OREANDA-NEWS. Fitch Ratings has assigned Kazakhstan-based electricity and heat generator and distributor Joint Stock Company Pavlodarenergo (Pavlodarenergo) a Long-Term Foreign Currency Issuer Default Rating (IDR) of 'B+' with Stable Outlook. A full list of ratings actions is available at the end of this commentary.

The ratings of Pavlodarenergo are aligned with those of its sole shareholder, Joint Stock Company Central-Asian Electric-Power Corporation (CAEPCo, B+/Stable; see 'Fitch Downgrades CAEPCo to 'B+'; Outlook Stable'), reflecting its position as the largest operating subsidiary of CAEPCo, with 55% of group EBITDA.

The ratings also reflect Pavlodarenergo's vertical integration, stable regional market share, and a benign regulatory regime in the distribution segment. However, the ratings are constrained by an unfavourable tariff environment in the generation segment, and a significant capex programme, which Fitch expects to be partially debt-funded.

We assess CAEPCo, Pavlodarenergo and another 100% subsidiary, Sevkazenergo, on a consolidated basis, since there is no ring-fencing, treasury is centrally managed and debt is located at both holdco and opco levels.

KEY RATING DRIVERS

FX Exposure Pressures Credit Metrics

The Kazakhstan tenge devaluation of more than 90% in 2015 weakened Pavlodarenergo's credit profiles due to a currency mismatch between the company's debt and revenues and the absence of hedging to reduce foreign exchange risk exposure. As a result the company's funds from operations (FFO) adjusted gross leverage increased to 2.9x at end-2015 from 2.0x at end - 2014, and FFO interest coverage weakened to 7.1x from 9.6x during the same period.

At end-2015, 60% of company's outstanding debt was denominated in US dollar, versus all local currency-denominated revenue. We expect the pressure to continue, even with no further tenge devaluation. At end-2015, Pavlodarenergo had 48% of cash and deposits in US dollars.

Covenant Breach

As a result of the tenge devaluation Pavlodarenergo breached its assets/liabilities ratio covenant as per its loan agreements with EBRD in 2015, for which the company received a waiver. We expect Pavlodarenergo to breach this covenant in 2016 even with no further tenge depreciation. Failure to obtain a waiver or revise the covenant may lead to a rating downgrade. EBRD indirectly owns 22.6% of Pavlodarenergo.

Significant Capex, Negative FCF Expected

Capex is expected to remain significant despite the completion of the so-called mandatory investment programme, which the company agreed with the government in 2009-2015 when tariff caps were in place. Fitch expects Pavlodarenergo to generate solid cash flow from operations (CFO) of KZT11.5bn on average over 2016-2019, although FCF is likely to remain negative at an average KZT1bn per year over the same period.

The negative FCF will be mainly driven by the company's significant investment programme of KZT10.4bn on average annually for 2016-2019 as well as dividend payments of about 50% of net profit over the medium term. We have assumed lower capex due to our lower-than-management forecast revenue to reflect that most of the investment is discretionary in nature. Fitch expects Pavlodarenergo to rely on new borrowings to finance cash shortfalls.

Dividends to Delay Deleveraging

Pavlodarenergo's financial policy to pay dividends could delay de-leveraging in the long term. To the extent CAEPCo has sufficient funds to service its debt, Pavlodarenergo retains some flexibility to lower dividends to preserve cash, as demonstrated in 2011 when it cut dividend to offset higher capex. According to CAEPCo, Pavlodarenergo will not pay dividends in 2016, while our rating case assumes a 50% payout starting from 2017. Nevertheless, we expect FCF to remain negative since FFO will not be sufficient to cover the high capex and dividends.

Generation Dominates Despite Integration

Pavlodarenergo is CAEPCo's largest operating subsidiary. The company is integrated across the electricity value chain with the exception of fuel production and transmission, which gives the company access to markets for its energy output and limits customer concentration. Pavlodarenergo covers electricity and heat generation, distribution and supply in Pavlodar region, which was responsible for 4.1% of electricity generation in Kazakhstan at end-2015. Despite integration, Pavlodarenergo's EBITDA is dominated by generation services.

