Fitch Ratings – Singapore – 05 Oct 2020: Fitch Ratings has assigned a ‘BB-‘ rating to the proposed US dollar senior unsecured notes to be issued by Indian steelmaker JSW Steel Limited’s (JSWS, BB-/Negative) US-based subsidiary Periama Holdings, LLC (Periama).

The proposed notes are guaranteed by JSWS and are rated at the same level as JSWS’s Long Term Issuer Default Rating (IDR). The guaranteed notes will rank pari passu with JSWS’s senior unsecured obligations. Although the notes are guaranteed to the extent of 125% of outstanding principal, we consider it full and worthy as it should cover 100% of principal payments plus all interest accrued up to the point at which all principal is paid, as per Fitch’s criteria. Periama is wholly owned by JSWS, including an indirect stake. The proceeds of the proposed notes will be used for repayment of loans to JSWS, including interest, and for general corporate purposes.

JSWS’s gross debt/EBITDA leverage for the financial year ending March 2020 (FY20) stood at 6.7x, higher than our negative rating action threshold of 4.5x. We estimate JSWS’s gross leverage to increase to 7.0x and free cash flow (FCF) to remain negative in FY21, due to weak EBITDA as a result of the impact of the coronavirus pandemic on domestic demand. We also include potential outflows for the acquisition of assets in India under insolvency proceedings.

We expect leverage to improve to around 4.5x in FY22 and decline further thereafter, due to higher EBITDA, controlled capex and improved FCF. JSWS’s deleveraging and improvement in its FCF profile may take longer if industry conditions remain weak, capex is higher than we expect or an improvement in the performance of acquired assets is delayed. This could indicate a weaker financial profile and the risk is reflected in the Negative Outlook.

KEY RATING DRIVERS

Periama Holds Some US Assets: Periama acts as a holding company for JSWS’s plate and pipe operations based in Baytown and coking coal operations in West Virginia. The plate and pipe segment reported an EBITDA loss of USD32 million in FY20 driven by inventory losses and weak utilisation rates, overshadowing USD4 million of EBITDA from the coking coal operations. Periama had borrowings of around USD960 million at end-June 2020, of which over USD800 million were loans from JSWS. The repayment of intercompany loans from proceeds of the proposed bond should boost liquidity at JSWS.

Weak 1QFY21; Gradual Improvement Seen: JSWS’s reported consolidated EBITDA declined by 64% yoy in 1QFY21, hit by a 25% fall in standalone sales volumes, a 50% drop in standalone unit EBITDA margin, and losses overseas. However, the company’s share of export volumes rose to 57%, from 15%-25% normally. As a result, JSWS’s volumes fell much less than the 55% yoy drop in India’s finished steel consumption. Cost-efficient companies such as JSWS were able to take advantage of the strong demand recovery in China to boost exports to the country and elsewhere in the region.

We expect Indian steel demand to contract in FY21. However, volumes should continue to improve over the next few quarters, led by rural consumption, and lead to better margins due to operating leverage. Higher prices supported by the price rebound in China should also drive margins in 2QFY21 and beyond. Hot-rolled steel sheet prices in China have improved by around USD100/metric tonne (mt) since April 2020, and Indian prices have started to tick up since late-July, with a lag.

EBITDA Losses at Overseas Assets: JSWS’s overseas operations, which mainly comprise the plate and pipe mill in Baytown and a flat steelmaking facility in Mingo Junction (Acero Junction), both in the US, and the Aferpi rolling mill for long products in Italy, were unprofitable in FY20 and continued to incur EBITDA losses in 1QFY21. The company has cut capex and is looking to reduce costs by curtailing operations at Acero Junction until the electric arc furnace is upgraded in 4QFY21. In Italy, the company is focusing on certain profitable products, such as rails and grinding balls, to improve profitability. Based on its efforts, JSWS expects positive EBITDA from these assets by 2HFY21.

Bhushan Power Acquisition: JSWS received regulatory clearance to acquire Bhushan Power and Steel Ltd (BPSL) on 17 February 2020. However, the deal has been challenged in the Indian Supreme Court. News reports indicate an enterprise value of around INR195 billion. We have assumed around INR45 billion of outflow from JSWS for the purchase of a 49% stake in FY21. In addition, Fitch is likely to consolidate, fully or proportionally, BPSL’s debt and EBITDA for calculating JSWS’s leverage metrics, even in the absence of any corporate guarantee from JSWS, due to BPSL’s high strategic importance for JSWS and joint-management control. Fitch intends to fully consolidate BPSL’s financials if JSWS is unable to find a third-party partner.

Lower Capex Likely: JSWS has cut its consolidated capex to around INR90 billion in FY21 and is focusing on certain projects that can generate healthy earnings within a year or two to keep leverage in check. These projects include completion of the expansion of its crude steel capacity at its Dolvi plant by 5 million tonnes per annum (mtpa) to 10mtpa, its pellet plant and cold-rolling capacity expansion at Vijayanagar, some downstream product lines that should improve the share of value-added products in overall sales, and operation of seven newly acquired captive iron ore mines. We have assumed a limited capex increase in FY22 and FY23 based on our expectation that JSWS will prioritise deleveraging over capacity enhancement. However, the company scaled up its spending plans significantly in 2018, and higher-than-expected capex remains a significant risk to JSWS’s credit profile.

