Moody’s Affirms Eurasian Resources Group’s Caa1 Rating; Negative Outlook
Moody’s Investors Service (“Moody’s”) has today affirmed the Caa1 corporate family rating (CFR), caa2 baseline credit assessment (BCA) and Caa1-PD probability of default rating (PDR) of Luxembourg-based integrated mining group Eurasian Resources Group S.a r.l. (ERG). At the same time, Moody’s has maintained the negative outlook on all of ERG’s ratings.
The rating agency also added the limited default (/LD) indicator to ERG’s PDR following the restructuring of its bank facilities by its main lenders, which Moody’s views as a form of distressed exchange and is a default according to the rating agency’s definitions. The LD indicator will be removed after approximately three days.
The Caa1 CFR rating for Eurasian Resources Group Sarl is based on Moody’s’ mining methodology which assesses the standalone credit quality of the company, and Moody’s rating methodology for government-related issuers (GRIs), as the Government of Kazakhstan owns a 40% stake in ERG through the State and Privatisation Committee. According to these methodologies, the CFR reflects a combination of (1) ERG baseline credit assessment (BCA) of caa2; (2) the Baa3 sovereign rating of the Kazakh government; (3) the high default dependence between the company and the government; and (4) Moody’s assessment of moderate government support to ERG in the event of financial distress. The Caa1 CFR continues to incorporate one notch of uplift from the caa2 BCA.
The affirmation of ERG’s caa2 BCA primarily reflects Moody’s assessment of the company’s liquidity as weak, in spite of the expected benefits from the recently finalized debt restructuring with Sberbank (Ba2 negative) and Bank VTB JSC (Ba2 negative), the company’s main lenders. The amended terms under both loans will allow to save cash interests for c. $200m in 2017 and a similar amount in 2018, via a reduction of the margin by 1% p.a. and the deferral of c.300bps of cash margin for 24 months starting from October 2016. Furthermore, both banks agreed to amend the level of financial maintenance covenants to allow higher headroom for the next testing dates, albeit such headroom might be reduced if the company’s performance does not improve, as covenants become tighter over time. A further benefit is the extension of the debt maturity of the US$3bn VTB facility to 2022 from 2020 originally, with a further 3 years extension option. Moody’s believes that the debt restructuring, albeit credit positive, provides only a temporary relief and mainly defers refinancing risk. From Q4 2018 onwards the PIK component of the annual interests will no longer be in place and higher cash interests at 7% p.a. will be reinstated, while the interests deferred in 2017 and 2018 will need to be repaid. Furthermore, from 2019 onwards the annual debt amortization will rise, from relatively modest debt repayments in 2017 and 2018.
The appending of the “/LD” indicator to the PDR results from the completion in December 2016 of the restructuring of the bank facilities borrowed from Sberbank and Bank VTB. Moody’s views the terms agreed with the lenders as a distressed exchange, reflecting the adjusted interest rates, including PIK elements, and extended maturity, which is a form of default under Moody’s definition. Moody’s will remove the “/LD” designation from the PDR after three days. Moody’s understands that the debt restructuring completed by ERG does not constitute an event of default under any of the company’s debt agreements.
In spite of the lower cash interests to be paid in 2017 and 2018 on the Sberbank and VTB facilities, Moody’s expects that the current and projected available liquidity will not be sufficient to address ERG’s cash requirements projected over the next 12 months, particularly if prices for ferroalloys, copper, aluminum and iron ore, the main commodities for ERG, deteriorate from current levels and become more aligned to the baseline prices Moody’s assumes for 2017.
A major weakness of ERG’s liquidity is the very limited availability (c. US$ 5m as of December 2016) under the committed bank facilities, which makes the company entirely reliant upon unrestricted cash balance of US$ 317m at the end of 2016 and projected free cash flows. Free cash flows should turn to slightly positive in 2017 at c. US$25m under Moody’s baseline commodity prices assumptions and provided ERG’s capex and working capital needs do not exceed US$1.1bn in aggregate and dividends, if reinstated, are not higher than US$140m. However, available cash and projected free cash flows will be tight to address scheduled debt repayments, net of rolled-over facilities, for c. US$225m in 2017, as well as funding for c. US$50m the buy-out of minority stakes in the company owning a copper-cobalt project (‘project RTR’) in the Democratic Republic of Congo (‘DRC’, B3 stable).
Given the modest liquidity headroom, a cash shortfall may stem from a reduction in commodity prices below Moody’s baseline levels, much higher than expected capex and working capital requirements, or larger than anticipated dividend payments. Any possible material capex overrun to develop ERG’s US$770m project RTR in the DRC could also exert negative pressure on liquidity, if this translates into more equity funding from ERG becoming required, on top of USD$128m already committed and of over US$600m of project financing already signed-up by a consortium of primary Chinese lenders. Moody’s notes that the company’s decision to launch a major project in DRC and its consideration to reinstate dividends subject to excess liquidity being available signal a financial policy more aggressive than previously considered.
