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Fitch Rates X5 Finance B.V.'s Planned Eurobond 'BB(EXP)'
April 3, 2017 / 2:24 PM / 8 months ago

Fitch Rates X5 Finance B.V.'s Planned Eurobond 'BB(EXP)'

(The following statement was released by the rating agency) MOSCOW/MILAN/LONDON, April 03 (Fitch) Fitch Ratings has assigned X5 Finance B.V.'s rouble Eurobond a senior unsecured rating of 'BB(EXP)'. Fitch has also affirmed the Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) of X5 Retail Group N.V. (X5), the parent company of X5 Finance B.V., at 'BB'. The Outlook is Stable. A full list of rating actions is available at the end of this commentary. The planned Eurobond is rated in line with X5's IDR, as structural subordination to debt raised by operating companies is eliminated by guarantees. The Eurobond placement should strengthen X5's liquidity and extend its debt maturity profile, enhancing the group's financial flexibility by diversifying its funding sources and investor base. The final rating is contingent upon receipt of final documents conforming to the information already received by Fitch. KEY RATING DRIVERS Leading Multi-Format Retailer in Russia: X5's business risk profile is strong for the ratings. It is supported by its leading position in Russia's food retail market and by consistent market share gains over the past three years, a trend which we are confident will continue. The business model is supported by X5's multi-format strategy, with a focus on the defensive discounter format, and on continuously improving logistics and distribution systems. These factors should enable X5 to strengthen its market position, despite increasing competition from other large retail chains in the country. Solid Execution of Growth Strategy: X5 has almost doubled its revenue since 2013, while maintaining strong operating cash-flow generation and a stable EBITDA margin of around 7%. In 2016 the company had the fastest revenue growth in the sector (28% yoy) due to accelerated new store openings and industry-leading like-for-like (LfL) sales growth (8% yoy). X5's record of effective implementation of its growth strategy lowers execution risks related to further expansion, as the company aims to solidify its position as Russia's largest food retailer and double its market share by 2020. Strong Growth to Continue: We project X5's revenue CAGR at around 20% over 2017-2020, supported by new store roll-outs and positive LfL sales growth. We expect growth to now decelerate as a result of slowing inflation, but project that in 2017 it should remain strong compared with peers due to store refurbishments and a catching up in sales densities at maturing stores. There is also upside for LfL footfall growth from the recent introduction of a loyalty card at X5's discounters. Moderate Leverage: Fitch expects X5's FFO adjusted leverage to remain stable after its reduction in 2016 to 3.5x (2015: 3.9x) which is fully aligned with the ratings in the sector in Russia. Our current projections show more conservative leverage metrics than our previous forecasts, which contribute to improving X5's headroom under its 'BB' rating. If maintained, this could lead to a positive rating action over the medium term. Profit Margins Unaffected by LTI Payments: We understand from management that once the current long-term incentive (LTI) programme is fulfilled, it is likely to be followed by another one. The targets and other conditions of the new programme are not known yet. However, as LTI bonuses are likely to be a recurring expense for X5 we assumed it at 0.2% of the company's revenue in 2019-2020. This should not compromise X5's profit margins, and we expect its EBITDA margin to remain strong relative to western European food retail peers. Expected Decrease in EBITDA Margin: X5 reported a strong EBITDA margin of 7.4% in 2016 (2015: 6.8%). This was ahead of our expectations. In our projections however we conservatively factor in a gradual decrease to below 7% (adjusted for potential LTI payments) by 2020 due to potential gross margin sacrifices to fend off competition and protect footfall rates. Our projections also assume that X5 will be able to maintain stable operating lease expenses as a proportion of revenue, despite the company's plan to expand primarily through leasehold stores. This is based on X5's growing presence in regions with lower rents and its strong bargaining power with landlords, as proven in 2016. Weak Fixed Charge Coverage: Funds from operations (FFO) fixed charge coverage remains the main constraining factor for X5's ratings as it is below the levels consistent with a 'BB' category in the sector. The metric is under pressure from substantial operating lease expenses and we project it to remain broadly stable over 2017-2020 (2016:1.9x). In our view, weak coverage metrics are somewhat mitigated by favourable lease cancellation terms and the partial dependence of leases on store turnover. DERIVATION SUMMARY X5 benefits from a stronger business profile than Lenta LLC (BB/Stable) and O'Key Group SA (B+/Stable) due to its larger business scale and stronger format diversification. We also expect a similar leverage profile for X5 and Lenta. Even though X5 exhibits weaker fixed charge cover metrics, overall, we assess X5 has more headroom under its 'BB' rating than Lenta. In comparison with international retail chains, X5 has a scale commensurate with the lower 'BBB' category rating and similar credit metrics but more limited geographic diversification, which is partly offset by stronger growth prospects. X5 also compares well with Chile-based Cencosud SA (BBB-/Stable). However, the weak operating environment in Russia contributes to a lower rating for X5 relative to global peers, in line with our criteria. