Fitch Ratings has affirmed JSC Russian Railways’ (RZD) Long-term foreign currency Issuer Default Rating (IDR) at ‘BBB’ with a Stable Outlook. Fitch has also affirmed RZD Capital P.L.C.’s foreign currency senior unsecured rating at ‘BBB’. A full list of rating actions is at the end of this release.
The affirmation of the ratings reflects the continued strong support of the Russian Federation (BBB/Stable).
KEY RATING DRIVERS
Ratings Aligned with Sovereign
RZD’s ratings are aligned with those of the Russian Federation, given its 100% state ownership and strategic importance to the Russian economy. The ratings reflect the strong links between the state and the company, including the approval of capex and annual tariffs, the provision of federal and regional subsidies for passenger and freight transportation, direct equity injections to fund RZD’s key infrastructure projects, and more recently, the state pension fund financing of long-term infrastructure projects with long-dated CPI-linked infrastructure bonds. In FY13, the government also approved the issuance of RUB150bn preferred shares, to be purchased by the National Wealth Fund over 2014-2016 and finance infrastructure development in the Far East. No final decisions have been made on privatisation but according to the position of the government, any privatisation of a minority stake is unlikely to occur until 2017 at the earliest.
‘BBB’ Standalone Profile
Fitch assesses RZD’s standalone creditworthiness in the mid ‘BBB’ category. This is driven by RZD’s position as the monopoly owner and operator of the rail infrastructure, essential for transporting freight and passengers across Russia and abroad. It also has sizeable operations in freight and passenger transportation in Russia. RZD’s standalone profile is limited by the absence of long-term tariffs, despite plans for their introduction, as well as its exposure to commodity market risks, and somewhat limited, albeit improving, geographical diversification. To a large degree, it is dependent on financial state support and credit metrics have weakened on the back of earnings pressure and still high capex.
State Financial Support Still Substantial
In the medium term, Fitch expects RZD to continue receiving tangible financial support in the form of sizeable subsidies (RUB53bn in FY13), the majority of which relate to passenger transportation, and state support for infrastructure development (RUB56bn in FY13), which is done in form of equity injections. Although these were lower than FY12, they are expected to increase again in FY14. Subsidies are forecast to be around RUB75.7bn whilst equity injections will total around RUB78.5bn given the development of the Far East.
2014 Tariff Freeze Temporary
Fitch viewed negatively the unexpected freezing of RZD’s 2014 freight tariffs when it was announced back in September 2013. The government’s decision raised questions over the transparency and predictability of the regulatory framework and in turn, earnings visibility. Fitch’s concerns have since been largely addressed, given the promise of additional subsidies (RUB26bn) to compensate for the tariff freeze and the approval of a tariff corridor for certain cargo types. This is forecast to allow RZD to increase tariffs for oil transportation and raise additional funds of RUB16bn. The Ministry of Economic Development in Russia has confirmed that as of 2015, tariffs will increase at the level of inflation and that the intention is to introduce long-term infrastructure tariffs based on a return on invested capital. This would further support the company’s ratings but implementation is not expected until 2015 at the earliest.
Subdued Volume Recovery
Fitch expects freight volumes to recover in 2014, following the 2.8% decrease in 2013, albeit at lower growth rates than in previous years. Fitch forecasts Russian GDP growth rates will remain relatively depressed at between 2%-3% in 2014 and 2015. Construction volumes are likely to have a much greater recovery, as the sharp declines during 2013 were primarily due to high 2012 comparatives and the near completion of infrastructure for the Sochi Olympic Games, but growth in oil transportation is expected to remain impacted by the VSPO-2 oil pipeline to China commissioned back in 2013. Freight transportation volumes had improved slightly by 1.8% in December 2013 and 1.2% in January 2014compared to the same period of preceding year.
