OREANDA-NEWS. Fitch Ratings has affirmed Italian utility Snam S. p.A.'s Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB+'. The Outlook on the IDR is Stable. The Short-term IDR has been affirmed at 'F2'.

The affirmation mainly reflects the company's positioning in the Italian regulated gas market, the fair regulatory system, confirmed also by the allowed rate of return set from 2016 and a balanced strategy. The rating also factors in the announced demerger of the gas distribution business run by Italgas S. p.A., which based on our estimates will increase the group's financial flexibility.

Fitch believes that Snam will at least partially use the increased headroom to pursue moderate external growth in line with the company's strategic approach. However, we expect the main ratios to remain comfortably placed for the current rating, with average funds from operations (FFO) adjusted net leverage of 6.1x and net debt/(RAB + associates) of 51% in 2016-20.

KEY RATING DRIVERS

Italian Incumbent in Regulated Gas Activities

Snam manages one of the largest gas transport networks in Europe (around 32,500km excluding associates) and the largest storage infrastructure (capacity of 16 billion cubic metres), benefiting from a transparent regulatory framework, with negligible exposure to volume risk.

The group accounts through the equity method four main stakes in European pipelines, in which it invested around EUR1.4bn at year end 2015. CDP (through CDP RETI (BBB/Stable) and CDP Gas) owns 30.1% of the company and is the reference shareholder.

Impact of the Demerger

The structure of the demerger implies a debt reduction of around EUR3.7bn for Snam at closing, while the company will retain a 13.5% stake in ITG Holding S. p.A. (BBB+(EXP)/Stable), which will own 100% of the operating company Italgas. On this basis, we expect that ITG Holding will have a higher initial FFO net adjusted leverage of around 7x in 2017, while Snam would present a lower initial leverage ratio of around 6x. Moreover, Snam will not be involved in the gas distribution tender process, further increasing its financial flexibility.

In terms of debt capacity and rating guidelines, we believe that the transaction is broadly neutral for Snam. The slightly riskier profile of the spun-off activity (reflected in slightly tighter rating guidelines for ITG Holding for the same rating) is offset by the reduced size and diversification and some emerging overhead costs related to the transaction, in our view. However, we do not expect a significant impact on the companies' cost structure at operational level, due to the almost absent synergies between Snam and Italgas. Post demerger capex will represent around 40%-45% of the group's EBITDA on a structural basis.

Mature Regulatory Framework

The gas transport and storage 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 timely recovery of the operating costs (updated annually for inflation and an efficiency factor) and capex (through an allowed return on RAB and allowed depreciation) and in our view, is fairly supportive. The current regulatory period is the fourth and covers 2014-2017 for transport and 2015-2018 for storage.

The transport and storage activities do not offer the same opportunity to outperform opex allowance of the distribution business, since the allowance defined by the regulator is based on the cost structure of the incumbent. The efficiency factor is equal to 2.4% for transport and 1.4% for storage, based on a 50%-50% profit sharing of extra efficiencies with end users. The company bears negligible counterparty risk.

Regulatory Updates

The real pre-tax WACC is equal to 5.4% for transport and 6.5% for storage starting from 2016. The interim update is due in 2019, while the next regulatory period of the WACC will start in 2022. We view positively the updated formula for the definition of WACC from 2016, as it increases stability and visibility of the allowed remuneration.

Potential updates in the next regulatory period for transport (2018) could include the reduction of the time lag for recognition of capex into the RAB from two years to one year (with the elimination of the extra 1% compensation for time lag), as the regulator has recently done for other regulated activities. The AEEGSI adopted a more stringent approach to extra-remuneration for storage in the current regulatory period and we expect a more selective approach also for transport, with benchmarking of capex (potentially through the totex approach) and the reduction of extra-remuneration for strategic investments.

Equity Stakes in Predictable Assets

Snam has invested in four associates in line with its long-term target to play a role in the development of the North-South and East-West gas corridors in Europe. TIGF SA (40.5% stake), TAG GmbH (84.47% of the shares, 89.22% of the economic rights) and Interconnector UK Ltd (15.75% held through a JV with Fluxys) are largely regulated assets, with strategic relevance and a limited volume risk. We expect dividends from these companies to represent around 8% of the consolidated FFO for 2016-2020.

