MARC AFFIRMS KNM GROUP BERHAD'S AND KNM CAPITAL SDN BHD'S SHORT-TERM AND LONG-TERM RATINGS OF MARC-1ID/A+ID; REVISES OUTLOOK TO NEGATIVE

Nov 28, 2012 -
MARC has affirmed the short-term and long-term ratings at MARC-1ID and A+ID and revised the outlook of the ratings to negative from developing for the following rated programmes/issuers:

1. RM300.0 million Murabahah Underwritten Notes Issuance Facility (MUNIF)/Islamic Medium Term Notes (IMTN) Programme of KNM Capital Sdn Bhd (KNM Capital);
2. RM400.0 million Islamic Commercial Paper (ICP) Programme of KNM Group Berhad (KNM); and
3. RM1.1 billion Islamic Medium Term Note (IMTN) Programme of KNM.

The affirmed ratings are based on the good competitive position and operating profitability of KNM’s key operating subsidiary and high-end process equipment manufacturer, Borsig GmbH (Borsig), moderated by the competitive process equipment marketplace, weaker consolidated operating margins, negative cash flow caused by higher working capital requirements, rising debt burden and declining financial cushion. The group reported an improved financial performance for the first nine months of 2012 (9MFY2012) and higher capacity utilisation of its process equipment manufacturing plants but its operating margins remained tight and available liquidity has declined from year end-2011 levels.
The revised outlook considers the risks associated with KNM’s renewable energy venture in Peterborough, UK as well as the project’s gestation period, upcoming RM95 million of note maturities in 2013, and MARC’s expectation that free cash flow will be substantially negative at the consolidated level as a result of project expenditure on the 80MW EnergyPark Peterborough waste-to-energy plant.
KNM’s leverage is expected to trend higher on account of the Peterborough renewable energy project that is 80% owned by KNM, with developer Peterborough Renewal Energy Limited holding the balance. The first phase of the Peterborough renewable energy project will cost £233 million (RM1.1 billion), of which 80% will be financed by syndicated loans while the remaining 20% will be financed by an equity investment from KNM and Peterborough Renewal Energy Limited. KNM has funded its portion of the 20% equity investment and is in the process of raising the syndicated loans. KNM’s ability to offset consequent pressure on its balance sheet metrics through an infusion of new capital and to improve its operating margins will be critical to maintaining its rating. MARC understand that KNM recently raised about RM196 million through its two-call rights issue exercise which are to be used to pare down the group’s borrowings. The group also plans to list Borsig on the Singapore Exchange (SGX) in 2013.
While KNM’s revenue stability could potentially improve in the medium-term as a result of its venture into the renewable energy sector as an engineering, procurement, construction and commissioning (EPCC) contractor and operator of waste-to-energy projects, the near-term execution risks associated with such ventures and the expectation that the majority of project costs will be financed with substantial incremental debt at the consolidated level are of particular concern to MARC. Currently weighing on MARC’s assessment of execution risk is KNM’s short track record of performance as an EPCC contractor and lack of experience as a renewable energy plant operator, notwithstanding the company’s plans to engage an experienced third party plant operator. KNM also faces meaningful country risks in respect of its Peterborough and Orizon renewable energy projects to be undertaken in the UK and Sri Lanka respectively. MARC notes further that the energy renewal projects have been facing challenges in reaching financial close.
KNM’s efforts to realign its product portfolio and improve operating profitability helped lift its consolidated operating margins to 5.49% as at end-September 2012 (9MFY2011: -7.25%). Wholly-owned subsidiary Borsig continues to be the group’s largest earnings contributor, accounting for 58.7% and 78.3% of the group’s consolidated revenue and earnings before interests, taxes, depreciation and amortisation (EBITDA). For 9MFY2012, the European segment led by Borsig reported strong earnings growth while the Asia & Oceanic segment saw some improvement. On the other hand, the group’s operations in the Americas, in particular Brazil, continued to be a drag on its financial performance. The group’s current order book provides short-term earnings visibility until 2013; excluding the renewable energy projects, the group’s order book stood at RM2.3 billion as at end-July 2012.
For 9MFY2012, the group recorded higher revenue and pre-tax profit of RM1.8 billion (9MFY2011: RM1.4 billion) and RM60.6 million (9MFY2011: -RM136.9 million) respectively. Its improved financial results reflected a shift in its business mix towards higher margin process equipment and a write-back of provision of foreseeable losses amounting to RM28.6 million. KNM’s cash flow from operations turned negative RM14.3 million (9MFY2011: RM237.1 million) as a result of higher working capital requirements during the period. Contract work in progress increased to RM506.7 million (FY2011: RM450.4 million). KNM also repaid RM95 million of notes issued under KNM Capital due this year. The group funded its free cash flow deficit of RM55.5 million (FY2011: RM104.8 million) with its internal liquidity resources, as a consequence of which, cash and cash equivalents declined to RM121.2 million as at September 30, 2012 from RM399.2 million as at year-end 2011.
The rating is likely to be downgraded if there is a weakening of KNM’s credit profile, as signalled by deterioration in its leverage and debt protection metrics brought on by competitive pressure, project execution challenges and/or failure to demonstrate sustained improvement in profitability or failure to proceed with its plans to raise equity finance and list Borsig by 2013.
Contacts:
Se Tho Mun Yi, +603-2082 2263 / munyi@marc.com.my;
Sharidan Salleh, +603-2082 2254 / sharidan@marc.com.my.