OREANDA-NEWS. Fitch Ratings has assigned Italy-based gas distribution group ITG Holding S. p.A. (ITG Holding) an expected Long-Term Issuer Default Rating (IDR) of 'BBB+(EXP)' and an expected senior unsecured rating of 'BBB+(EXP)'. The Outlook on the IDR is Stable.

The ratings mainly reflect the group's solid business profile as leading gas distributor in a regulatory environment that we view as generally supportive and transparent, and the company's positive operational performance. The ratings also factor in the starting debt of the group (EUR3.5bn pro-forma at year-end 2015) and the external growth targeted by Italgas S. p.A. (Italgas), the operational subsidiary of ITG Holding, in the context of gas distribution tenders in Italy. Fitch expects funds from operations (FFO) adjusted net leverage to trend towards 6.5x and net debt/(RAB + associates) in the 60%-66% range in 2016-19.

The final ratings are contingent upon the demerger of Italgas from Snam S. p.A. (BBB+/Stable) and the confirmation of the post-demerger financial structure conforming materially to information already received. At completion of the transaction, ITG Holding's only shareholding will be 100% of Italgas and it will be the group's only borrower.

KEY RATING DRIVERS

Solid Business Profile

Italgas is the leading gas distributor in Italy with 30% market share (6.5 million redelivery points excluding associates). Gas distribution is fully regulated and does not retain volume risk, apart from a limited exposure to the trend of redelivery points. The group's network stands at around 56,700km.

Italgas posted positive operational performances historically, significantly outperforming the opex allowances set by the regulator. We expect the impact of the demerger on the company's cost structure to be limited, due to almost absent synergies on the ground with Snam.

Post demerger, Snam will own 13.5% of ITG Holding, implying 26% ownership for CDP (through CDP RETI (BBB/Stable), and CDP Gas) and 60.5% for the other current Snam shareholders. Italgas is entering an unusual phase characterised by simultaneous tenders for gas concessions and completion of smart meters roll out.

Fairly Supportive Regulatory Framework

The gas distribution activity in Italy is regulated by the independent regulator Autorita per l'Energia Elettrico, il Gas ed il Sistema Idrico (AEEGSI). The regulatory framework allows the recovery of the operating costs (updated annually for inflation and an efficiency factor) and capex (through an allowed return on RAB and allowed depreciation). The current regulatory period is the fourth and covers 2014-2019.

The starting level of allowed opex/delivery point is based on the size of the operator and the customer density. Since the largest size considered to set the allowance is above 300,000 redelivery points, Italgas effectively exploits its scale to achieve outperformance. The efficiency factor is equal to 1.7% for distribution and 0% for metering and will be redefined in 2017. Counterparty risk is low, as the company is paid by wholesale counterparties including Eni (A-/stable) and Enel (BBB+/Stable).

Capital Cost Update

The real pre-tax WACC is equal to 6.1% for distribution and 6.6% for metering starting from 2016. The reduction from the level of 2014-15 (6.9% and 7.2% for distribution and metering respectively) is consistent with the current interest rate environment. We view positively the updated methodology in place from 2016, as it increases stability and visibility of the allowed remuneration.

The regulator is moving towards benchmarking capex, with the likely introduction of standard costs or a total price cap mechanism (including opex and capex and always based on delivery points rather than gas volume). Although this evolution implies tightened scrutiny of the sector's capital spending, it could represent an opportunity for Italgas, given its scale and the possibility to outperform the targets.

Tenders for Gas Concessions

The Italian DSOs operate on the basis of concessions granted by municipalities. Italgas and its affiliates have a portfolio of 1,472 concessions. Most concessions in the country are expired, but companies are entitled to run the business until a new tender procedure is finalised. The existing concessions have been grouped in 177 districts (Ambiti Territoriali Minimi; ATEM) to foster market consolidation and efficiency and will be retendered. New concessions will be granted for 12 years.

The start of the tender process has been postponed several times, mainly due to the lack of administrative details and the limited reactivity of the local authorities, often reluctant to join in broader ATEM and change the favourable terms of the existing concessions. First tenders notices were published at the end of 2015 and awards should start from 2H17. However, some outstanding appeals and technical complexity could further delay the process, in our view.

