MERIS (Middle East Rating & Investors Service) Downgraded the National Scale Rating (NSR) of Ezz Steel Company (ESRS.CA) to “B+” with a “Negative Outlook” for both the Entity and the Instrument Ratings.
Ezzsteel’s rating downgrade of the senior unsecured debt to B+from the current BB+ rating, while the outlook will be maintained negative, is driven mainly by two key factors.
The first factor underpinning the rating downgrade in the bond reschedule agreement which the company agreed on with the bondholders on June 2013, that allows the issuer to waive the payment of the two amortization installments due in the current year amounting to EGP 220mn. As such, the issuer has to pay in full the outstanding amount (EGP 440mn) in year 2014 over two installments.
The total outstanding amount will be paid fully by the original bond maturity date. The coupon will continue to be paid semiannually with an additional 2% increase as a penalty rate to end up at 16.5%. The reason for the bond rescheduling is to direct the proposed cash flow to support and accelerate the completion of the group’s vertical expansion plan.
As of December 2012, the outstanding balance of the notes is EGP 440mn. According to MERIS, this is considered a default, and the rating might be further downgraded in case the issuer is not able to honor the revised payment schedule.
The second factor affecting the rating grade is the negative implication of the increase in the explicit debt guarantee granted earlier in 2010 to Ezz Steel Rolling Mills (ERM). In June 2013, management extended the line of credit with an additional EGP 551.5mn, to bring up the total facility to EGP 2.8bn; in order to meet the increase in investment cost, attributed to the devaluation of the Egyptian pound over the last two years. The loan is secured by a first degree real estate mortgage for all the tangible and intangible assets of the project, in addition to a corporate guarantee issued by the parent company “Ezzsteel”.
In MERIS view, this corporate guarantee imposes a serious concern for Ezzsteel existing bondholders; as it places them in a structurally subordinated position compared to ERM secured lenders, especially in time of distressed cash flow at both the holding and the subsidiary levels, as it might result in depleting the issuer financial resources at the existing bondholders’ expense.
This is considered a critical concern from MERIS’ stand point, especially in light of the deteriorating financial performance of the issuer in general and the relatively fragile cash generating ability; as it is highly dependent on dividends received from subsidiaries, leaving the company’s financial position vulnerable to any unpredicted events.
At the same time, the company is facing critical external as well as internal challenges which heighten the risk profile of the group. So far, the company’s operating performance has demonstrated an ability to withstand serious hurdles. Nevertheless, MERIS believes that the future outlook is questionable, which might impose extra pressure on the company’s financial and operating performance, which is reflected in the negative rating outlook. At the same time, the political issues and the negative perceptions around the chairman of the company are considered a key rating driver, as it might seriously impact overall performance. Nonetheless, so far, it has had no material impact on the company’s business operation.
The rating grade takes into account the leading position of Ezzsteel, in addition to the solid reputation and strong brand name. This is supported by a top caliber management team with good industry experience. Moreover, it is projected to reflect positively on the business operations MERIS believes that the group business profile will improve starting from 2015, following the completion of the vertical and horizontal expansion scheme, currently on going, which accordingly will intensify the synergies among the group.
The new DRI facility will sufficiently offset the high raw material costs and mitigate the foreign currency risk, which will reflect positively on profitability margins. The group is considered a leading steel producer in Egypt and the region specialized mainly in rebars and flat steel, with a combined capacity of 5.8mn tons.
Rating Outlook
The negative outlook reflects the foreseen pressure on the company’s cash flow metrics, especially in case of any further decrease in cash dividends received from subsidiaries and/or any potential support the parent company may have to provide to subsidiaries in the form of cash injection or any other type of subsidization. It also takes into consideration the challenges associated with the allegations against the key shareholder, which might also negatively affect the business.
