OREANDA-NEWS. S&P Global Ratings today affirmed its 'BBB-/A-3' long - and short-term corporate credit ratings on Icelandic electricity generation and transmission company Landsvirkjun. The outlook is stable.

The affirmation largely reflects our view that the likelihood that Landsvirkjun will receive government support, if needed, continues to be very high. It further reflects Landsvirkjun's solid position in the Icelandic power market, supported by high market share, low production costs, and long-term contracts. However, we see that it continues to be exposed to high customer concentration and the aluminum sector. We also see a continued gradual strengthening of Landsvirkjun's credit measures and have therefore revised our assessment of the company's financial risk profile to aggressive from highly leveraged. We also raised Landsvirkjun's stand-alone credit profile (SACP) to 'bb-' from 'b+'.

We consider that there is a very high likelihood that the Icelandic government would provide timely and sufficient extraordinary support to Landsvirkjun in the event of financial distress. We base this assessment on Landsvirkjun's:Very important role for the Icelandic government, given its dominant position as the incumbent power company and 64.7% owner of the national transmission grid; strategic importance to the Icelandic economy; and central role in the promotion of power-intensive industries. Very strong link with the Icelandic state, given the state's 100% ownership and our expectation that the company will not be privatized in the medium term; and the risk to the sovereign's reputation if Landsvirkjun were to default. Landsvirkjun's fair business risk profile reflects its position as the dominant power producer in Iceland, with a market share of generation of about 70% despite the country's relatively small size. The generation is allocated mostly to the power intensive aluminum production.

We see that Landsvirkjun also benefits from a very low-cost hydro and geothermal renewable generation asset base, which continues to support its above average EBITDA margins of 75%-80%. Moreover, its long-term take-or-pay contracts with customers provide earnings predictability and EBITDA stability.

However, in our opinion, Landsvirkjun's earnings and profitability continue to be tempered by its high customer concentration, where the top three customers purchase about 70% of energy production, and given that its customer base is mostly composed of aluminum producers. This makes Landsvirkjun vulnerable to unexpected failures under single contracts. We also see this exposure as heightened because one-third of Landsvirkjun's revenues are directly linked to the aluminum price. However, we expect this portion to continue to decline over time as the company renegotiates existing contracts and adds new consumers.

Landsvirkjun's credit metrics have continued to improve as the company continues to pay down debt that accumulated throughout the completion of its largest hydro plant. In our revision of the financial risk profile to aggressive from highly leveraged, we factor in our view that management and the shareholders are supportive of the deleveraging path. We expect that the company's metrics will continue to improve toward 15% funds from operations (FFO) to debt over the next few years, from about 11.7% in 2015, which will be supported by low capital expenditure (capex) and dividends.

Under our base case, we assume: Revenues declining slightly in 2016 due to the low aluminium price. Aluminum prices at about $1,500/ton in 2016, $1,550/ton in 2017, and $1,650/ton in 2018.EBITDA margins of about 75%. Capex of about $200 million in 2016 and declining thereafter. Based on these assumptions, we arrive at the following credit measures for 2016-2018: FFO to debt of about 11% in 2016, 12.5% in 2017, and about 15.5% in 2018.Discretionary cash flow to debt of 1%-10%.The stable outlook reflects our assumption that Landsvirkjun will continue to benefit from a very high likelihood of support from the Icelandic government, improving credit metrics, low cost generation, and relatively stable EBITDA.

We could raise the ratings if Landsvirkjun continues to deleverage to and it has financial policies that support its FFO to debt around 20% and its competitive position remains stable. We could also consider an upgrade if we raise the sovereign rating on Iceland as this would indicate that the government's ability to provide extraordinary support has increased.

We currently see a downgrade as unlikely, but it could occur if we see a reduced likelihood of support from the government to Landsvirkjun or if the company's SACP deteriorated significantly to 'b', which we view as unlikely in the next two years.