OREANDA-NEWS. Fitch Ratings has affirmed Southern Water Services (Finance) Limited's (SWSF) senior secured ratings for its class A debt (wrapped and unwrapped) at 'A-' and class B debt at 'BBB'. The Outlooks for both classes of debt are Stable.

SWSF is the debt-raising vehicle of Southern Water Services Limited (Southern Water), the regulated, monopoly provider of water and wastewater services for parts of Sussex, Kent, Hampshire and the Isle of Wight, in the UK.

The rating affirmation reflects the efficiency challenge embedded in the final determination of tariffs for the period April 2015 to March 2020 (AMP6), revenue adjustments of around GBP215m for related AMP5 revenue under-recoveries, and Fitch's expectation of adequate financial metrics.

The ratings also take into account Southern Water's improved operational and regulatory performance, and the secured nature of the group's financing structure, which benefits from structural enhancements, including trigger mechanisms (such as dividend lock-up provisions tied to financial, positive and negative covenants) and debt service reserve liquidity.

KEY RATING DRIVERS

Credit Metrics as Expected

Fitch forecasts for AMP6 leverage (net debt/regulatory asset value (RAV)) of 72% for class A and 81% for class A plus class B (senior debt), and average post-maintenance and post-tax interest cover (PMICR) of 1.8x for class A debt, and 1.6x for senior debt. When adjusting for swaps with pay-down provisions the ratios are reduced to 1.6x for class A and 1.4x for senior debt. For financial year ended 31 March 2016 (FY16E), Fitch forecasts leverage of 71% for class A and 80% for senior debt, and adjusted PMICR of 1.7x (1.5x swap adjusted) for class A and 1.4x (1.3x swap adjusted) for senior debt.

Strong PMICR metrics forecast by Fitch are offset by weaker leverage for the rating level. Forecast PMICRs are commensurate with ratings that are one notch higher than current ratings. However, forecast leverage is weaker than the rating guidelines of 70% and 80%. In addition, forecast PMICR ratios, excluding the one-off additional cash flow from under-recoveries of revenue, are consistent with the company's current ratings.

Improving Performance

For FY16, Southern Water indicated that they expect to report stable asset serviceability for all assets and further improvement in performance related to drinking water quality, leakage and pollution incidents. However, the company is still lagging behind peers in customer service.

Over the last price control, AMP5, the company notably improved its regulatory and operational performance and met all of its regulatory outputs. As a result of this, we believe that the company is adequately positioned to address the challenges of AMP6. For FY15, Southern Water reported stable asset serviceability in all four areas for its networks, and met most of its regulatory targets including leakage for which the company is one of the top performers in the industry, together with meter penetration. Over AMP5, the company also improved its Service Incentive Mechanism score, which reflects customer satisfaction, to 79 from 54.

Operational Outperformance Expected

Fitch expects the company to outperform capex and opex targets over AMP6, given the implementation of identified efficiencies and new processes for this period. Following the conclusion of the first year of price control management has more clarity and confidence in achieving the operational efficiencies identified prior to the start of the price control. Fitch forecasts include total expenditure (totex) outperformance of GBP86m, in nominal terms over AMP6.

Sale of Non-household Retail Business

Southern Water recently announced the sale of its non-household retail business to Business Stream. In our view, the sale of the non-household retail business, which represents 5% of its total retail business, is neutral for the ratings and should enable the company to focus on improving services for its household customers. We consider counterparty risk as low given that Business Stream has been operating as retailer in the competitive market in Scotland for eight years, and forms part of the Scottish Water group, which is ultimately owned by the Scottish government.

As part of the market code for non-household retail supply, which is still being developed by Ofwat (the regulator for the UK water sector), we expect Southern Water to be able to collect revenues from customers directly in the event of non-payment by the retailer to mitigate counterparty risk. The sale is contingent on the opening of the non-household retail market on 1 April 2017.

RCV Reduction in March 2020

Ofwat will make a one-off midnight adjustment to UK water companies' regulated capital values (RCVs) in March 2020 as a result of the price review 2014 (PR14) rulebook reconciliation. The adjustment will not affect the companies' cash flows over AMP6 as they will retain the runoff revenues and the return earned through AMP6. However, it will result in a reduction in RCV of around 2% for water companies, although the reduction for each company will depend on its capex. For Southern Water, the RCV will be reduced by GBP78m (at 2013 prices). This represents an increase in leverage of around 1.8% based on Fitch's forecast RCV for 2020.

In our view, the RCV reduction could put pressure on companies' credit metrics for AMP7, especially those with high gearing. The increase in gearing following the RCV adjustment could decrease financial flexibility as a result of reduced liquidity and increased refinancing risk as it may limit the ability of some companies to take on more debt. However, we believe they have sufficient time to adapt their strategies over AMP6 to protect ratings either by reducing dividends or through equity injections.

Index-linked Swaps

Southern Water has a portfolio of index-linked swaps with a notional amount of GBP1.3bn embedded in its capital structure with three - and five-year pay-down provisions, of which GBP227m have mandatory breaks. We expect management to actively manage the liquidity exposure associated with the breaks in the swaps at least 24 months in advance.

KEY ASSUMPTIONS

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

- Regulated revenues in line with the final determination of tariffs for AMP6, i. e. assuming no material over - or under - recoveries

- Combined totex outperformance of around GBP86m in nominal terms over AMP6

- Underperformance in retail costs

- Unregulated EBITDA of around GBP4m per annum

- Retail price inflation of 2% for FY17 and 2.5% thereafter

- No impact on cash flow generation from outcome delivery incentives, given that financial rewards and penalties will all be taken into account as part of the next price review

- Proceeds from the sale of the non-household retail business and a reduction in EBITDA of around GBP4m p. a. from FY18

RATING SENSITIVITIES

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

- Pension-adjusted net debt/RAV comfortably and consistently below 70% (class A) and 80% (class B) and PMICR above 1.5x (class A) and 1.2x (senior debt), and improvement in regulatory performance to at least sector average.

Given Southern Water's improved cash flow generation and incremental financial flexibility at the current rating level negative rating actions are a remote prospect at present. However, future developments that could lead to negative rating action include:

- Deterioration in cash flow generation leading to increases in gearing to procure funds for opex and capex requirements

- A decline in operational or regulatory performance

- Regulatory decisions such as moving additional parts of the value chain in the calculation of the tariff determination away from RAV-based regulation or swapping RPI indexation for CPI

LIQUIDITY

As of 31 March 2016 the group had unrestricted cash and cash equivalents of GBP17.9m and GBP340m of committed, undrawn revolving credit facilities with a 2019 maturity. In addition, the company will receive proceeds of GBP250m in September 2016 related to its bond issuance in May. This liquidity position is sufficient to cover maturities, opex and capex requirements as well as incremental dividends to the holding company for the next 24 months.

In addition, debt service reserve liquidity of GBP142m and operating and maintenance reserve liquidity of GBP45m are in place in accordance with the group's secured and covenanted financing documentation. However, this back-up liquidity is only available for addressing liquidity needs during financial distress.