PARIS: S&P Global Ratings has affirmed ‘BB+’ ratings on Home Appliances Group Arcelik A.S and on the company’s senior unsecured debt, based on the view that the company can withstand a sovereign stress scenario.

The negative outlook reflects the view that weak consumer demand in Turkey and foreign currency exchange volatility might pressure credit metrics over the next 12 months.

Arcelik generates about 35% of its revenues in Turkey and will most likely continue to be negatively affected by the weak market conditions in white goods and consumer electronics. Foreign exchange (FX) volatility of the lira versus the euro and U.S. dollar remains a high risk over 2020 due to macroeconomic uncertainty.

“We expect a market slowdown in most of Western Europe with flat growth; and mid-to-high single digit for Eastern Europe,” S&P noted in a release.

Emerging markets should also positively affect the group’s profitability despite bringing some FX volatility that could impair the group’s margins. The larger exposure to Eastern Europe and Asia enables the group to enjoy volume growth over the medium term despite some volatility.

The large presence in Western Europe (30% of revenues) enables Arcelik to generate earnings in hard currencies to service the bonds and a stable geographical diversification.

Arcelik’s main competitive advantage is its low operating cost base and increasingly its brands. The operating cost base benefits from having group production facilities located in countries that have low labor costs (Turkey, Romania, South Africa, Bangladesh, and Pakistan) and are close to consumer end markets.

Arcelik has some pricing power thanks to its well-known local (Arcelik, Singer, Arctic, Defy, and Dawlance) and global (Beko) brands covering various segments within the consumer durable space. “We are more cautious on the group’s competitive advantage in consumer electronics. Also, raw materials costs (plastics and steel) seem to be declining, which should support more stable operating margins in the next 12 months”.

Arcelik can withstand a sovereign stress scenario, allowing us to rate it four notches above Turkey. The company enjoys a large share of earnings in hard currency thanks to its large presence in Western Europe.

The group also maintains at all times very large cash balances (TRY5.5 billion at September 2019) mostly held in U.S. dollars and euros. This enables the group to pass both the sovereign and transfer and convertibility stress tests, hence why we can rate it four notches above Turkey. In our hypothetical sovereign default stress test, we assume, among other factors, a 50% devaluation of the lira against hard currencies and a 15%-20% decline in Arcelik’s organic EBITDA.

“We believe the company can withstand a hypothetical sovereign default because, in the event of further depreciation of the lira, the appreciation of deposits abroad would offset the increase in Arcelik’s short-term foreign currency debt-service. Failure to pass this test would lead us to equalize our rating on Arcelik with the foreign currency sovereign ratings on Turkey (unsolicited; B+/Stable/B), which would imply a three-notch downgrade”.

The negative outlook reflects downside risks to base-case projections given weak consumer demand in Turkey and currency exchange volatility. “Our base case assumes 20%-25% revenue growth (mostly due to high price inflation in Turkey) and about 10% EBITDA margin thanks to pricing power and flexible operations costs. We therefore forecast EBITDA interest coverage of about 2.5x in 2019 and about 3.0x in 2020.

“We could lower our rating on Arcelik over the next 12 months if the group could not lower its interest burden on its Turkish lira-denominated debt due to inability to refinance the bulk of its short-term debt at a rate below 20% on average, leading to EBITDA interest coverage of close to 2x. We would also view negatively weak operating performance in Western Europe, which helps generate hard currency earnings.

“We could revise the outlook to stable if Arcelik is able to sustainably lower its interest expenses while posting solid operating performance in Western Europe and stabilize cash flows in Turkey. We would therefore need to see sustained interest coverage close to about 3x and positive free cash flow. This would materialize if Arcelik refinances its short-term debt at a cost close to 16%, and if the group’s EBITDA margin increases by almost 150 bps in in the next 12 months”.