Fitch Ratings has affirmed Ukrainian commodity processor Kernel Holding S.A.'s Long-Term Issuer Default Rating (IDR) at 'B+' with stable outlook, according to a posting on the rating agency's website.

"The ratings incorporate a leverage spike and weak operating results expected for financial year ended June 2018 due to a challenging operating environment. However, we also expect a rebound in profits and an improvement in leverage, due to Kernel's expansion plans and strong support from the group relationship banks. Kernel is also at an advanced stage of obtaining further funding from the European Investment Bank to cover its 2019 FY capex. We see limited execution risk in Kernel's expansion plans," Fitch stated.

"Kernel has suffered since 2015 FY from an excess of crushing capacity in Ukraine over seeds supply, which created a challenging environment to procure seeds, increased costs and compressed margin for sunflower oil producers. Kernel's sunflower oil margin is estimated by Fitch to decrease to $50-55 per tonne for 2018 FY from $164 per tonne in 2014 FY. In addition, international sunflower oil prices in 2017-2018 dropped to historically low levels. While the pressure on Kernel's profit has been exacerbated by the low margins with which competing international traders are ready to operate, Fitch believes that the stronger 2018 harvest in Ukraine should better balance supply and demand during 2019 FY and support a recovery of Kernel's margin," the report says.

"Extrapolating from the nine months of 2018 results, we project that Kernel's 2018 FY consolidated EBITDA would suffer a drop of approximately 30% from 2017 FY's $321 million. This stems, in addition to challenges in the sunflower oil unit, from similar demand and supply dynamics in the grain trading business and from lower yield of the land bank acquired during 2017 FY. Kernel is responding to the difficult operating environment with a major expansion plan whereby it targets to achieve $500 million EBITDA by 2021 FY, mainly through the ability to trade and process larger volumes of grain and sunflower oil. The plan includes strengthening its procurement and processing capability in the currently less-invested region of western Ukraine, increasing the efficiency of its processing facilities, adding more farmland, storage and port capacity, as well as investing in renewable energy. We project a consistent increase of processed volumes and, assuming also a mild increase of international prices from historical lows, a gradual recovery of Kernel's EBITDA margin towards the mid-teens (from below 10% that we expect for 2018 FY)," according to the document.

"Kernel's expansion plan will see capex peak in 2018 FY and 2019 FY at an overall $500 million. The group also acquired two farming businesses for $203 million in 2017, including around $42 million of acquired net working capital. We project deeply negative free cash flow (FCF) for 2018 FY and 2019 FY of $140 million and close to $200 million, respectively. A bond issued in 2017 covered 2017 FY and 2018 FY cash requirements and Kernel is in the process of arranging a $250 million bank facility with a multilateral lending institution to cover 2019 FY funding requirements. The final phase of capex outflows are scheduled for 2020 FY but this is likely to be covered by internal cash flow, allowing Kernel to return a positive FCF position," Fitch experts said.

"As a result of debt increase and the likely slow recovery of EBITDA, we project Kernel's readily marketable inventories (RMI)-adjusted funds from operations (FFO) net leverage would about double to close to 3.0x in 2018 FY from a year ago. This level is still consistent with the group's 'B+' IDR. At the same time, higher throughput volumes as well as sales of renewable energy to the grid by using Kernel's own biomass, should enable FCF to turn positive by 2020 and support de-leveraging. However, underperformance in EBITDA could stall this recovery. Through its leadership as integrated agricultural commodity exporter from Ukraine, Kernel is well-placed to continue taking advantage of the country's fertile farmland, favorable climate and geographical position as well as its low, albeit increasing, labor cost. Ukrainian crops enjoy scope for demand growth globally, due to their non-GMO quality, the limited ability of other regions (the Americas and the Middle East) to increase these crops and the projected long-term growth of their global consumption. Together with other local producers, Kernel is investing to increase farm yields through mechanization and leverage the country's availability of some of the most fertile land in the world," they added.

"Kernel's Local-Currency (LC) IDR is above Ukraine's LC IDR of 'B-', reflecting Fitch's assessment that the group's moderate dependence on the local operating environment, with majority of revenue from exports and a strong infrastructure enabling it to ensure continuity of supply, will not compromise the group's operating performance. Also, Kernel has limited reliance on Ukraine's constrained banking system and its major funding sources consist of a $500 million eurobond issued in January 2017, $300 million PXF facilities provided by international banks and a new $250 million term loan to be provided by a multilateral lending institution, hence confirming its good access to external liquidity," the report says.

"Kernel's Foreign-Currency (FC) IDR is two notches above Ukraine's Country Ceiling of 'B-' due to our expectation that the group will maintain substantial offshore cash balances and a comfortable schedule of repayments for its FC debt, resulting in a hard-currency debt service ratio sustainably above 1.5x over 2018-2020 FY(2017 FY: 1.9x). Maintaining the FC IDR on a par with the LC IDR remains premised on Kernel obtaining committed long-term funding of at least a three-year tenor to fund its further investments in 2019 FY, given our expectation that internally generated cash flow will not be sufficient to cover them," it says.

"Kernel is focused on only few commodities, primarily sunflower oil and meal, corn, wheat and barley, and it remains largely reliant on Ukraine for sourcing them. This exposes it to risks of a contraction in the Ukrainian harvest, but so far this has not materialized despite a weakening in farmers' access to external financing over the past few years. However, even if the harvest declines, we believe Kernel would be able to manage the risks due to its leading market position, ownership of port and other infrastructure assets, and its better access to external liquidity than many of its Ukrainian competitors. Kernel has a stronger FFO margin (2017 FY: 12.5%) than global agricultural commodity processors and traders. This is due to its asset-heavy business model with substantial processing operations (relative to trading) and infrastructure assets, and integration into farming. Kernel's asset structure and integration within operating segments allow the group to retain leading market positions in sunflower oil and grain exports, and are positive for its credit profile. We expect Kernel to strengthen its competitive advantage in Ukraine once it completes it 2017-2020 investment plan. These initiatives, including a new trading unit in Switzerland, will enhance Kernel's integrated business model and enable the group to better compete with major foreign traders that also operate in the country," Fitch said.