Fitch Downgrades Aralco S.A Industria e Comercio's IDR to 'CCC'

Fitch Ratings has downgraded Aralco S.A Industria e Comercio's Foreign Currency and Local Currency Issuer Default Ratings (IDR) to CCC from B, and National Long-Term Rating to 'CCC(bra)' from 'BBB-(bra)'. Fitch has also downgraded to 'CCC' from 'B' the rating for the USD250 million unsecured senior notes due 2020. The issuer of the notes was Aralco Finance S.A. (Aralco Finance), a fully-owned subsidiary of Aralco Industria e Comercio S/A. The recovery rating is unchanged at 'RR4'.

KEY RATING DRIVERS

The downgrades reflect Fitch's concerns about Aralco's short-term liquidity position and escalating refinancing risks due to its inability to generate positive cash flow from operations. Aralco's struggles are partly related to the company's underinvestment in its sugarcane fields that has resulted in cane fields that have a higher average age than its peers, which has driven down its yields. During the last 12 months (LTM) ended Sept. 30, 2013, the company had high working capital requirements due to its need to finance its third party suppliers of sugarcane.

Aralco recently revised its previous guidance down by 1 million tons and is now forecasting total crushed volumes of 5 million tons for the FY14. As a result, capacity utilization should be significantly lower than its peers in Brazil. Due to depressed global sugar prices and modest ethanol prices in Brazil, the company's funds flow from operations (FFO) is not expected to materially improve during the next 12 months. Aralco's free cash flow (FCF) is expected to be negative in FY14 due to its limited FFO, supplier financing, and investments in rejuvenating its cane fields. Consequently, the company will remain reliant upon external sources of financing to fund its operations.

Moderate Business Scale

Aralco is a medium-sized sugar and ethanol company operating in a fragmented, commodity-based sector where scale is relevant and volatility, common. The company runs 7.2 million tons of crushing capacity spread over four industrial units in the Northwest of the Sao Paulo State. Its business model benefits from lower logistics and land lease costs, but production flexibility is low as two thirds of all sucrose it produces goes to production of hydrous and anhydrous ethanol sold in the domestic market. This reduces the volatility of its earnings, though, at the same time, it makes the company more exposed to political risk as the domestic ethanol industry dynamics is strongly linked to Brazil's regulated gasoline prices and related government energy policies. The company's forecast crushed volumes of 5 million tons for the FY14 places utilization capacity at 69%, considerably lower than its peers.

Average Business Position Benefits from Link to Copersucar

Aralco owns a 5.8% stake in the cooperative Copersucar. The company ownership stake in Copersucar mitigates demand risk, lowers logistics costs and provides better stability in the company's collection flow. Copersucar's large scale business accounts for approximately 22% of crushed sugar cane in the Central South region of Brazil and for 11% and 12% of the global trade of sugar and ethanol, respectively, making it an important price making agent. Copersucar is formed by 47 mills that belong to 24 independent economic groups. Its members crushed 118 million tons of sugar cane in the 2012/2013 season.

Aralco sells 100% of its production to Copersucar through a long-term exclusivity contract. Prices for its products are linked to the average sugar and ethanol market prices plus a small premium. Copersucar's members are responsible for the agricultural activities and for the sugar and ethanol production, while Copersucar is responsible for all commercial activities and associated logistics, as well as for the implementation of hedging policies. Copersucar remunerates Aralco based on the realized production on a monthly basis during the year, independent of the moment the sale to the final customer occurs.

Weak Liquidity and Negative CFO

As of Sept. 30 2013, Aralco's cash position of BRL61 million accounted for only 16% of the company's short-term debt. The ratio would be 28% if the advances from Copersucar are excluded from the short-term debt calculations. Aralco's cash from operations (CFO) was negative BRL 105 million during the LTM, adding pressure to its short-term liquidity position and increasing refinancing risks significantly. This negative cash flow generation compares unfavourably with a cash inflow of BRL108 million in the FYE13 and resulted from the combination of weaker operating performance and higher working capital requirements. These higher working capital requirements arose from the company's need to finance its suppliers at a much larger extent than in the prior year. Aralco's weak liquidity position is partly mitigated by the working capital financing line that is provided by Copersucar. This credit line is limited to a maximum of 40% of the company's revenues. This line, which is equivalent to approximately BRL200 million, enhances financial flexibility and is linked to guarantees on inventories and/or bank guarantees.

Higher Leverage

For the LTM ended Sept. 30, 2013, Aralco's consolidated net debt/EBITDA ratio was 14.2 times as per Fitch's internal methodologies, the highest level among its peers by far. Excluding advances from Copersucar which are backed by sugar and ethanol inventories of BRL173 million, Aralco's net debt/EBITDA would be 12.4 times for the same period. This compares unfavorably with net debt to EBITDA of 6x as of the FY13.

Fitch's EBITDA metrics do not include non-cash gains of BRL66 million generated under a tax financing program granted by the State of Sao Paulo. This higher leverage reflected not only the negative CFO reported as of Sept. 30, 2013 but also Copersucar's strategy of holding ethanol inventories in anticipation of better prices to be achieved over the off-season. Although it does not affect its cash flow generation, Copersucar's cash & carry strategy delayed the recognition of revenues by Aralco, causing an accounting impact on its EBITDA generation.

RATING SENSITIVITIES

A negative rating action will be triggered if Aralco's FFO and CFO do not recover in the near term and if liquidity deteriorates further. A positive rating action could occur if both FFO and CFO recover and if leverage goes down on a consistent basis. A positive rating action could also occur if the company obtains significant amounts of external financing, either through debt or equity.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (Aug.5, 2013);

--'National Ratings - Methodology Update' (Oct. 31, 2013).

Applicable Criteria and Related Research:

Corporate Rating Methodology - Effective from 8 August 2012 - 5 August 2013

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=684460

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=816346

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Fitch Ratings
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Claudio Miori, [phone]
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Fitch Ratings Brasil Ltda
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Associate Director
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