Margin Pressures, Cost Optimisation Important
RZD’s margins and consequently funds from operation (FFO) generation have faced increasing pressure since 2010. In H113, EBITDA margins as calculated by Fitch declined to 22%, almost 550bpsrelative to H112. In common with many Russian rolling stock operators, this was largely driven by the company’s somewhat high fixed cost base. Other contributory factors were the acquisition of GEFCO, slightly lower subsidies received from the government and product mix (increase in lower-margined coal transportation). Some improvement in margins is expected by year end due to the company’s cost optimisation plan. RZD forecasts it will have succeeded in generating at least RUB99m cost savings. In an environment of lower forecasted volume growth, RZD’s continued ability to rationalise its cost base will be essential to support margins and current FFO levels, particularly in view of continued high capex plans.
Continuing High Capex
Capex net of state capital injections, which reflect the company’s own projects, has gradually increased over the past few years and is expected to peak at around RUB504bn in FY13, around 197% of FFO generation. Some decrease relative to earnings is expected in the medium term but over 2014-2016, RZD forecasts it will still invest around RUB1.2trn (around RUB1.4trn on a gross basis). The company’s projects reflect the implementation of security measures but also the elimination of infrastructure bottlenecks and renovation of the company’s locomotive fleet, which management has confirmed can to some degree be postponed.
Reducing Credit Metrics Headroom
Fitch anticipates RZD’s net debt/EBITDA will materially increase to around 2.0x in FY13 from around 1.1x in FY12 and remain between 2.2x-2.5x in the medium term due to continued earnings pressure and still high capex net of state capital injections. RZD’s internal guideline, supported by the Minister of Economy, is 2.5x. Fitch would therefore expect the government to either increase its financial support in the event of further operational deterioration and/or reduce the company’s net capex plans. Fitch expects RZD’s ratings will continue to be driven by its ties with the state, but stresses that sustained net debt/EBITDA greater than 2.5x, would potentially indicate the government’s reduced willingness or ability to protect the company’s credit metrics.
In Fitch’s assessment of RZD’s creditworthiness, Fitch takes into consideration adjusted credit metrics. FFO adjusted net leverage is expected to deteriorate to around 2.3x in FY13 from around 1.4x in FY12 but remain below 3.0x in the medium term. FFO fixed charge cover is forecast to decline to around 5.0x by 2015 from around 8.0x in FY12.
LIQUIDITY & DEBT STRUCTURE
Adequate Liquidity, Manageable Maturities
RZD’s cash and cash equivalents stood at RUB70bn as at 1H13, which combined with RUB14bn of bank deposits, was sufficient to cover short-term debt maturities of around RUB68.6bn. Forecast negative free cash flow will add to funding requirements, but Fitch expects these to continue to be funded by the capital markets rather than existing cash. Fitch recognises RZD’s success in accessing debt capital markets in the past and there is additional comfort in the state’s approval of pension-funded infrastructure bonds (RUB150bn in 2013) as well as access to other forms of debt instruments including money-market and credit lines from local banks, if bond market conditions became less favourable. RZD also has the option to postpone capex plans where necessary. There are no material maturities falling due in the medium term and average debt profile maturity of RZD exceeded 9 years at the end of 2013. As at FY13, RZD had available unused credit lines of RUB241bn.
Positive: Future developments that could lead to positive rating action include:
– Economic growth, supporting rail transportation revenue growth that exceeds Fitch’s expectations, would be positive for RZD’s ratings. However, at the current ‘BBB’ level, an upgrade of Russia’s sovereign rating would be a pre-requisite for an upgrade of RZD’s IDR.
– If a positive rating action is taken on the Russian Federation, Fitch is unlikely to continue to fully align RZD’s ratings with the sovereign unless the legal links with the state are perceived to have strengthened, for example through substantial direct guarantees of RZD’s debt.
Negative: Future developments that could lead to negative rating action include:
– Fitch expects to continue aligning RZD’s IDR with Russia’s at the ‘BBB’ level, given the strength of government links. Therefore, Fitch is unlikely to downgrade RZD before downgrading Russia first. However, sustained FFO net adjusted leverage above 3.0x and FFO fixed charge coverage below 5.0x may be negative for RZD’s ratings unless further evidence of state support is provided.