Strong 1H16 Results

Pavlodarenergo demonstrated strong operational and financial results in 2015 and 1H16. Electricity production rose 11% yoy in 2015 compared with a 3.3% decline in Kazakhstan and a further 7.3% yoy in 1H16 versus a 0.4% decline in Kazakhstan. Despite our forecasts of Kazakhstan GDP declining by 1% and inflation rising 14% in 2016, we expect the company's financial profile to remain strong with an average EBITDA margin of about 32% over 2016-2019, which will support its ratings. This is based on our assumptions of approved tariff growth for distribution and 0% tariff growth for generation for 2016-2018.

Regulatory Environment

Following the postponement of the capacity market launch in Kazakhstan until 2019, the regulator decided to freeze generation tariffs and set them at 2015 levels for 2016-2018. However, in electricity distribution five-year tariffs were approved using the "cost plus allowable margin" methodology instead of the previously used "benchmarking".

In the heat segment the "cost plus allowable margin" methodology continues to be applied with approved tariffs for a period of five years. The heat distribution business continues to be loss-making due to large heat losses and regulated end-user tariffs, which Fitch assumes are kept low for social reasons (heat generation is reported within overall generation and is cash flow-accretive).

KEY ASSUMPTIONS

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

- Electricity volume growth in line with Fitch GDP forecasts of 2% p. a. over 2017-2019

- Tariffs growth as approved by the government for distribution at 8% CAGR over 2016-2020 and 0% for generation for 2016-2018

- Capex in line with the company's adjusted capex/revenue ratio

- Inflation-driven cost increase

- No further tenge depreciation

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

RATING SENSITIVITIES

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

- A negative rating action on CAEPCo as Pavlodarenergo's ratings are aligned with the parent's IDR

Positive: Future developments that could lead to an upgrade include:

- A positive rating action on CAEPCo

The sensitivities may change if the links with CAEPCo weaken. For the rating of CAEPCo, Pavlodarenergo's ultimate parent, Fitch outlined the following sensitivities in its rating action commentary of 27 July 2016:

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

- Sustained slowdown of the Kazakh economy, further tenge devaluation, increase in coal prices that is substantially above inflation or tariffs materially lower than our forecasts, leading to FFO-adjusted gross leverage persistently higher than 4x and FFO interest coverage below 3.5x.

- Committing to capex without sufficient available funding and worsening overall liquidity.

Positive: Future developments that could lead to an upgrade include:

- A stronger financial profile than forecast by Fitch supporting FFO adjusted gross leverage below 3x and FFO interest coverage above 4.5x on a sustained basis.

LIQUIDITY AND DEBT STRUCTURE

Adequate Liquidity

Fitch views Pavlodarenergo's liquidity as adequate, assuming the availability of external funding to finance the forecast negative FCF over 2016-2019. According to management, the CAEPCo group's treasury is co-ordinated centrally for the parent company and the subsidiaries. At end-1H16, Pavlodarenergo's cash and cash equivalents stood at KZT1.0bn, which together with short-term bank deposits with a maturity up to one year of KZT1.1bn and unused credit facilities of KZT3.2bn, are sufficient to cover short-term debt maturities of KZT5bn. However, further tenge devaluation and negative FCF over 2016-2019 mean Pavlodarenergo will likely raise further debt to finance cash shortfalls.

At end-2015 most of Pavlodarenergo's debt was made up of bank loans (KZT31bn or about 80%) and unsecured local bonds maturing in 2017 (KZT7.7bn or 20%).

Senior Unsecured Debt Rating

Pavlodarenergo's KZT8bn local senior unsecured bond is rated 'B+', in line with the company's IDR. This is because the bonds are issued at the operating company level, Pavlodarenergo's overall leverage is not excessive and the level of encumbered assets compared with senior unsecured debt is low. At end-2015, pledged assets amounted to KZT50bn (out of total assets of KZT111bn).

FULL LIST OF RATING ACTIONS

Long-Term Foreign and Local Currency IDRs assigned at 'B+', Outlook Stable

National Long-Term Rating assigned at 'BBB(kaz)', Outlook Stable

Local currency senior unsecured rating assigned at 'B+'; Recovery Rating 'RR4'