Fitch Ratings has affirmed China-based steel producer Inner Mongolia Baotou Steel Union Co., Ltd.'s (BSUC) Long-Term Foreign-Currency Issuer Default Rating (IDR) and foreign-currency senior unsecured rating at 'BB+'.

The Outlook is Stable.

BSUC's ratings are derived from our internal assessment of the consolidated credit profile of its immediate parent, Baotou Iron & Steel (Group) Co., Ltd. (BISC). BSUC's ratings are linked to the creditworthiness of BISC under our Parent and Subsidiary Linkage Rating Criteria due to strong linkages between the two entities. BISC is 77% owned by the Inner Mongolia Autonomous Region and we assess its creditworthiness based on the four factors set out in our Government-Related Entities Rating Criteria. The Stable Outlook reflects our expectation that BSUC's operations are sustainable, with continued operational, management and financial support from BISC.

Key Rating Drivers

Parent's Strong State Linkages: BISC is the world's largest rare earth producer and received 75% (historically around half) of the annual rare earth ore production quota issued by China's Ministry of Industry and Information Technology in 2022. BISC has China's largest reserves of rare earths and niobium, in which the country has a near monopolistic position. The government deems BISC's rare earth and niobium reserves as a national strategic reserve and an important political tool.

BISC is also the largest industrial company in the Inner Mongolia Autonomous Region by revenue and provides significant employment opportunities, with 57,600 employees at end-2022. This reinforces social stability.

'High' Operational, Strategic Support Incentive: We assess BISC's operational and strategic incentive to support BSUC as 'High'. BISC owns 55% of BSUC, its main steel operating subsidiary, which accounted for more than 70% of the group's total assets and around 40% of consolidated EBITDA at end-2022. In addition, BISC has absolute management control over BSUC, with significant management overlap. Some of group's rare earths also serve as raw material for BSUC's steel products.

'Medium' Legal Incentive for Support: We believe that BISC has a 'Medium' legal incentive to support BSUC, as it continuously guarantees a significant part of BSUC's bank debt. BISC provided guarantees to over 70% and 40% of BSUC's total debt in 2022 and 2021, respectively. According to management, guarantees will decrease from the 2022 level but we expect the guarantee percentage to remain meaningful.

Leverage to Drop: BSUC's and BISC's leverage (net debt/EBITDA) rose to 5.7x and 3.6x in 2022 (2021: 3.3x and 2.6x), respectively, on weak steel profitability amid high raw-material costs and a low steel average selling price (ASP). BSUC's leverage profile outperformed BISC's as its rare earth operations generated over CNY9 billion in EBITDA on increased volume and a favourable ASP. We expect both companies' leverage to improve in 2023-2026 on normalising steel raw-material costs and solid rare earth earnings, despite a capex pickup for environmental upgrades.

Financial Flexibility Offsets High Leverage: BSUC's financial flexibility remains healthy with EBITDA interest coverage of 4.1x in 2022 (2021: 5.7x), benefitting from decent funding costs given its good banking relationships and BISC's government-related entity status. BSUC had CNY22 billion in short-term debt and CNY14 billion in long-term debt outstanding at end-2022, against CNY5 billion in cash on hand and CNY9 billion in unused available credit facilities.

However, over 65% of short-term debt is bank borrowings, which we expect to roll over given its strong banking relationships. BSUC obtained around CNY40 billion in bank facilities in the last decade, which increased to over CNY50 billion by end-2022 with support from major commercial and policy banks.

Derivation Summary

We rate BSUC on a top-down basis from its parent under our Parent and Subsidiary Linkage Rating Criteria. Our internal assessment of BISC's credit profile is based on our Government-Related Entities Rating Criteria.

BSUC's rating is derived from the same methodology that we use for Aluminum Corporation of China Limited (A-/Stable) and Zhaojin Mining Industry Company Limited (BB+/Stable).

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

Revenue of around CNY70 billion in 2023 as declining steel ASP will be partially offset by a volume increase. Revenue to remain at around CNY70 billion in 2024 as steel prices continue to normalise.

EBITDA margin to improve to 9.5% in 2023 from lower raw material costs before rising further to average over 10% in 2024-2026 on continued raw material cost reduction.

Capex of 2%-3% of revenue for BSUC during 2023-2026; capex will be used mainly for environment-related facility upgrades and automation.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

An upward revision in Fitch's internal assessment of the creditworthiness of Inner Mongolia Autonomous Region

Increase in the likelihood of support from the Inner Mongolia government

An upward revision in Fitch's internal assessment of the creditworthiness of BISC

Factors that could, individually or collectively, lead to negative rating action/downgrade:

A downward revision in Fitch's internal assessment of the creditworthiness of Inner Mongolia

Weakening likelihood of support from the Inner Mongolia government

Weakening linkages between BISC and BSUC

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Adequate Liquidity: BSUC had CNY22 billion in short-term debt outstanding at end-2022, compared with CNY5 billion in cash on hand and CNY9 billion in unused available credit facilities. The credit facilities are uncommitted, but we believe they are adequate, as committed facilities are uncommon in China. BSUC's debt maturity is concentrated, with short-term debt accounting for over half of total debt. We expect BSUC to be able to continue rolling over its bank borrowings, which make up 65% of short-term debt, in light of its good banking relationships and support from BISC.

Issuer Profile

BISC is engaged in iron ore and rare earth mining and steel production with BSUC as its main operating subsidiary. BSUC has the capacity to produce around 17 million tonnes of steel products annually. Its main products include pipes, flat steel, section steel and long products. BSUC expanded its business profile to include iron ore and rare earth mining in recent years, supported by asset injections from BISC.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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