Italgas Targets External Growth

Italgas plans to exploit the tenders to increase its market share in the country from around 30% to around 40% (excluding associates), with redelivery points rising from 6.5 million to more than 8 million at the end of the process. This would imply net financial cash outflows, since the awarded operator has to pay to the outgoing one an amount based on net reconstruction value of the acquired network, which can be assumed overall to be aligned with the RAB. The new concessionaire will also be obliged to employ current staff.

We estimate a net cash-out related to tenders of EUR0.4bn in 2017-19, assuming that almost less than half of the tenders will be awarded in this period, which currently seems quite challenging for the system.

Leverage Drives the Rating

Italgas will go through a prolonged phase of external growth, with additional spending related to smart meters roll-out (more than EUR100m per year). The pace of the tenders will define the peak level of leverage, but also the year from which deleverage could start. Based on our assumption on the tenders' timetable, we expect the FFO net adjusted leverage to trend towards 6.5x in 2018-19. Further delays would likely have a positive impact on the ratio in the short term.

Limited Headroom

Fitch identified negative guidelines for the 'BBB+' rating at 6.5x for the FFO net adjusted leverage and 63% for the net debt/(RAB + associates). We view headroom for Italgas as limited if the tenders proceed as factored in our figures. We would tolerate a temporary moderate breach of the rating guidelines if it was from a capex spike related to tenders. If it was related to structurally lower operational performance or more aggressive dividend policy, it may result in a downgrade.

We expect healthy coverage ratios and free cash flow to be structurally (i. e. excluding tenders) neutral to positive, also in light of the operational efficiency, the satisfactory status of the network and the declining tax rate.

Financial Structure

The targeted financial structure comprises only senior unsecured debt at the ITG Holding level, initially represented by a European Investment Bank facility of EUR0.4bn and bank debt including a bridge facility of EUR2.3bn, term loans of EUR0.5bn and a revolving credit facility for EUR1.1bn (of which we expect EUR0.5bn to be drawn at year end 2016). The bridge facility should be refinanced through senior unsecured bonds in 2017.

Improving Tax Environment

The fiscal environment in Italy is improving, as witnessed by the abolition of the Robin Tax in 2015 and the reduction of corporate tax rate by 3.5pp in 2017 foreseen by the 2016 Stability Law. We note that for an Italian regulated utility the tax rate on EBT (excluding Imposta Regionale sulle Attivita Produttive) is expected to reduce to 24% in 2017 from 38% (27.5% + 10.5% Robin Tax) in 2013, with a meaningful benefit for cash flow generation ability.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Italgas include:

- No meaningful regulatory changes

- Cash outflows related to tenders of around EUR400m in 2017-19

- Average annual capex of EUR430m in 2016-19, substantially higher than the historical level for the smart meter roll-out and the higher capex intensity deriving from tenders

- Reduction of tax rate to 24% from 2017 (from 27.5%)

- Flat dividends around EUR150m from 2017, assuming that the demerger would be broadly neutral for current Snam's shareholders in terms of dividends received

RATING SENSITIVITIES

Positive: Future developments that could lead to positive rating action include:

- FFO net adjusted leverage below 5.7x on a sustained basis, net debt/(RAB + associates) approaching 55%, with structurally positive free cash flow before dividends and financial investments and assuming an unchanged business risk profile.

- Increased visibility in relation to the evolution of the tenders and the company's ability to successfully integrate the acquired activities.

Negative: Future developments that could lead to negative rating action include:

- FFO net adjusted leverage above 6.5x, FFO interest coverage below 4.5x, net debt/(RAB + associates) above 63% over a sustained period, for instance as a result of structurally higher than expected investments or lower-than-expected contribution from gas distribution tenders, upward revision to Italgas's dividend policy.

- Weakening business risk profile, as a consequence of a less predictable regulatory framework.

LIQUIDITY

ITG Holding's liquidity profile will benefit from revolving facilities of EUR1.1bn with maturities of three to five years. We estimate that around EUR0.5bn of the revolving credit facilities will be kept as a liquidity buffer. The company will have to refinance the bridge loan of EUR2.3bn, which has a tenor of one year, with an extension option for an additional year, while the term loans will have maturities of three to five years. We consider that the refinancing risk is mitigated by the established track record of funding access of the business within Snam, the fully regulated nature of the business and the visibility of the European Central Bank's monetary policy, at least in the short term.