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Rating action

Scope Ratings GmbH (Scope) has today upgraded the issuer rating of Hungarian bakery products manufacturer Zalaco Sütőipari Zrt. (Zalaco) to BB-/Stable from B+/Positive. Scope has also upgraded the company’s senior unsecured debt rating to BB from BB-.

Rating rationale

The upgrade of the issuer rating reflects the company’s resilient operating performance, which lead to faster-than-expected deleveraging. The company's preliminary 2023 figures show a solid operating performance, driven by its efficient pricing strategy that successfully hedged against high inflationary costs. The company confirmed its ability to pass on the increased cost base to its customers across all business lines. The high capex phase related to the implementation of automated production lines has been completed, with the final production line having been implemented and tested in 2023.

Zalaco’s business risk profile (assessed at B+) continues to benefit from the steady demand in the non-discretionary consumer goods sector, particularly in food production, which exhibits low volatility, moderate barriers to entry, and low substitution risk.

The company's profitability remains a key driver of the rating, as evidenced by relatively high and stable EBITDA margins compared to local competitors. The notable absolute EBITDA growth in 2023 was mainly driven by significant price increases at the beginning of the year and a decline in flower prices of around 20%, while utility costs decreased slightly. However, the achieved EBITDA for 2023 is considered to be a one-off and a normalisation is expected with margins reaching around 11% in 2024-2025. This normalisation is attributed to the implementation of partially initiated price reductions in 2023, which will be fully effective in 2024, together with expected further price decreases in each of Zalaco’s business lines from the first quarter of 2024.

In contrast to the past, the company has now adopted a strategy of hedging electricity and gas prices. The current fixed price for 2024, with an option to extend for one year, provides better visibility on the cost base environment.

Inventory shrinkage and obsolescence costs remain at around 2% of sales, reducing gross margins by 200 bps (ESG factor: credit negative). Profitability will additionally be supported by the expected full utilisation of the high-margin automated production line for frozen products (-7% volume increase in 2023 compared to 2022), which was refurbished and completed in May 2023.

Zalaco's business risk profile remains primarily constrained by its lack of geographic diversification, as slightly delayed export sales of its frozen products limit its exposure to a specific region. This situation is expected to continue in short to medium term as international retail chains postpone commercial negotiations. In addition, the company's sales are heavily concentrated on the international retail chain 'Lidl', which accounted for approximately 50% of sales in FY2023 (compared to 54% in FY2022) and is expected to increase further in the medium term as the main customer/partner sales of frozen products. 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 BBB-) is underpinned by a solid cash conversion cycle, reflected in substantial cash generation. Significantly lower than expected leverage in 2023 is the result of solid EBITDA performance. Scope-adjusted debt/EBITDA stood at 1.4x at YE 2023 (down 1.9x YoY). However, Scope expects leverage to move to around 2.5x in 2024-2025 driven by the expected normalization of EBITDA.

Scope doesn’t expect the heavy investment phase to continue after the completion of the significant investments in machinery in 2022 partially confirmed by expected positive free operating cash flow in FY2023. However steady demand for frozen produces from international retail chains could push the company into another expansion phase to increase production capacity.

Zalaco's M&A strategy was initially delayed due to both the Covid pandemic and high inflation rates. However, there is a possibility that Zalaco will now become more active in pursuing its expansion strategy, and acquisitions in the bakery sector could be on the horizon. The company has identified a potential target and management emphasizses that it will consider acquisition EBITDA multiples of up to 5x.

Zalaco’s liquidity profile remains adequate. Significant cash cushion at around HUF 5.0bn, together with expected free operating cash flows starting from YE 2023, minimises the company’s short-term refinancing risks.

Scope highlights that Zalaco’s senior unsecured bond issued under the Hungarian National Bank’s Bond Funding for Growth Scheme has a covenant requiring the accelerated repayment of the outstanding nominal debt amount (HUF 4.4bn) if the debt rating of the bond stays below B+ for more than two years (grace period) or drops below B- (accelerated repayment within 30 days). Such a development could adversely affect the company’s liquidity profile. The rating headroom to entering the grace period is three notches.

One or more key drivers of the credit rating action is considered an ESG factor.

Outlook and rating-change drivers

The Stable Outlook reflects Scope’s expectation that the company will maintain organic growth, while profitability margins will remain stable at historical levels after initiated price reductions, resulting in a Scope-adjusted debt (SaD)/EBITDA ratio of around 2.5x.

A positive rating action is deemed remote in the foreseeable future given the company’s limited size and geographical reach. A positive rating action on Zalaco could be considered if the company improves its geographical diversification and size while maintaining its current financial risk profile.

A negative rating action could result from a deterioration in credit metrics, as indicated by a SaD/EBITDA towards 3.5x 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 dividend payments.

Long-term and short-term debt ratings

Scope has upgraded Zalaco’s senior unsecured debt to BB from BB- including the HUF 4.4bn bond (ISIN HU0000359765). This reflects Scope’s upgrade of the issuer rating to BB-/Stable and the 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 approximately HUF 1.0 bn including financial guarantees. Although the recovery analysis indicates a relatively high recovery rate for senior unsecured debt, Scope has limited the uplift for the instrument to one notch due to the small scale and the risk that company could raise higher-ranking debt, which would dilute the recovery for senior unsecured debt holders.

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, 16 October 2023; Consumer Products Rating Methodology, 3 November 2023), 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 these 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 and/or Outlook 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: Thomas Faeh, Executive Director
The Credit Ratings/Outlook were first released by Scope Ratings on 24 April 2020. The Credit Ratings/Outlook were last updated on 2 March 2023.

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

Conditions of use/exclusion of liability
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