Cost-Efficient Operations: JSWS has a strong market share in southern and western India, where its plants are located, supported by a gradually improving share of value-added products. JSWS’s main plant at Vijayanagar (12mtpa) was placed in the first quartile of research group CRU’s hot-rolled coil cost curve for 2019. This lifted the weighted-average cost position of its steelmaking operations, including plants at Dolvi and Mingo Junction, to a level comparable with that of peers in the second quartile of the cost curve. JSWS also ranks among the top-10 steel producers globally, according to World Steel Dynamics, benefitting from factors such as high yields and low labour costs.

Senior Unsecured Rating Unaffected: JSWS’s secured debt/EBITDA, on a consolidated basis, stood at around 3x in FY20. Fitch regards a threshold of 2.0x-2.5x as the level at which unsecured creditors’ interests are materially subordinated to the interests of secured or prior-ranking creditors. However, further bespoke recovery analysis suggests average recovery prospects for senior unsecured creditors. Therefore, we rate the senior unsecured debt and notes at the same level as the IDR.

DERIVATION SUMMARY

JSWS is rated higher than the ‘b+’ Standalone Credit Profile (SCP) of Indian peer, Tata Steel Limited (TSL, BB-/Negative). TSL’s SCP factors in robust operations in India, but is dragged down by a much weaker operating profile in Europe. TSL’s Indian operation has better vertical integration and a higher EBITDA margin than that of JSWS. However, this is partly counterbalanced by JSWS’s cost-efficient operations. We also estimate JSWS’s total debt/EBITDA leverage, after including acceptances and long-term customer advances, will be lower than that of TSL for the next two years.

JSWS is rated lower than ArcelorMittal S.A. (AM, BB+/Negative) and EVRAZ plc (BB+/Stable). AM’s business profile is stronger, as it is the world’s most diversified steel producer by product type and geography and the world’s largest steel company based on capacity. AM also benefits from a solid level of vertical integration into iron ore and a strong product mix, with more than half being high value-added products. AM’s leverage and coverage metrics are also stronger. The higher rating of EVRAZ, a major Russian integrated long-steel producer, reflects the integrated nature of its operations, high self-sufficiency in raw materials and a competitive cost profile; these underpin its higher EBITDA. EVRAZ also benefits from lower leverage and higher coverage ratios. The company’s rating incorporates the higher-than-average systemic risks associated with the Russian business and jurisdictional environment.

JSWS is rated higher than United States Steel Corporation (US Steel, B-/Negative), whose rating reflects Fitch’s expectation that its key steel end-markets, particularly automotive and energy, will deteriorate in 2020. As a result, we estimate much weaker total debt/EBITDA leverage than the 7.4x in 2019. US Steel’s scale in terms of EBITDA and margin is also significantly lower than that of JSWS.

KEY ASSUMPTIONS

Fitch’s Key Assumptions Within Our Rating Case for the Issuer

– Standalone sales volume to rise by a CAGR of 6% over FY21-FY23

– Annual standalone EBITDA per tonne of around INR7,300 in FY21, INR9,100 in FY22 and INR9,600 in FY23

– EBITDA contribution from subsidiaries of INR5 billion in FY21 and around INR20 billion annually thereafter

– Average annual consolidated capex of around INR95 billion over FY21-FY23

– Spending on acquisitions of INR60 billion in FY21.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to negative rating action/downgrade:

– Lack of clear deleveraging path towards 4.5x total debt/EBITDA leverage by FY22

– Expectations of sustained negative FCF

– EBITDA/(interest paid) below 3.0x on a sustained basis

Factors that could, individually or collectively, lead to positive rating action/upgrade:

– Fitch may revise the Outlook to Stable if performance is better than the sensitivities for negative rating action.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings,

LIQUIDITY AND DEBT STRUCTURE

Manageable Liquidity: JSWS had cash and cash equivalents of INR119 billion at FYE20, and long-term debt maturities (including long-term customer advances) of around INR75 billion. We expect JSWS to roll over its short-term acceptances and debt of INR210 billion, given its robust operating profile. Negative FCF in FY21 could pressure liquidity, but the company should be able to meet its long-term debt repayment obligations by using cash freed from draw down of available capex and working-capital facilities as well as cutting of discretionary capex, should market conditions block refinancing efforts. JSWS had an undrawn capex facility of INR57 billion and fund- and non-fund-based working facilities of INR105 billion as of FYE20.

JSWS is likely to rely on refinancing for its long-term debt maturities in FY22 and FY23, which total over INR200 billion. We think a large drop in leverage and negative FCF should support the company’s refinancing efforts, but risks could rise if its financial profile does not improve.

SUMMARY OF FINANCIAL ADJUSTMENTS

Material Non-Standard Financial Adjustments:

1) Payment (FY20: INR40.5 billion) by Duferco S.A. under a five-year advance payment and supply agreement for supply of steel products has been treated as debt. The advance is interest-bearing and the repayable amount will be adjusted by export of steel to Duferco.

2) Acceptances, related to trade payables and payables for capital projects, have been treated as debt (FY20: INR125.1 billion)

3) Unamortised upfront fees on borrowing (FY20: INR3.6 billion) have been added back to debt.

4) Government tax incentive relating to earlier years (FY20: INR4.7 billion) and one-off income from fees for assignment of procurement contract (FY20: INR2.5 billion) have been excluded from revenue.

5) Forex losses (FY20: INR8.3 billion) have been excluded from operating costs. Interest on lease liabilities (FY20: INR2.5 billion) and depreciation of right of use assets (FY20: INR2.6 billion) have been treated as lease expenses and deducted from EBITDA.