OREANDA-NEWS. Fitch Ratings has affirmed Wales & West Utilities Limited's (WWU) and Wales & West Utilities Finance plc's (WWUF) class A senior secured ratings at 'A-' and class B senior secured ratings at 'BBB'. The Outlook is Stable.

The affirmation reflects WWU's continued solid operational and regulatory performance during RIIO-GD1 (financial years to March 2014 to 2021), with cost outperformance delivered according to plan. The company's credit profile continues to be supported by low business risk stemming from a favourable and transparent UK regulatory framework.

At the same time WWU's financial profile is constrained by index-linked hedging, which generates net cost rather than benefit. Fitch expects WWU's credit metrics for class A debt, in particular post maintenance interest cover ratio (PMICR), to remain stretched during GD1. At the same time we expect credit metrics for class B debt to remain comfortably within current ratings. An increase in net swap cost leading to weaker interest cover ratios remains a rating risk.

KEY RATING DRIVERS

Low Business Risk

WWU is the sole owner and operator of the gas distribution network (GDN) in Wales and the south-west of England, regulated by Ofgem. The company's operating cash flows are highly predictable due to a long-term regulatory framework.

Sound Operating Performance

WWU met all the output targets set by Ofgem during the first two years of GD1. It has achieved a cumulative total expenditure (totex) outperformance of 16% and is ranked fourth among UK's eight GDNs. On the iron mains risk removal target WWU was 99% ahead of Ofgem's target and also ranks fourth among its peers. Customer satisfaction performance remains the company's strength.

WWU believes it could achieve an average totex outperformance of 14%-15% in the remaining years of the price control, half of which would come from the iron mains replacement (repex) programme, with the remainder coming from operating expenditure (opex) and capex. Retention of outperformance within the business and a limited increase in equity distributions is credit-positive.

Deeply Out of Money Swaps

As at 30 December 2015, WWU's capital structure included RPI index-linked swaps with a notional principal of GBP1bn. These were initially put in place as a hedge against inflation-linked revenue. The portfolio is deeply out-of-money with marked-to-market value of (GBP767m) at end-May 2016. The company incurs net costs of carrying the swaps in its capital structure. Deferred RPI indexation payments provide only a short-term benefit to cash interest due to three-year pay-down provisions.

Fitch views WWU's index-linked swap portfolio as a rating risk. We note the 2018 mandatory swap breaks were successfully extended in 2015 and 2016. However, a costly extension of 2020 and 2022 mandatory swap breaks (GBP140m notional in each of the years) or an RPI materially exceeding 3% on a sustained basis could put additional pressure on the company's cash flows. Conversely, a change in the company's financial strategy could alleviate the pressure.

Should RPI, swap renegotiation fees and LIBOR lead to net swap costs increasing beyond the level consistent with the current ratings, we may review the ratings. We would take into account the headroom under the gearing ratio, which should help absorb the net swap impact.

Satisfactory Gearing, Weak PMICR

Fitch expects net debt-to-regulatory asset value (RAV) to average 67% for class A debt and 72% for class B debt during the eight-year GD1 period. This is within our guidance of 70% and 77.5%, respectively. Average eight-year PMICR (including net swap impact) for class A debt is expected to be slightly weaker than the downgrade guidance, at around 1.3x (versus our guidance of 1.4x) and slightly stronger for class B debt, at 1.2x (versus our guidance of 1.1x). Average forecast PMICR (excluding swaps impact) is comfortable for both class A debt and class B debt, at 1.5x and 1.4x, respectively.

PMICR, including annual swap costs (treating accretion as part of the annual interest), is considerably lower than PMICR excluding swap impact. As a result, Fitch analysis references and monitors primarily PMICR including net swap costs as this ratio is more relevant for the ratings.

Secured Financing Structure

The senior secured ratings benefit from structural enhancements afforded by financing covenants, ring-fencing (including dividend lock-up covenants), debt service reserve liquidity, a standstill regime and control over WWU's equity.

Improved Interest Rate Composition

We view positively WWU's increased floating-rate exposure as it provides more headroom to outperform the allowed cost of debt in a low interest rate environment. Ofgem's cost of debt allowance takes into account the change in real market rates as it is based on the iBoxx 10-year simple trailing average index. At 31 March 2016 the company's gross borrowings, including the impact of hedging, comprised 17% fixed rate debt, 11% floating-rate debt and 72% fixed real rate debt. WWU's floating-rate exposure is set to increase to around 20% by FY17.

KEY ASSUMPTIONS

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

- Allowed cost of debt in line with current Ofgem's assumptions (2.55% real in FY16 and 2.38% real thereafter)

- RPI of 1.5% in FY16, 2.7% in FY17, 2.9% in FY18 and 3% thereafter (used for modelling revenue, RAV, swaps and interest on index-linked debt)

- Average actual cash cost of debt (including net swap impact) increasing to 6.4% in FY21

From 4.5% in FY16

- Totex outperformance of 13% on average for the whole RIIO-GD1

- Average annual incentive income of GBP4.4m (in 09/10 prices) for the whole RIIO-GD1, including additional income for information quality incentive of GBP1.4m per annum

- New debt financing in FY16-FY21 assumes GBP300m of floating-rate debt (at 6M Libor + 0.82%), GBP200m class A index-linked bonds (at 2.5% real) and GBP100m class B index-linked bonds (at 4% real)

RATING SENSITIVITIES

Class A

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

-Leverage (net debt-to-RAV) less than 65% and PMICR in excess of 1.6x

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

-Failure to achieve expected operational performance leading to leverage in excess of 70% and PMICR consistently below 1.4x

Class B

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

-Leverage less than 73% and PMICR in excess of 1.3x

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

-Leverage in excess of 77.5% and PMICR less than 1.1x

The referenced PMICR includes net swap cost.

Fitch is unlikely to downgrade debt ratings in the event of average interest cover for the regulatory period falling marginally below guidelines, as long as there continues to be material headroom under the leverage ratio.

LIQUIDITY

As at 31 March 2016, WWU's total liquidity amounted to GBP288.3m, including cash and cash equivalents of GBP138.3m and an undrawn committed revolving facility of GBP150m (expiring in December 2018). Liquidity also includes a debt service reserve facility of GBP70m, and an operating reserve facility of GBP20m. Near-term contractual maturities include a GBP200m class A bond maturing in December 2016. Fitch expects negative FCF in the year ending 31 March 2017 to be around GBP29m.