Fitch Ratings has affirmed Taiwan-based Dragon Steel Corporation's (DSC) National Long-Term Rating at 'AA-(twn)' with a Stable Outlook and National Short-Term Rating at 'F1+(twn)'.

Fitch has also affirmed DSC's senior unsecured rating at 'AA-(twn)'.

DSC's National Rating is one notch below the rating of its 100% parent, China Steel Corporation (CSC, AA(twn)/Stable), in line with Fitch's Parent and Subsidiary Linkage Rating Criteria, reflecting high incentives for CSC to support DSC. DSC is a key steelmaking subsidiary that accounts for a substantial amount of the group's total capacity.

The Stable Outlook reflects Fitch's expectation that the linkages between CSC and DSC will remain intact.

Key Rating Drivers

Strong Parental Linkage: DSC's rating is derived from that of CSC based on its high operational, medium strategic and low legal incentives to provide support. DSC is highly integrated with parent in terms of management, operations and brand. In addition, CSC approves DSC's key operational, investment and finance decisions. DSC contributes around 6 million tonnes (mt) of CSC's total 16mt of crude steel production capacity and operates two of the parent's six blast furnaces. It is instrumental in helping preserve CSC's leading domestic position of about 70% of Taiwan's steel market.

DSC provides material financial contribution, accounting for about 25% of CSC's EBITDA in 1H22. DSC is the only subsidiary of CSC that operates electric arc furnaces, which produce high value-added steel products such as H-section steel and steel plating. DSC does not plan to expand capacity at the moment.

Moderate Diversification: DSC's profitability depends on its hot-rolled coil products, which contributed about 62% of total revenue in 2021 and a similar amount in gross profit. DSC's lower level of product diversification means its profitability can be more volatile than that of its parent, which has a more diverse range of products. However, we believe this is partially offset by DSC's moderate geographical diversification, with exports making up 26% of its revenue in 2021. The company's major export destinations include China, Japan and south-east Asia.

Negative FCF, Increasing Leverage: We expect post-dividend free cash flow (FCF) to turn negative in 2022, due to lower EBITDA generation on lower steel prices and a large dividend payment associated with its strong performance in 2021. As a result, we expect its EBITDA net leverage to increase to 2.4x in 2022 from 1.0x in 2021.

We expect the EBITDA margin to improve in 2023 because raw material prices are set to moderate, based on Fitch's price assumption. We therefore expect FCF generation to improve but consistent dividend payment will most likely keep its EBITDA net leverage at above 1.5x over 2023-2024.

Derivation Summary

DSC's ratings are derived using a top-down approach based on strong linkages with its parent, and are notched down once from the parent's rating. Its linkages with CSC compare well with those of peers that are notched down once from their respective parents and are core operating subsidiaries of their respective parent group.

Key Assumptions

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

No additions to steelmaking capacity in the near term;

Revenue to decline by 11.5% in 2022, around 17% in 2023 and 2%-5% thereafter;

EBITDA margin to decline to 14% in 2022 (2021: 25.1%), before increasing gradually to 17.5% in 2025;

Annual capex of TWD3.8 billion-TWD4.3 billion over 2022-2025;

Disciplined dividend payment based on performance;

No major M&A.

RATING SENSITIVITIES

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

Positive rating action on the parent, provided that the linkages between CSC and DSC remain intact;

Strengthening of linkages between DSC and CSC.

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

Negative rating action on CSC;

Weakening linkages between DSC and CS.

Liquidity and Debt Structure

Adequate liquidity: DSC's liquidity is supported mainly by unused banking facilities and short-term refinancing. It had available cash of TWD2.35 billion at end-September 2022, and TWD43 billion in unused banking facilities, against short-term debt of about TWD25 billion. Furthermore, DSC has access to CSC's group treasury and can also borrow from banks and credit markets at very low rates due to the parent's support. We expect DSC to continue to refinance its short-term debt.

Issuer Profile

DSC is the only integrated steel producer in Taiwan that operates both blast and electric arc furnaces. It accounts for about 37% of CSC's total crude steel production capacity and holds two of CSC's six blast furnaces.

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