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Rating action

Scope Ratings GmbH (Scope) has today affirmed its B+ issuer rating on Hungarian baked goods manufacturer Zalaco Sütőipari Zrt. (Zalaco) and revised the Outlook to Positive from Stable. Scope has also affirmed its rating for the senior unsecured debt category of BB-.

Rating rationale

The Outlook change to Positive from Stable is mainly driven by the company’s resilient operating performance and higher-than-expected EBITDA generation (up 34.6% YoY) for FY 2022 resulting in faster-than-expected deleveraging. The company's preliminary 2022 figures show a sound operating performance, which can be attributed to its efficient pricing strategy that successfully hedged against high inflationary costs. The company demonstrated its ability to pass on the increased cost base to its customers across all business lines. Furthermore, a significant surge in sales volumes of highly profitable frozen products had a favourable impact on the overall profitability. The heavy capex phase related to the implementation of automated production lines has been completed, with the final production line having been implemented and tested in 2022.

Although the company faced workforce shortages and rising production costs, resulting in the closure of its plants in Mindszent and Sopron, it was able to avoid potential supply disruptions by redistributing production capacity from other plants. The closure of the two plants is viewed as an exceptional circumstance, and we do not anticipate any significant operating challenges from the workforce shortage.

Zalaco’s business risk profile (assessed at B+) continues to benefit from the steady demand in the non-durable consumer goods sector, particularly in food production, which exhibits low volatility, moderate barriers to entry, and low risk of substitution. While the company's profitability is another major factor that supports the rating (as indicated by relatively high and stable EBITDA margins compared to local competitors), the increase in raw material and utility costs during FY 2022 had a considerable adverse impact on overall profitability and required selling price adjustments (retail 20%, frozen 6% and wholesale 16% on average in 2022). Scope sees unhedged utility supplier contracts as a common feature in the Hungarian bakery market.

The company has confirmed additional price increases on various products in January 2023 which is expected to help mitigate the gross margin pressure caused by the elevated cost base and maintain profitability at current levels. Furthermore, while consumers may become more price conscious as inflation pressures increase, Scope does not expect any ‘sticker shock’ effect for Zalaco customers as its main product portfolio consists of non-discretionary products. The inventory shrinkage and obsolete inventory costs remain at around 2% of sales, which decreases gross margins by 200 bp (ESG factor: credit negative). The profitability is additionally supported by the expected full utilisation of the high-margin automated production line for frozen products (14.7% volume increase in 2022 compared to 2021) starting in May 2023.

Zalaco's business risk profile is primarily constrained by its lack of geographic diversification, as slightly delayed export sales of its frozen products limit exposure to a specific region. This situation is expected to continue in the short to medium term, as international retail chains are postponing commercial negotiations. In addition, the company's sales are heavily concentrated on the international retail chain Lidl, which accounted for approximately 54% of FY 2022 sales (compared to 57% in FY 2021) and is expected to increase further in the medium term as its main customer/partner for frozen product sales. However, the risk of significant sales exposure to Lidl is partially mitigated by Zalaco's ability as a small-cap company to deliver quality-oriented products and maintain sustainable business operations.

Zalaco’s financial risk profile (assessed at BB-) is supported by a sound cash conversion cycle, as reflected by substantial cash generation. Lower-than-expected leverage in 2022 is the result of a solid EBITDA development coupled with the repayment of financial lease liabilities, which decreased overall reported debt by HUF 177m. Scope-adjusted debt/EBITDA stood at 3.4x at YE 2022 (down 1.2x YoY). Scope expects gradual deleveraging at a slower pace after FY 2022.

The capital expenditure required for the new production line has been completed in FY 2022 which resulted in negative free operating cash flow. Scope doesn’t expect a heavy capex phase after YE 2022 but steady demand for frozen produces from international retail chains might require an additional expansion phase to increase production capacity. Alternatively, Zalaco is monitoring potential acquisition targets and remains in the screening phase. However, as of now, no suitable acquisition opportunity has been identified.

Zalaco’s liquidity profile remains adequate. A significant cash cushion at around HUF 1.0bn, together with expected free operating cash flows starting from YE 2023, minimises short-term refinancing risks for the company.

Outlook and rating-change drivers

The Positive Outlook reflects Scope’s expectation that Zalaco’s Scope-adjusted debt/EBITDA will remain below 3.5x and Scope-adjusted funds from operations/debt stays above 20%. The Outlook incorporates the company tackling inflation and keeping its margins. We do not expect any M&A activity or a significant capex programme. The Positive rating outlook also reflects the successful transition towards the frozen products automated production line.

An Upgrade could be warranted if Scope-adjusted funds from operations/debt exceeds 20% on a sustained basis and Scope-adjusted debt/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 production streamlining strategy. An Upgrade will incorporate that company will be able to manage higher electricity and gas prices effectively and maintain its operations without any significant negative impact.

A negative rating action (i.e an Outlook change back to Stable from Positive) could be triggered by a failure to keep Scope-adjusted debt/EBITDA below 3.5x and Scope-adjusted funds from operations/debt above 20%. A further downside is deemed to be remote but could result from a deterioration in credit metrics, as indicated by Scope-adjusted funds from operations/debt of below 10% and Scope-adjusted debt/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 debt rating

Scope has affirmed senior unsecured debt at BB- including the HUF 4.4bn bond (ISIN HU0000359765). This reflects Scope’s expectation of a superior recovery for senior unsecured debt positions in the hypothetical event of a company default. The recovery analysis is based on a hypothetical default scenario in 2025, which assumes outstanding senior secured debt of HUF 975m including financial guarantees.

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

Methodology
The methodologies used for these Credit Ratings and/or Outlook, (General Corporate Rating Methodology, 15 July 2022; Consumer Products Rating Methodology, 4 November 2022), are available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With the 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 Ratings: public domain, the Rated Entity, third parties and Scope Ratings' internal sources.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting the Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlook and the principal grounds on which the Credit Ratings and/or Outlook are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlook are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlook are UK-endorsed.
Lead analyst: Zurab Zedelashvili, Associate Director
Person responsible for approval of the Credit Ratings: Olaf Tölke, Managing Director
The Credit Ratings/Outlook were first released by Scope Ratings on 24 April 2020.The Credit Ratings/Outlook were last updated on 7 March 2022.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use/exclusion of liability
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