OREANDA-NEWS. Fitch Ratings has affirmed Luxembourg-based Kernel Holding S.A.'s (Kernel) Long-term foreign and local currency Issuer Default Ratings (IDRs) at 'B' and 'B+', respectively. Reflecting the location of most of Kernel's operations in Ukraine, Kernel's foreign currency IDR is constrained by Ukraine's Country Ceiling of 'B'. Fitch has also affirmed Kernel's National Long-term rating of 'AA+'(ukr). The Outlooks for the Long-term IDRs and National Long-term rating are Stable.

Kernel's ratings continue to reflect its position as the largest processor and exporter of bulk sunflower oil in Ukraine and a top four grain exporter and farming operator. Free cash flow (FCF) should shift to positive territory from FY13. Fitch expects Ukraine to continue to enjoy a favourable position in international trade of agricultural commodities, aided by scope for increasing efficiency of production and demand growth. These positives are contrasted by a decline in profit margin and cash absorption from working capital, capex and possibly M&A activity, which could push FFO adjusted net leverage above 2.5x but below the threshold of 3.0x considered consistent with the current ratings.

KEY RATING DRIVERS

Accelerated Growth

Kernel's strong revenue growth in the financial year to June 2012 (FY12) has continued in H113 (ended December 2012), helped by increased production capacity to meet long-term demand for edible oils, and steady soft commodity prices. EBITDA continued to record mid-single digit growth in FY12 and H113. Its EBITDA margin has come under pressure (1H13: 10.7%; 1H12: 15.1%) due to a drop of profitability in the core bulk oil and grain trading businesses and a few integration issues affecting profitability in its farming division. While management does not expect profit margins to recover in the near term for grain trading and bulk oil, consolidated EBITDA margin should begin to improve gradually from FY14 and stabilise closer to 12% as Kernel's farming operations recover.

Diversification and Integration Benefits

Kernel benefits from its presence across the agriculture value chain. Recent expansion reflect Kernel's desire to achieve greater scale and critical mass in key segments, such as farming and infrastructure, as well as diversification in terms of procurement and processing capacity following its investments in Russia (Russian Oils in August 2011 and joint venture with Glencore announced in September 2012). Contrasting these benefits, Kernel's latest acquisitions entail some integration or turnaround risks.

Weak Cash Flows

Kernel's grain trading and oil processing businesses are characterised by significant working capital swings and suffered from a large absorption of working capital averaging USD200m in FY11 and FY12. Furthermore, the new businesses of farming will also absorb substantial investments in working capital. Additionally, Fitch expects expansionary capex to continue at a sustained pace and to restrain annual FCF to a mildly positive value over FY13-FY14. Net lease adjusted FFO-based leverage increased substantially to 2.4x in FY12 (1.4x in FY11) although it is expected to remain well below 3.0x even incorporating any headroom for under-performance in EBITDA, working capital absorption or larger than anticipated capex.

Regulation Risk Remains

Kernel remains exposed to changing rules in terms of grain trading in Ukraine and Russia. The possibility of a weak harvesting season increases the risk of the imposition of export restrictions by the government, to maintain low domestic prices. This could affect the profits of Kernel's grain (export) segment which accounted for 7.4% of the group's EBITDA for the 12-month period to December 2012.

Open Positions in Grain Trading

In FY12 Kernel's grain trading, similarly to other industry players, did not make any meaningful profits as management took a trading position in anticipation of a potential early lift of export restrictions from Ukraine. Fitch understands that Kernel maintains adequate risk management policies relative to other domestic traders; however this is unlikely to help insulate it from the high supply and price volatility that affects all traders in Ukraine.

RATINGS SENSITIVITIES

Negative: Future developments that could lead to negative rating action include:

- A severe shock from commodity prices or export restrictions leading to funds from operations (FFO) net lease adjusted leverage above 3.0x on a continuing basis

- Shortage of liquidity with respect to the group's projected peak requirements of working capital

- Negative free cash flow (FCF) margin of 5% for two consecutive periods

Positive: Future developments that could lead to positive rating actions include:

- Maintenance of an integrated business profile and conservative debt/equity funding structure leading to FFO net lease adjusted leverage below 1.0x on a continuing basis

- Positive FCF on a continuing basis (at least two years) and maintenance of a conservative acquisition policy.

An upgrade of the foreign currency IDR would be possible only if the Country Ceiling for Ukraine was upgraded (currently 'B').