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - annual revenue growth around 20% over 2017-2020, driven by selling space CAGR above15% over 2017-2020 and positive LfL sales growth; - LTI expenses at around 0.2%-0.3% of revenue over 2017-2020; -EBITDA margin (adjusted for potential LTI expenses) gradually decreasing below 7% by 2020; -capex at around 4%-6% of revenue; -no dividends; -neutral free cash flow (FCF); -no large-scale M&A activity. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action - Positive LfL sales growth comparable with close peers, together with maintenance of its leading market position in Russia's food retail sector - Ability to maintain the group's EBITDA margin at around 7%. - FFO-adjusted gross leverage below 3.5x on a sustained basis - FFO fixed charge coverage around 2.5x on a sustained basis Future Developments That May, Individually or Collectively, Lead to Negative Rating Action - A contraction in LfL sales growth relative to close peers, particularly if combined with EBITDA margin erosion to below 6.5% - FFO-adjusted gross leverage above 5.0x on a sustained basis - FFO fixed charge cover significantly below 2.0x on a sustained basis if not mitigated by flexibility in managing operating lease expenses - Deterioration in liquidity as a result of high capex, worse working-capital turnover and weaker access to local funding LIQUIDITY AND DEBT STRUCTURE Adequate Liquidity: We expect an improvement in X5's liquidity and extension of its debt maturity profile after the placement of its new RUB30 billion Eurobond. Pro forma short-term debt at end-2016 of RUB17 billion and expected negative free cash flow should be sufficiently covered by X5's Fitch-adjusted unrestricted cash of RUB13 billion and available undrawn committed credit lines of RUB32 billion. In addition, X5 has flexibility in managing its capex plans, which is the major driver behind the expected negative FCF, while the group's operating cash-flow generation remains strong. We also believe X5 retains good access to local funding, due to its large scale, non-cyclical food retail operations and strong operating performance. Average Recoveries for Eurobond Holders: The planned RUB30 billion Eurobond is rated in line with X5's IDR of 'BB', although it is expected to be issued by the non-operating company X5 Finance B.V., which was specifically established for the purpose of the Eurobond placement. Structural subordination to operating companies' debt is eliminated by the presence of suretyships from major operating companies accounting for not less than 80% of the group's EBITDA and net assets. Therefore, there is virtually no debt that would rank prior to the Eurobonds, thus reinforcing our view of average recovery prospects in case of default. Structurally Subordinated Local Bonds: Fitch rates four rouble bonds issued by X5 Finance LLC's (financial company, 100%-owned by X5) one notch below X5's IDR at 'BB-' as their bondholders do not have recourse to operating companies. Therefore their rights are structurally subordinated to lenders at the level of operating companies and bondholders of RUB15 billion local bonds and new Eurobonds that feature suretyships from the main EBITDA-generating entities. Prior-ranking debt was below 2x of the group's 2016 EBITDA, which is Fitch's threshold for a material possibility of subordination and lower recoveries for unsecured creditors. Nevertheless, our view of below-average recovery prospects is based on our assumption that X5 may issue additional debt ranking prior to bonds to fund its expansion strategy. FULL LIST OF RATING ACTIONS X5 Retail Group N.V. - Long-Term Foreign- and Local-Currency IDRs: affirmed at 'BB', Stable Outlook; X5 Finance B.V. - Senior unsecured rating: assigned 'BB(EXP)'/ 'BB'/'RR4' X5 FINANSE LLC (100%-owned by X5 Retail Group N.V.) RUB15 billion bonds due September 2031 - Local currency senior unsecured rating: affirmed at 'BB'/'RR4' RUB5 billion bonds due October 2022 - Local currency senior unsecured rating: affirmed at 'BB-'/'RR5' RUB5 billion bonds due March 2023 - Local currency senior unsecured rating: affirmed at 'BB-'/'RR5' RUB5 billion bonds due April 2023 - Local currency senior unsecured rating: affirmed at 'BB-'/'RR5' RUB5 billion bonds due August 2023 - Local currency senior unsecured rating: affirmed at 'BB-'/'RR5' 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 Giulio Lombardi Senior Director +39 02 8790 87214 Summary of Financial Statement Adjustments Cash: Fitch adjusted available cash at end-2016 by deducting RUB5 billion to reflect average working capital requirements throughout the year. 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