale compared to its listed competitors, revenue concentration in St Petersburg where O‘KEY enjoys strong market share but where potential for growth remains limited due to the increased saturation and competition from other retail chains. The group is developing aggressively outside St Petersburg (including the Moscow region) and targets to be present in at least 25 cities in Russia with populations of over 500,000 by 2015. The group’s positioning in the hypermarket segment captures the structural shift and consumers’ aspiration in Russia. However, Fitch believes that O‘KEY’s more midscale/upscale positioning in its product range and non-food offer might expose O‘KEY to more pressure than discounters in a weakening economic environment. Fitch also expects the overall Russian food retail industry to remain increasingly competitive with a year-on-year decline of the non-organized retail market and the overall strong network from the main food retail operators in prime and secondary cities. Therefore Fitch expects on-going pressure on the group’s operating margin due to the group’s expansion plan (customer’s lower income, except Moscow) and increased costs (labour, leased costs). Fitch believes that the group’s expansion growth entails inherent execution risks, even if Fitch acknowledges that O‘KEY’s benefits from strong management expertise in the retail industry. The group has shown a solid track record in opening stores over the past few years (07-11 compound annual growth rate 32.2%). Fitch believes that a successful roll-out and the pace of growth will depend on the group’s capacity to manage internal (IT, human resources, logistics) and external factors (such as locating sites, acquiring or leasing appropriate sites on commercially reasonable terms, finding skilled contractors, obtaining administrative approval on time, dealing efficiently with Russian regulations on food retail and construction). It will also depend on the state of overall economic environment in regions where O‘KEY is expanding. In terms of financials, the group’s leverage with a leased adjusted net debt/funds from operations (FFO) debt at 3.5x FYE12e is in line with its rating category for a Russian retailer, a level that Fitch expects to remain steady. Fitch expects O‘KEY to generate negative free cash flow in the coming years due to the group’s expansion plan (high capex due to the openings of owned hypermarkets). Fitch estimates that this capex will be partially internally financed at about c.58% in the next two years which means that the group will need to raise new debt to finance its current development programme. Fitch notes that this characteristic is not specific to O‘KEY as other food retailers in Russia are also growing fast and therefore generating negative free cash flow. Fitch sees O‘KEY’s liquidity risks as manageable. Apart from its current relationships with local banks which finance working capital and expansion on a unsecured and secured base (the group had RUB5.3bn of total undrawn bank facilities as at 31 July 2012) and is in process of signing a new RUB2.5bn bank facility, O‘KEY is also listed on the London Stock Exchange (15% free float) which gives the group additional financial flexibility. Fitch also understands that the group’s capex programme is flexible (RUB15bn in FY12E) and could be rapidly scaled down if needed, as capex consists of investments to open new stores and buy new plots of lands. Maintenance capex is expected to remain quite low and capital commitment amounted to RUB2.8bn as at 30 June 2012. WHAT COULD TRIGGER A RATING ACTION? Positive: Future developments that may, individually or collectively, lead to positive rating action include - O‘Key showing solid execution of its expansion plan - The group’s capacity to show positive like-for-like sales growth - Maintaining the group’s EBITDA margin of at least 7.5%-8%. - Fitch also acknowledges that an improvement in the group’s free cash flow would be viewed as supplementary rating positive factors. Fitch also expects the group’s size to reach at least EUR500m in EBITDA terms. In terms of leverage, for a ‘BB-’ rating Fitch expects an adjusted net debt/FFO ratio falling permanently towards 2.5x and FFO/fixed charge >3.5x. Negative: Future developments that may, individually or collectively, lead to negative rating action include: - A sharp contraction relative to its peers of like-for-like sales and EBITDA margin erosion (7%) combined with FFO adjusted net leverage remaining above 4x (3.5x on EBITDAR basis).(Caryn Trokie, New York Ratings Unit)

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