OREANDA-NEWS. Fitch Ratings has affirmed Northern Ireland-based Phoenix Natural Gas Limited's (PNG) Long-Term Issuer Default Rating (IDR) at 'BBB' with a Negative Outlook and senior secured rating at 'BBB+'. The ratings have been removed from Rating Watch Negative (RWN) where they were placed on 8 April 2016. Fitch has also affirmed PNG's Short-Term IDR at 'F3'. A full list of rating actions is at the end of this commentary.

The affirmation reflects our expectation that PNG's financial profile will remain commensurate with its ratings during the new price control starting in 2017 (GD17). Financial profile improvements will mainly come from the favourable cost of debt adjustment mechanism introduced in the final determinations (FD) and from the shareholders' commitment to modify their distribution policy in order to maintain the ratings.

The Negative Outlook is driven by the uncertainty around the actual cost of debt outperformance to be locked in during GD17 and the exact dividend policy. We may revise the Outlook to Stable once we have full clarity regarding the company's updated business plan for GD17 which confirms its ability to sustain average forecast PMICR at or above 1.5x and average forecast net debt/total regulatory value (TRV) at or below 70% (taking into account potential negative TRV adjustments at the beginning of the subsequent price control, GD23).

KEY RATING DRIVERS

FD Offers Better Financeability

The FD for GD17 published in September 2016 offers a marginally better remuneration package and materially better financeability than the draft determination (DD) published in March 2016. The major regulatory parameters were unchanged with allowed pre-tax WACC confirmed at 4.3%. The connections target for PNG has been slightly reduced and the penalty for a lost connection equalised with the reward for a gained one, substantially reducing the risks associated with underperformance on connections. Financeability and in particular interest cover improved due to the possibility of retaining cost of debt outperformance for the long-term.

Potential Upside for PMICR

The amended cost of debt adjustment mechanism, specified in the FD, could materially improve the company's forecast PMICR versus our previous expectations based on the DD. This is because the FD allows PNG to retain the full cost of debt outperformance for the whole six-year price control. Ultimately 80% of the outperformance would be returned to the customers via a downward TRV adjustment at the beginning of the next price control, GD23. Returning outperformance through a TRV adjustment rather than an outright reduction of revenue allowances spreads the payback period over a much longer period and hence provides significant cash benefits to PNG in GD17.

The cost of debt outperformance would be measured as the difference between the initial allowance and the iBOXX index for 'BBB' rated corporates at refinancing. Should the company outperform iBOXX, it would retain the full benefit for good.

We anticipate some of the cost of debt outperformance will be achieved by the company at the point of GBP275m bond refinancing in early 2017. This expectation is based on the 5.6% cost allowance for the new debt specified in FD (nominal, assumes annual forecast RPI of 3.1%) and the current market environment with all-time low yields.

Potential Adjustment to Dividends

Shareholders' targeted distribution policy for PNG is plausible and remains consistent with a 'BBB' rating. However, the exact dividend plan for GD17 is yet to be formulated. Should shareholders' commitment for PNG be altered, it would be reflected in the rating.

Commensurate Financial Profile Expected

Our preliminary forecast suggests a range of possible financial profiles in GD17. These vary based on a number of assumptions including cost of debt, taxes, inflation, opex and incentive performance. These profiles are in line with the ratings as we assume that the dividends would be moderated if required. For example, our rating case results in the average PMICR of 1.5x and average net debt/TRV of 66%. This incorporates an assumption of a dividend reduction versus the average dividend paid in 2014 and 2015.

KEY ASSUMPTIONS

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

-UREG's regulatory assumptions set in the FD

-Zero out/(under) performance on opex, capex or connections incentive

-Long-term RPI of 2.5%

-Around 66 basis points outperformance on the cost of new debt versus the allowances

-Annual dividend payments of GBP23m in 2017-2022

RATING SENSITIVITIES

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

- Sustained PMICR of below 1.5x due to more challenging financing conditions during GD17

- Sustained high gearing of net debt-to-adjusted TRV in excess of 70%

Positive: The Outlook is Negative and Fitch does not anticipate an upgrade. Future developments that may nevertheless, individually or collectively, lead to a revision of Outlook to Stable include:

- Sustained PMICR at or above 1.5x

- Sustained net debt-to-adjusted TRV at or below 70%

- Adequate liquidity position

A revision of the Outlook to Stable would be possible once we receive full clarity regarding the company's updated business plan including actual cost of debt outperformance to be locked in during GD17 and the exact dividend plan.

We adjust forecast TRV to reflect the negative NPV impact of cost of debt outperformance and of a gradual reduction in corporation tax rate from 20% at the start of the price control to 19% from 1 April 2017 and to 17% from 1 April 2020.

LIQUIDITY

Fitch views PNG's liquidity as tight due to the upcoming GBP275m secured bond maturity in July 2017. The refinancing is planned for early 2017, when the new GD17 price control commences. At 30 June 2016 the company held cash of GBP17m and had available capex and working capital facilities of GBP37m due in August 2018. We project slightly negative free cash flow of GBP10m in the 12 months from 30 June 2016. We generally view refinancing risk of European regulated networks as low, but an unsatisfactory liquidity position too close to actual bond maturity would be reflected by the ratings. A revision of the Outlook to Stable is pending, among other factors, improved liquidity.

FULL LIST OF RATING ACTIONS

Phoenix Natural Gas Limited

-- Long-Term IDR affirmed at 'BBB', Outlook Negative, removed from RWN

-- Senior secured rating affirmed at 'BBB+', removed from RWN

-- Short-Term IDR affirmed at 'F3'

Phoenix Natural Gas Finance Plc

--Senior secured bonds guaranteed by PNG affirmed at 'BBB+', removed from RWN