OREANDA-NEWS. Fitch Ratings has downgraded Honghua Group Limited's (Honghua) Long-Term Issuer Default Rating (IDR) and senior unsecured rating to 'BB-' from 'BB'. Meanwhile, the Outlook has been revised to Negative from Stable.

The downgrading reflects deterioration in Honghua's profitability and cash flow generation in a difficult operating environment in 2014. The company's adjusted EBITDA margin dropped to below 9% in 2014 from 11.4% in 2013, and it is not likely to recover in 2015. We expect its FFO adjusted net leverage ratio to increase to around 4x from 2.6x at end-2013 and to remain above 3x for the next 12-18 months.

The Negative Outlook reflects our expectation that operating environment will continue to be difficult in 2015, which may hinder Honghua's deleveraging process.

KEY RATING DRIVERS

Adverse Operating Environment: The Chinese government's 2014 anti-graft campaign in the domestic oil and gas sector had a chilling effect on private oilfield services providers. In addition, the sharp decline in global oil prices in 2H14 prompted producers to reduce their shale and offshore drilling activities, and cut capex.

Services and Offshore Drilling Hit: Honghua's oilfield services business segment posted an operating loss of CNY215.4m in 2014 (2013: CNY32.9m profit) after state-owned oil and gas companies delayed signing outsourcing contracts. Honghua's recent expansion into offshore drilling equipment manufacturing was followed by the oil price plunge that has curbed offshore drilling activities. As a result, the company's offshore drilling equipment manufacturing business had a deeper operating loss of CNY150.4m in 2014 (2013: loss of CNY27.8m). At current oil prices, Honghua will find it very challenging to secure new orders for its new manufacturing facility.

Land Rigs Relatively Stable: Honghua's core businesses in land rigs fabrication and parts supply remain relatively stable compared with other segments. Total revenue from the two segments was CNY7.24bn, compared with CNY 7.44bn a year earlier. Operating margins for the two businesses narrowed slightly during 2014, and whether this trend continues will partly depend on the financial strength of onshore drillers, especially those operating in Venezuela and Russia, which face international sanctions with weakening currencies and slowing economic growth.

Capex Discipline Important: Honghua's capex spending in 2013 and 2014 were in support of expansion into oilfield services and construction of an offshore drilling equipment manufacturing base. While this was intended to diversify Honghua's product offerings, it also put pressure on the balance sheet. Fitch expects Honghua's free cash flow generation to remain neutral for the next two years with approximate annual capex of CNY300m.

Liquidity Not an Immediate Concern: At end-2014, Honghua had short-term borrowings of CNY2.8bn. Although it only had unrestricted cash of CNY1.44bn and pledged bank deposits of CNY612.7m, the company says it has unused bank facilities of about CNY10bn from various domestic lenders. Fitch does not see liquidity as an immediate concern, not only because the company can roll over its short-term debt, but also because its fixed assets (end-2014: CNY3.2bn) can be used as collateral for further borrowing.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
- Brent oil price of USD55/barrel for 2015, USD65/barrel for 2016, and USD80/barrel thereafter;
- Steady average price for Honghua's contracts;
- No material counter-party risk from customers;
- Capex of about CNY300m each year for 2015-2016

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, result in negative rating action include:
- EBITDA margin below 8% (2013: 11.4%) on a sustained basis
- FFO adjusted net leverage of over 4x (2013: 2.6x) on a sustained basis
- Negative free cash flow generation during the industry downturn
- Continued weakening of its market position in land rigs and poor execution of contracts for offshore rigs

Positive: Future developments that may, individually or collectively, result in the rating Outlook being revised to Stable include:
- The company avoids breaching negative rating guidelines over the next 12-18 months