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Rating action

Scope Ratings has today assigned an issuer rating of B+/Stable to Hungary-based Zalaco Sütőipari Zrt. A rating of B+ has been assigned to the future senior unsecured debt category.

Rating rationale

Zalaco’s business risk profile (rated B+) benefits from the company’s prominent presence in western Hungary, despite only mid-single-digit market shares in the national market. In recent years, Zalaco has become the leader of Transdanubia’s bakery market, with its retail chain supplying an extensive range of fresh products daily. It has also gradually increased its production and sales capacities for frozen products. The company has a proven track record of annual top-line growth averaging 20% over the last three years, mainly driven by a solid partnership with Lidl and its potential to grow. We expect Zalaco to increase (at least double from 6%) its market shares on the domestic market in the medium term. This should be achieved by ramping up already-finalised greenfield investment to boost production capacity and outreach in western Hungary and by gaining a foothold in Budapest or other cities through acquisitions.

Geographical diversification is the main constraint on Zalaco’s business risk profile, as it is concentrated on one country (further limited by exposure to one specific region) and one industry. Zalaco has high customer concentration in its international retail chains: Lidl accounted for 54% of 2019 sales, while smaller domestic chains and public institutions accounted for only about 5%. At the same time, effective cooperation and a positive track record with international retail chains supports the ability of small-cap companies to deliver quality-oriented products and maintain sustainable business operations.

Although Zalaco does not compare well with its European consumer goods peers, due to its smaller scale, it has relatively high and stable profitability margins in a local context, thanks to its: i) vertically integrated business model; and ii) well-established sales channels. In the short to medium term, Zalaco’s profitability would be positively affected by an automated production facility mitigating labour force shortages and reducing scrap percentages. We expect a gradual increase in EBITDA margins, reaching 14% in 2022, following fully ramped-up automated production lines and ongoing greenfield investment, providing the advantage of scale in the region in which Zalaco operates.

Zalaco’s financial risk profile (rated B+) is supported by our expectation of strong revenue growth, as already confirmed by previous years, which showed above 15% annual growth. This should also lead to a parallel increase in operating profits, resulting in a stable underlying EBITDA margin of about 12%, which is likely to have enabled significant operating cash flow generation in 2019. Considerable growth capital expenditure of about HUF 1.3bn and HUF 4.4bn in 2018 and 2019 respectively, resulted in negative free operating cash flow. Despite the healthy 30% EBITDA increase, leverage, as expressed by Scope-adjusted debt (SaD)/ adjusted EBITDA, rose to over 4x in 2019, mainly driven by the new investment loan of HUF 2.3bn. We expect gradual deleveraging after 2021, assuming: i) the ramping-up of two automatic production lines, which will increase annual production capacity; and ii) potential acquisitions, diversifying Zalaco’s sales exposure to additional regions of the domestic market. We expect funds from operations (FFO)/SaD and SaD/EBITDA to reach 30% and 3x respectively in 2022.

Zalaco’s liquidity profile deteriorated in 2018-2019, mainly affected by negative free operating cash flow. Despite a lack of committed credit lines, we believe that Zalaco’s liquidity has a high likelihood of becoming adequate in the medium term. This is based on a comfortable operating profitability reflected to substantial free cash generation used to re/finance short-term debt maturities.

Most cash inflows from operations (95%) are exposed to the domestic market. However, a devaluation of the Hungarian currency against the euro/US dollar, caused by potential downside/turbulence, global recessions or shocks (e.g. Covid-19), would not have a material impact on the company’s business profile. This is because: i) Zalaco provides goods for which demand is countercyclical in recessions; and ii) the company’s forex risk exposure is limited – with no notable dependence on external customers or exposure to imported raw materials. Despite the solid demand on product portfolio Zalaco’s supply chain and profitability may suffer from extension of lockdowns due to Covid-19.

Outlook and rating-change drivers

The Stable Outlook reflects our expectation that Zalaco’s expansion strategy, and increasing demand for its product portfolio, will improve FFO/SaD to around 20% without significantly exceeding a SaD/EBITDA ratio of 4x.

A positive rating action could be warranted if FFO/SaD exceeds 20% on a sustained basis and SaD/Scope-adjusted EBITDA consistently trends below 3.5x. A decrease in leverage may be achieved by an increase in profitability following the successful implementation of the company’s expansion strategy.

A negative rating action could result from a deterioration in credit metrics, as indicated by FFO/SaD of below 10% and SaD/EBITDA of above 5.0x on a sustained basis. An increase in leverage could be triggered by an adverse operational development, leading to reduced profitability or the need for additional external financing for capital expenditure, M&A or unplanned intercompany loans.

Long-term and short-term debt ratings

Zalaco plans to issue a HUF 4.0bn senior unsecured corporate bond under the MNB Bond Funding for Growth Scheme. The planned bond with a bullet loan structure has a 3.5% coupon and 10 years’ maturity. Proceeds from the bond are allocated for refinancing, expansion and M&A.

Our hypothetical default year is YE 2022, simulating a scenario in which the company has issued the new, proposed HUF 4.0bn senior unsecured bond and proceeds have been used accordingly. Although our recovery analysis indicates a relatively high recovery rate for senior unsecured debt, we have limited the uplift for the instrument to zero notches (average recovery) due to senior secured loan outstanding.

Stress testing & cash flow analysis
No stress testing was performed. Scope performed its standard cash flow forecasting for the company.

Methodology
The methodology used for this rating(s) and/or rating outlook(s): Corporate Rating Methodology, 26 February 2020 is available on www.scoperatings.com.
Information on the meaning of each rating category, including definitions of default and recoveries can be viewed in the “Rating Definitions - Credit Ratings and Ancillary Services” published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how Environmental, Social or Governance factors (ESG factor) are incorporated into the rating can be found in the respective sections of the methodologies or guidance documents provided on www.Scoperatings.com/methodologies/ ESG factors in ratings.
The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rating process was conducted:
With Rated Entity or Related Third Party Participation    YES
With Access to Internal Documents                                 YES
With Access to Management                                           YES
The following substantially material sources of information were used to prepare the credit rating: public domain, the rated entity, agents of issuer, third parties and Scope internal sources.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds on which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Regulatory Disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH, Lenéestraße 5, D-10785 Berlin, Tel +49 30 27891-0.
Lead analyst Olaf Tölke, Managing Director
Person responsible for approval of the rating: Henrik Blymke, Managing Director
The ratings/outlooks were first released by Scope on 24 April 2020.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2020 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5 D-10785 Berlin.

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