OREANDA-NEWS. Fitch Ratings has revised the Outlook on Germany-based ENTEGA Netz AG's (ENTEGA Netz) Long-Term Issuer Default Rating (IDR) to Positive from Stable and affirmed the IDR at 'BBB-' and senior unsecured rating at 'BBB'.

The revision of the Outlook reflects ENTEGA Netz's more conservative financial profile than previously anticipated, and efforts by its parent ENTEGA AG (ENTEGA) to reduce debt and improve sustainably earnings through an efficiency programme.

The ratings reflect reduced target leverage of around 4.5x on a funds from operations (FFO) adjusted net basis, the low business risk of the network assets as well as uncertainties around the upcoming tariff settlement and progress of re-organisation of ENTEGA Netz's parent group. The ratings also reflect the structural enhancement of the financing structure, including a debt service reserve account.

KEY RATING DRIVERS

Conservative Financial Policies

ENTEGA Netz distributes its net income in full to ENTEGA under a profit and loss transfer agreement. Previously we assumed that the company would distribute all cash to the parent in the near term. Financial policies now in place will lead to ENTEGA Netz retaining significant cash balances for the foreseeable future. Therefore we forecast FFO net leverage to be around 4.5x over the rating horizon (after EUR14.7m of restricted cash becomes available for general corporate purposes in March 2018) and FFO interest cover at around 2.7x.

Both financial metrics are in line with upgrade guidelines. The revision of the Outlook to Positive reflects that an upgrade is pending more clarity around the upcoming regulatory settlement (within the next two years) and progress of the parent group to sustainably improve earnings.

Parent Group Re-Structuring

During 2015, ENTEGA reduced group net debt by around EUR44m to EUR428m (EUR323.8m when de-consolidating project finance companies) through the disposal of smaller non-core assets, such as onshore wind in France. It also re-focused its product strategy on the regional home market and renewable generation assets in Germany and progressed with implementing an efficiency programme reviewing all expenditure, including material cuts to personnel costs.

Fitch believes that the network business and other operations with a public interest have a debt capacity of EUR300m-EUR325m at a 'BBB' level (this assessment may incrementally change depending on the outcome of the price control process). In case of ENTEGA, we would not currently attribute any significant debt capacity to the conventional generation, trading or retail supply.

Assuming that ENTEGA would not support any of the project finance companies with material cash injections if performance deteriorated and that risks related to the competitive businesses will be managed carefully, the financial profile of the wider group should not constrain ENTEGA Netz's rating for much longer. Some further asset disposals are expected in 2016 and Fitch will continue to assess the financial profile of the group.

Slow Progress of Price Control

The efficiency rate will continue to be determined based on the best result from the four models that are currently deployed, while there might be some incremental changes regarding the parameters going into the models. Preliminary indications set the cost of equity at 6.91% in nominal terms and 5.12% in real terms and the time lag of remunerating enhancement capex is expected to be removed.

However, no information is available yet regarding what the generic cost of debt will be. This is an important element, given that the Umlaufrendite (the applicable benchmark for German fixed income securities) has dropped into negative territory. To date there is also no precedent of how the Federal Network Agency will deal with embedded debt. ENTEGA Netz has an outstanding bond with a coupon of 6.25%.

Regulated Income Stream Flows Through Sister Company

ENTEGA Netz is the asset owner, while e-netz Suedhessen GmbH & Co. KG (a sister company) is the asset operator and executes the capital expenditure programme. As long as e-netz Suedhessen does not divert any part of the regulated income stream to group companies other than ENTEGA Netz, for example by means of dividends, intercompany loans or other, this arrangement should be neutral for ENTEGA Netz's ratings.

Profit and Loss Transfer Agreement

In 2013 ENTEGA Netz entered into a profit and loss transfer agreement with its parent to optimise the group's tax position. At the same time, the agreement provides for a termination without notice in case the bond provisions were infringed. As a result, ENTEGA Netz continues to be required to fund day-to-day operations of the regulated business, maintain debt service reserve of EUR16.5m and retain monthly instalments for the bond coupon, before being able to pay any dividends.

KEY ASSUMPTIONS

- EBITDA to decline by around EUR5m by 2020, reflecting cost pressures and lower cost of capital assumptions related to the third regulatory period

- Interest receivable on cash balances of 1% over the medium term

- Capital expenditure in line with management guidance

- Distribution of net income in line with the profit and loss transfer agreement. As a result, readily available cash on the balance sheet remains significant over the rating horizon, between EUR60m-EUR70m over the medium term and once the contingent liabilities related to the demerger from ENTEGA lapse and associated EUR14.7m of restricted cash become available for general corporate purposes between EUR80m-EUR90m

RATING SENSITIVITIES

Negative: The Outlook is Positive and Fitch therefore does not anticipate a downgrade, future developments that could nonetheless lead to negative rating action include:

- FFO adjusted net leverage increasing above 7x or FFO net interest cover falling below 2.25x.

- Changes to the regulatory framework that led to increased business risk.

- Difficulties meeting the efficiency targets embedded into price limits.

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

- Improvement of the financial profile of ENTEGA, the parent, and its wider group.

- A stronger business profile, with German network regulation developing over time, demonstrating that the Federal Network Agency pursues a reasonable approach founded on sound economic principles and evidence of how the regulator balances consumer and investor interests, there is scope for transparency and predictability to improve for Fitch to take a more favourable view on German regulation.

- FFO adjusted net leverage reducing below 6x on a sustained basis and FFO net interest cover comfortably above 2.5x.

LIQUIDITY

ENTEGA Netz does not have any committed, undrawn credit facilities. It relies on prudent planning of monthly cash management as part of ordinary treasury activities for liquidity. As a fall-back, ENTEGA Netz maintains a debt service reserve account of EUR16.5m (representing a minimum of three-month lease payments from Verteilnetzbetreiber (VNB) Rhein-Main-Neckar GmbH) in accordance with transaction documentation.

As of December 2015 ENTEGA Netz held EUR69.7m readily available cash (including the EUR16.5m debt service reserve) and EUR14.7m of restricted cash held against contingent liabilities. The latter will lapse in March 2018, at which point in time the EUR14.7m will become available for general corporate purposes. The company has no short-term debt and we anticipate positive free cash flow.