ERG’s Caa1 BCA rating continues to reflect, as partially risk mitigating considerations, the strengths associated to its business profile, namely (1) good access to high-grade and long-reserve-life mining assets in Kazakhstan; (2) a competitive cost structure as a result of high-quality mines and efficient processing plants, especially in the profitable ferroalloys core business; (3) good operational and commodity diversity, with several operating mines and processing facilities in Kazakhstan and, for copper, in the Democratic Republic of Congo (DRC, B3 stable), and (4) important market shares in EMEA for ferrochrome, iron ore and aluminium.
Furthermore, Moody’s acknowledges that main credit metrics are likely to improve over the next 12 to 18 months from current relatively weak levels. The rating agency estimates that the adjusted gross debt/EBITDA ratio of ERG will gradually reduce during 2017 towards 4x from c. 5x at the end of 2016, driven by higher EBITDA, while adjusted gross debt should remain high at c. US$7.2bn at the end of 2017. The projected improvement in adjusted EBITDA, from c. US$1.5bn in 2016 to c. US$1.8bn in 2017, is underpinned by a better pricing environment this year compared to 2016 for ERG’s key commodities, and by the Kazakh tenge (KZT) remaining weak vs the US$ at a level of c 330 KZT/US$. Given most of ERG’s costs are denominated in KZT while revenues are mainly in US$, ERG’s performance in 2016 was significantly supported by the weaker KZT, and a similar benefit is assumed for this year.
Moody’s also considers that the probability of financial support that the Kazakh government would provide to ERG, in case of need, is appropriately captured by an assessment of ‘moderate’ according to Moody’s GRI methodology, given the strategic relevance of the company to the local economy, and considering the involvement of the government in the direction and management of the company, with two out of five Board members directly appointed by the government. Even if the government has never formally or publicly committed to any sort of explicit or verbal guarantee or financial support for ERG, Moody’s understands that, if the company were to be forced to ask for financial support from its shareholders, the process to obtain it in a timely manner is already clearly described in the shareholder agreement of ERG Sarl, which has been signed by all shareholders, i.e., the three founding shareholders, Mr. Machkevitch, Mr. Ibragimov and Mr. Chodiev, owning in aggregate a 60% stake, and the Kazakh government as the single largest shareholder with a 40% stake. This is an important factual element for Moody’s assumption of moderate government support, and for the justification of keeping one notch uplift to the BCA.
RATIONALE FOR NEGATIVE OUTLOOK
The negative outlook reflects Moody’s expectation that ERG’s liquidity will remain weak and exposed to downside risks. The outlook also factors in the possibility of a negative outcome of the ongoing UK Serious Fraud Office investigation, which may result in fines and penalties and make it even more difficult for the company to access the international credit markets in the future.
What could change the rating up
Positive pressure could build over time if ERG were able to improve its liquidity position with an overall assessment of adequate, and show some sustainable improvements in key credit metrics, namely the gross debt/EBITDA ratio, on a Moody’s adjusted basis, falling below 5x on a sustained basis, the interest cover ratio (EBIT/Interest) increasing above 1.5x, and free cash flow turning positive. Further positive rating pressure could be considered if Moody’s had reason to reassess the assumptions relating to the degree of support from and dependence on the Kazakh government, based on new elements indicating a stronger support than what the rating agency is currently factoring into the rating. Such assumptions are relevant, given that ERG’s CFR reflects the application of Moody’s rating methodology for government-related issuers.
What could change the rating down
Moody’s would consider downgrading ERG’s ratings in case of further weakening of the BCA. This could occur in a scenario where the company’s liquidity deteriorates, if Moody’s believes the company is unlikely to continue to get support from its lenders. Furthermore, a material deterioration in the key credit metrics could also exert negative rating pressure. Such a deterioration would be reflected into a gross debt/EBITDA ratio exceeding 6x on a Moody’s adjusted basis, and an interest cover ratio falling below 0.5x. A negative outcome of the pending SFO investigation, resulting in material fines and penalties and high reputational damage, would also exert negative pressure on the rating. Furthermore, a reassessment of the degree of support from the Kazakh government, to a weaker level than currently contemplated, would also lead to negative rating pressure.
The principal methodology used in these ratings was Global Mining Industry published in August 2014. Other methodologies used include the Government-Related Issuers methodology published in October 2014. Please see the Rating Methodologies page on www.moodys.com for a copy of these methodologies.
Eurasian Resources Group Sarl (ERG) is the holding company and owner of ENRC Ltd (formerly ENRC Plc), a vertically integrated mining group with main operating assets in Kazakhstan, and a number of early-stage development assets in Brazil and Africa. The group is primarily focused on the mining and processing of ferroalloys, iron ore, aluminium, copper and cobalt. ERG is also the world’s-largest ferrochrome producer (by chrome content) and one of the leading global exporters of iron ore. In 2015, ERG reported revenues of $4.3 billion. ERG is 40% owned by the Kazakh government (Baa3 negative) and accordingly falls within the scope of Moody’s rating methodology for Government Related Issuers (GRI).