OREANDA-NEWS. Fitch Ratings has affirmed Russia-based PJSC Federal Grid Company of Unified Energy System's (FedGrid) Long-Term Foreign Currency Issuer Default Rating (IDR) at 'BBB-'. The Outlook is Negative. A full list of rating actions is at the end of this release.

FedGrid's 'BBB-' rating continues to incorporate a one-notch uplift for state support from its standalone rating of 'BB+'. The uplift is currently limited to one notch by Russia's IDR (BBB-/Negative), although we continue to assess state support as commensurate with a two-notch uplift. This is evidenced by ultimate majority indirect state ownership, the company's strategic importance as the national electricity transmission grid operator, strong operational ties including tariffs and capex approval and track record of state support. The Negative Outlook mirrors that on the sovereign.

KEY RATING DRIVERS

'BB+' Standalone Rating

We currently assess FedGrid's standalone profile as commensurate with a 'BB+' rating given its monopoly position in electricity transmission in Russia, relatively low volume risk and sound financial profile. However, FedGrid's standalone profile is constrained by the inherent uncertainty and unpredictability in the Russian regulatory framework, as well as the company's extensive capex due to its modernisation and development needs, which are likely to result in continued negative free cash flow.

Sound Financial Profile

FedGrid reported strong financials for 2015-1Q16, outperforming our expectations. We expect it to maintain a solid financial profile over the forecast horizon, which will support its standalone rating. We expect Russian GDP to decline by 0.7% and inflation to grow by 8.2% in 2016, but we forecast FedGrid's financial profile will remain strong with an average EBITDA margin of about 55% over 2016-2019 and funds from operations (FFO) net adjusted (for connection fees) leverage to remain below our negative rating guideline of 3.5x over 2016-2019 (2.3x at end-2015). This is based on our assumptions of modest transmission tariff growth, high dividends and interest rates of 12% for all new debt to be raised over 2016-2019.

Higher Dividends

In April 2016, the Russian government issued a decree obliging major state-owned companies to pay 50% of their highest earnings base (RAS or IFRS) as dividends. In 2016 FedGrid will pay RUB17bn as dividends for 2015, which accounts for about 95% of net income under RAS or about 38% of net income under IFRS. In our rating case, we assume a 50% dividend payout of net income under IFRS annually for 2016-2019. This may result in average RUB15bn dividends per year for 2016-2019 but we believe it will be manageable for the company due to its solid financial profile.

Capex to Drive Negative FCF

FedGrid forecasts it will invest around RUB335bn (net of value-added tax) over 2016-2019. We expect FedGrid to continue to generate solid cash flow from operation of about RUB75bn annually on average over 2016-2019. However, a continued extensive investment programme and our expectation of increased dividend payments will result in free cash flow remaining negative at about RUB24bn annually on average over the same period. We expect FedGrid's investment programme to be partially debt funded. However, FedGrid has the flexibility to cut back its investment programme in the event of a lack of available funding or unfavourable interest rates. In 2014 the company demonstrated its capex flexibility, decreasing it by more than 40% yoy to RUB74bn from an average RUB133bn over 2009-2013.

Long-Term Tariffs, Regulatory Framework

As FedGrid mainly operates in regulated markets, we consider regulatory changes could have a serious impact on it compared with Russian generating utilities, which are less exposed to regulated markets. Russia's unpredictable and inconsistent regulatory framework is characterised by political interference and frequent changes in the tariff-setting mechanisms and is a key risk for Russian utilities. Since the long-term regulatory asset-based principles in electricity transmission tariff setting were introduced in 2010, which supported increased cash flows and margins, the government has revised the regulation and tariff levels several times to help keep end-user prices down due to political/social reasons. The high regulatory risk constrains the Russian utilities' standalone ratings to sub-investment grade.

At present, FedGrid's tariffs are approved by the Federal Antimonopoly Services for 2016-2019 assuming annual tariff growth in the range of 6.2%-7.5% from 1 July, linked to the CPI estimated by the Ministry of Economic Development of the Russian Federation.

State Support

Russia's 'BBB-' rating continues to limit the current uplift for state support to FedGrid's standalone rating to one notch. However, we continue to view the strength of the ties between the company and the state (its ultimate majority shareholder) as fairly strong and commensurate with a two-notch uplift.

