OREANDA-NEWS. Fitch Ratings has affirmed Portugal-based Redes Energeticas Nacionais, SGPS, S.A.'s (REN) Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB'. The Outlook on the IDR is Stable. The Short-term IDR has been affirmed at 'F3'. REN Finance B.V.'s senior unsecured rating is also affirmed at 'BBB'.

The affirmation reflects our forecast that REN's credit metrics will remain within the rating guidelines during 2014-2017, albeit with little rating headroom due to weaker funds from operations (FFO). The weaker FFO is a result of a lower allowed electricity rate of return (RoR) for the regulatory period 2015-2017 and our expectations of a decreasing 10-year Portuguese Treasury bond yield to which REN's regulated revenues are linked. We also expect that Portugal's extraordinary fiscal measures introduced in 2014, including a levy on the energy sector, would be extended to 2017, hence weakening REN's FFO.

On the other hand, expectations of low 10-year Portuguese Treasury bond yield should help improve refinancing costs, while improving economic prospects in Portugal (BB+/Positive) could result in a withdrawal of the extraordinary fiscal measures that were introduced in 2014, all of which would support the Stable Outlook.

KEY RATING DRIVERS

Stricter Electricity Regulatory Update
In December 2014, the Portuguese regulator (ERSE) approved new electricity remuneration parameters for the regulatory period 2015-2017. The framework has been largely maintained with some incentives enhancement; however, significant downward adjustments have been applied to key remuneration parameters, i.e. the base RoR decreased to 6.4% from 7.76%, the premium applied for newly spent efficient capex decreased to 0.75% from 1.5% and reference base cost for opex recovery was reduced.

In addition, the RoR is now indexed to the less volatile Portuguese 10-year Treasury bond, compared with the five-year Portuguese CDS previously, with a cap and floor on the RoR.

Overall, we calculate that the changes will reduce REN's EBITDA by EUR27m in 2015 as the additional earnings incentive for end-of-life assets will not compensate the reduced RoR and cut in premium for new efficiently spent capex. The reduction in allowed earnings will, however, be partially offset by potentially more favourable funding costs going forward and modest regulatory asset base (RAB) growth. REN will also benefit from increased visibility for the next three years for its electricity business while the current regulatory period for the gas business will run until 2016.

Exhausted Headroom for Leverage
Fitch estimates FFO-adjusted net leverage at an average of 6.4x between 2014 and 2017 (excluding international expansion), FFO interest coverage at an average of 3.1x and net debt-to-RAB at an average of 70%. In addition, free cash flow is expected to turn positive in 2016 after capex peaks in 2015, based on our forecast.

Although we expect year-on-year volatility in the metrics to persist, reflecting tariff and cash flow deviations, these levels are commensurate with our rating guidelines for REN but with limited headroom. Leverage and coverage metrics are close to the negative guidelines of 6.5x and 3.0x respectively.

Positive View on Regulation
Fitch continues to take a positive view on REN's regulated business given the earnings visibility, the existence of a floor in the RoR, the premium for efficiently spent investments, incentive schemes promoting the use of assets at end of life, and the RoR's link to the Portuguese bond yield to reduce sovereign risk. This is offset by volatility from tariff deviations, including cash flow volatility stemming from two trading power purchase agreements that REN manages, as well as by short review periods. We view the cut in the RoR as being in line with other EU jurisdictions and the reduction on incentives in new capex consistent with current subdued demand.

Tariff Deficit on Track
Fitch believes that the total stock of electricity tariff deficits (TDs) in Portugal will peak in 2015 (around EUR5.3bn) and will likely reduce in size thereafter. In October 2014, a 3.3% increase in low-voltage tariffs for 2015 was announced, well above the expected inflation rate and the government's initial commitment of a 1.5%-2% annual tariff increase, to offset weaker-than-expected recovery in demand. This demonstrates Portuguese policy makers' firm commitment towards TD resolution.

However, further intervention cannot be ruled out while economic recovery remains fragile. Fitch has assumed in its forecasts that measures already implemented to resolve the TD issue will be maintained, including extending the extraordinary energy sector tax introduced in 2014 of around EUR25m to 2017.

Reduced Domestic Capex
We forecast reduced capex until 2017, reflecting significant investments already made between 2009 and 2011 (average EUR340m) and a lower return and fewer incentives for new capex. We forecast higher capex in the gas business given the more attractive RoR compared with electricity up to 2016, and the agreement for the EUR72m acquisition of two gas storage facilities owned by GALP. Electricity capex will continue to account around two thirds of total investments in the period. Fitch views positively REN's flexibility to adapt its capex according to levels of expected return.

International Capex on Hold
REN's plan to invest up to EUR700m on international expansion, until 2016, remains on hold. Fitch's forecasts therefore assume no material international investment. An increase in total capex, domestic and international, above our expectations would likely push REN's credit metrics outside our rating guidelines and could lead to negative rating action.

Sovereign Rating Implications
REN's Long-term IDR and Stable Outlook are not constrained by the sovereign's credit profile. However, according to Fitch's approach to eurozone countries, a downgrade of the Portuguese sovereign rating could lead to a downgrade of REN's IDR, as our criteria allow domestically focused corporates to be rated up to three notches above their country's sovereign rating in the 'BB' category. Notching would depend on the factors affecting the sovereign rating trajectory and Fitch's view of its impact on corporate creditworthiness in the country. Nevertheless, this is deemed unlikely given the Positive Outlook on the Portuguese sovereign since last April.

LIQUIDITY AND DEBT STRUCTURE

As of 30 September 2014, REN had around EUR45m of readily available cash and around EUR1.6bn of undrawn committed facilities, including commercial paper under subscription guarantee, an undrawn EIB loan and credit lines. We view REN's liquidity as adequate for operating and funding needs up to 2016. Debt maturities total around EUR1bn until 2016 and we forecast slightly negative free cash flow of around EUR70m, depending on tariff deviations which will impact working capital and cash tax.