Fitch Ratings on Wednesday upgraded South Africa-based aerospace company Denel’s National Long-term Rating to ‘AAA(zaf)’ from ‘AA-(zaf)’ and affirmed its National Short-term rating at 'F1+(zaf)’, stating that the company’s outlook was stable.

The upgrade reflected a recalibration of the higher end of the South African National Rating Scale and the alignment of Denel's ratings with those of the South African sovereign (BBB/BBB+/Stable), reflecting expectation of timely support from government to service and repay Denel's debts.

Under Fitch's parent and subsidiary rating linkage methodology, the agency deemed Denel's legal, operational and strategic links with the State of South Africa as strong, including, in particular, the State's irrevocable and unconditional guarantee of a significant portion of Denel's debt.

Fitch stated that Denel's ratings reflected its full ownership by the State, its ultimate accountability to the South African Minister of Public Enterprises, as well as explicit shareholder support in the form of both capital injections and guarantees for the group's debt funding.

Fitch also viewed the financial support by government as critical to the liquidity needs of Denel in order for the company to execute its contracts under its order book.

In the financial year to March 31, 2013, Denel’s revenue increased 9.8% to R3.9-billion, which was ahead of Fitch’s expectation.

However, the trend of operating losses continued in the 2013 financial year, with the group incurring a loss before interest and tax of R114-million, as opposed to a loss of R96-million in 2012.

“We expect revenue growth to be driven by its R22-billion order book; however, we remain cautious on the group's margin recovery in the short term given the operating risks inherent in the defence industry, such as cost overruns and project delays, that could negatively impact profitability.

“As a result, we expect the group to remain loss-making in the 2014 financial year, before progressively returning to profitability by the 2017 financial year,” the ratings agency said.

Further, while Fitch acknowledged steps taken by management in reducing costs and diversifying revenues, it believed that Denel's standalone credit profile was not yet commensurate with an investment-grade rating given its trend of high leverage and weak free cash-flow generation.

In addition, a limited number of manufacturing platforms and a low level of self-funded research would also negatively impact Denel's operating profile, while the group would continue to be exposed to the fragile South African defence sector.

Meanwhile, Fitch expected the trend of subdued South African defence spending to continue over the short to medium term given government's increased focus on socioeconomic expenditure and the current fiscal deficit.

“Denel has managed to diversify its revenue base away from the South African defence sector with 50% of its revenue now being generated from exports, particularly to the Middle East and South East Asia.

“While we expect the export business to remain an important aspect of Denel's revenue growth, we also believe that competitive pressure is likely to intensify in the group's key operating markets, as larger prime contractors move into growing emerging markets, given uncertainty in mature developed defence markets,” Fitch said.

Meanwhile, the ratings agency pointed out that future developments that could, individually or collectively, lead to negative rating action included the withdrawal of government support and any weakening in financial support that would lead to Fitch assessing Denel on a standalone basis.