The strength of the ties is underpinned by the company's position as the national electricity transmission grid operator, its inclusion in the list of strategic enterprises that subject the company to special bankruptcy and insolvency procedures as well as special procedures regarding voting shares sale or dilution, and a track record of tangible state support. The latter includes an equity injection of RUB61bn over 2009-2014 to fund the company's capex and state pension fund financing of long-term infrastructure projects, with long-dated CPI-linked infrastructure bonds of RUB100bn in 2014 and RUB40bn in 2015. Moreover, after the transfer of the state's stake in FedGrid to Russian Grids in 2013, the Russian government signed a shareholders agreement with Russian Grids to retain control of FedGrid.

Limited Volume Risk

FedGrid's revenue depends on electricity transmission tariffs, which are approved until 2019 and are mostly linked to CPI. The company faces limited volume risk as the current electricity transmission tariffs are set based on, among other factors, customers' declared electricity capacity needs and not on actual electricity consumption. Customers declare their capacity needs for a five-year period, but they are reviewed and adjusted annually. FedGrid bills actual capacity if the customer exceeds its declared capacity.

FedGrid's business profile benefits from a moderately diversified and stable customer base, including distribution and independent grid companies, power-selling organisations and certain industrial customers. The gradual switch to tariff calculations based on actual capacity with the simultaneous introduction of capacity reservation payments is under discussion.

KEY ASSUMPTIONS

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

- Domestic GDP decline of 0.7% in 2016 and growth of 1.3%-2.0% in 2017-2019

- Inflation of 8.2% in 2016 and 6.0%-7.1% over 2017-2019

- Moderate electricity transmission tariff growth below inflation in 2016-2017 and in line with inflation in 2018-2019

- Cost inflation in line with expected CPI

- Capital expenditure in line with management's forecasts

- Dividend payments of 50% of IFRS net income over 2017-2019

- Interest rate of 12% for all new debt to be raised over 2016-2019

RATING SENSITIVITIES

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

- Evidence of weaker state support and/or a downgrade of Russia.

- A more ambitious capex programme resulting in deterioration of the financial profile (eg FFO adjusted net leverage (excluding connection fees) exceeding 3.5x and FFO interest coverage (excluding connection fees) below 3.5x on a sustained basis) could be negative for the standalone rating.

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

- Revision of the sovereign's Outlook or an upgrade. If Russia is upgraded to 'BBB', FedGrid's rating is likely to revert to incorporation of a two-notch uplift for state support, provided that the links with the state remain unchanged.

- Evidence of stronger state support (eg significant and consistent equity injections, state guarantees for FedGrid's debt, cross default provisions) coupled with an upgrade of Russia.

- A more transparent and predictable regulatory framework, coupled with the company's strong financial profile, which could be positive for the standalone rating.

LIQUIDITY

Adequate Liquidity

FedGrid's cash position of RUB59bn at end-1Q16 is sufficient to cover its short-term maturities of RUB30bn. Its debt repayment schedule is not onerous and is relatively balanced at about RUB25bn annually on average. The group also has access to uncommitted credit facilities of RUB153bn mainly from major Russian banks. Forecasted negative free cash flow over 2016-2019 will add to funding requirements.

Floating Interest, No FX Exposure

FedGrid is exposed to interest rate risk, as at end-1Q16 55% of its outstanding debt was represented by infrastructure bonds, which were raised at floating interest rate 'CPI + 1%-2.5%', while the remaining porting of FedGrid's debt is raised under fixed interest rates. FedGrid is not exposed to foreign currency risk as all of its debt at end-1Q16 was denominated in local currency.

FULL LIST OF RATING ACTIONS

JSC Federal Grid Company UES

Long-Term Foreign and Local Currency IDRs affirmed at 'BBB-'; Outlook Negative

Short-Term Foreign Currency IDR affirmed at 'F3'

Long-Term National Rating affirmed at 'AAA(rus)'; Outlook Stable

Senior unsecured local currency rating affirmed at 'BBB-'

Federal Grid Finance Limited

Senior unsecured local currency rating affirmed at 'BBB-'