S&P: Russian Rail Operator Federal Passenger Co. Outlook Revised To Negative On Higher Capex; 'BBB-/A-3' Ratings Affirmed

S&P Global Ratings today revised its outlook on Russian long-distance passenger rail operator Federal Passenger Co. JSC (FPC) to negative from stable. We affirmed our 'BBB-/A-3' long - and short-term issuer credit ratings on the company.

The revision of the outlook to negative reflects our expectation of a sharp increase in capital expenditures (capex) at FPC, largely debt funded, in 2018 and 2019. This is likely to lead to a decrease in the group's ratio of funds from operations (FFO) to debt to about 30%-32% in 2018 and 23%-25% in 2019, while its adjusted debt-to-EBITDA ratio should rise to 2.3x-2.5x in 2018 and 2.8-3.0x in 2019, if the capex program is fully implemented as planned. This represents much higher leverage than our estimate of FFO to debt of about 105% and debt to EBITDA of below 1x in 2017. As a result, we have reassessed FPC's financial risk profile to intermediate and we may revise it to significant if we have evidence that the new capex program is being executed in full and funded with debt. Still, we see uncertainty on the company's financial policy, as well as its ability to fully execute the sharp increase in investments of up to Russian ruble (RUB) 50 billion (about $900 million), according to our estimates, which may depend on suppliers and organizational capacity.

In our forecast for 2019, we have included only RUB28 billion of capex--against FPC's RUB50 billion plan--to reflect the company's financial policy and financial covenants, which are both set at 2.5x net debt to EBITDA. Including our adjustments, this roughly equals a ratio of debt to EBITDA of 3x. We see a risk that the company's financial policy might change and covenants could be reset or loans refinanced, leading to even more aggressive leverage at FPC.

We understand that the bulk of the expenditure will be on upgrading or replacing about 20% of FPC's rail car fleet. New and modernized cars can be used more intensively, allowing the same level of service to be provided with fewer rail cars. This, in turn, should allow for lower operational costs, leading to EBITDA improvement. We forecast a moderate positive effect on EBITDA generation to come in 2019 and continue in 2020.

In our base case, we forecast that adjusted EBITDA will fall to about RUB20.5 billion-RUB21.5 billion in 2018 with an improvement to RUB21.5 billion-RUB22.5 billion in 2019, compared with our estimate of RUB24.5 billion delivered in 2017. Lower EBITDA in 2018 will stem primarily from flat tariffs, which will be maintained in both regulated and unregulated segments. At the same time, a moderate increase in tariffs, along with the benefits of the upgraded fleet, should lead to better results in 2019. We expect the positive trend to continue into 2020.

At the same time, our ratings on FPC continue to reflect our view of the company as a government-related entity with a high likelihood of extraordinary support from the state, owing to its very important social role as a provider of affordable long-distance travel for Russia's population, as well as its strong link with the government through 100% ownership via the government-controlled infrastructure monopoly Russian Railways (RZD). Our rating on FPC also factors in ongoing government support via subsidies, as well as FPC's position as a strategically important subsidiary of RZD.

In our view, FPC maintains its role as a leading provider of affordable medium and long-distance travel in Russia. Rail passenger traffic fell again by 2.6% in 2017, a trend we see as natural, since long-distance routes are gradually being replaced by air travel. As price competition with airlines becomes difficult on many long-distance routes, FPC is increasingly focusing on short - to medium-distance routes, where airlines are less competitive or unavailable. Trains will most likely remain a preferred means of transportation, compared with bus and sometimes car, for such routes, as long as Russia's road system remains underdeveloped, leading to congestion and risk of accidents.

To address industry trends, the company is increasing speeds on shorter routes of 300 kilometers (km)-600 km, to make more destinations available within seven hours with its "day express" service. In this respect, part of the future capex will be directed to buying trains that will connect midsize cities, primarily in the European part of Russia. We note that margins on faster, short-distance trains tend to be higher, which should compensate for lower passenger numbers.

At the same time, we expect FPC to continue receiving state subsidies to compensate for the regulated part of tariffs. Other forms of ongoing support are also possible, such the reduction of value-added tax on rail transportation services to 0% from 18% over 2016-2017. We also believe FPC to be a strategically important subsidiary of RZD, as one of the largest companies within the RZD structure and given its socially important function.

We could downgrade FPC if its leverage were to increase significantly over the next 12 months, so that its FFO to debt fell below 30%.

We estimate that the company's investment program for 2018-2019 will be about RUB50 billion per year and will be largely funded with debt. Given the size of the program compared with historical numbers, we would consider a downgrade if we have evidence that the program will be implemented as planned. Along with weaker financial metrics, a downgrade of FPC could be triggered by the company's increased tolerance to financial leverage, exceeding the current policy of net debt to EBITDA of 2.5x. Weaker liquidity, driven by tight covenant headroom or unfunded committed cash outflows, could also trigger a negative rating action.

We could revise the outlook to stable if FPC's FFO to debt remains above 30%. This could happen if the company were to reduce its capex program, or its cash flow generation were materially stronger than our base-case forecast. We could also revise the outlook to stable if FPС were to finance its capex through sources other than debt, such as capital injections. We would also expect the company to maintain adequate liquidity at all times.
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