In December 2015 Snam acquired a 20% stake in TAP AG for a total consideration of EUR208m (including EUR78m for the replacement of Statoil in the shareholder loan). The pipeline represents the final part of the Southern Gas Corridor (between Greece and Italy) and its commissioning is expected by 2020. Capacity has been booked through long-term ship-or-pay contracts. Based on the structure of similar projects, we expect that Snam may need to guarantee pro-rata the company's debt until the end of the construction period. If so, we will track the evolution of this guarantee, but will not include its amount in the debt considered for our credit ratios, as far as the construction proceeds as scheduled.

Balanced Strategy

The updated strategy continues the historical pattern followed by the company. After the demerger, Snam will remain focused on its Italian regulated business and the management of the existing equity stakes. Development capex in transport will be mainly focused at expanding bi-directional cross-border flows and strengthening the network in view of the additional imports expected from TAP.

The increased financial flexibility could be partially used to pursue new initiatives in gas infrastructures abroad, consistent with the need for more gas interconnections across Europe. The company announced the possibility of implementing a share buyback of EUR500m by the end of 2017. We believe this will materialise if no relevant growth opportunity arises in the meantime. However, we believe that Snam's approach will remain overall prudent about debt sustainability.

Significant Headroom Post Demerger

Post demerger Snam's credit ratios will have significant headroom and could also bring some upward rating pressure. However, our ratings take into account the company's long-term strategy, which includes the monitoring of the European market to evaluate interesting growth opportunities. Therefore we included additional investments related to external growth of EUR700m in 2017-20 (but no share buyback) in the rating case, assuming that they would be related to assets with a solid business profile and with a limited contribution to FFO.

We note that such additional investments would still leave the company with an FFO net adjusted leverage of 6.2x at 2020, well within the guideline. We expect structurally neutral to positive free cash flows (after dividends and before investment for external growth) and solid coverage ratios.

Decreasing Cost of Debt

Management expects the cost of debt to be 2.6% in 2016 (from 3.2% in 2014) and to further reduce thereafter, thanks to cost optimisation initiatives. We also see a moderate room for cost of debt reduction, due to the approaching maturity of some expensive bonds. The average debt maturity is expected to remain five years, with around two-thirds of total debt at fixed rate. The bondholders consent solicitation is a condition precedent for the transaction, while we do not foresee problems in obtaining the waiver from the banks.

Improving Tax Environment

The fiscal environment in Italy is improving, as demonstrated 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 notice that for an Italian regulated utility the tax rate on EBT (excluding Imposta Regionale sulle Attivita Produttive) is expected to reduce from 38% (27.5% + 10.5% Robin Tax) in 2013 to 24% in 2017, with a meaningful benefit for cash flow generation.

KEY ASSUMPTIONS

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

- Regulatory changes for the next period for transport mainly related to the reduction of the time lag for capex recognition into the RAB

- Broadly stable controllable fixed costs

- RAB standing at around EUR20bn after the reduction of the time lag, with associates representing additional EUR2bn

- Average annual capex slightly lower than EUR900m in 2016-20, representing around 40-45% of the EBITDA

- Additional investments of EUR0.7bn across 2017-2020, with limited contribution to the FFO, to reflect the strategic interest for interconnection projects across Europe

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

- Dividends based on a DPS of EUR0.21 in 2017, with an annual growth of 2.5% thereafter

RATING SENSITIVITIES

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

- FFO net adjusted leverage declining below 6.0x on a sustained basis

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

- Deterioration of FFO net adjusted leverage above 6.7x, FFO interest coverage below 4.0x or net debt/(RAB + associates) approaching 65% over a sustained period, for instance as a result of the regulatory review or higher than expected investments

- Growing exposure to unregulated activities, upward revision to Snam's dividend policy or material debt-funded acquisitions abroad

LIQUIDITY

Fitch assesses Snam's liquidity position as solid. Cash balances are small, but at March 2016 undrawn committed lines amounted to EUR3.95bn, compared with debt maturities of EUR2.3bn and negative free cash flow of around EUR1bn in the last nine months of 2016. Additional debt repayment of EUR2bn is due in 2017. However, with the demerger expected in November 2016 Snam will receive a total amount of cash from Italgas of around EUR3.3bn (net of the transfer of EUR0.4bn EIB facility to Italgas), which could be used to optimise the financial structure, in our view.