OREANDA-NEWS. Fitch Ratings has affirmed Umgeni Water's National Long-Term and senior unsecured ratings at 'AA+(zaf)'. The agency also affirmed the South African state-owned bulk water utility's National Short-Term rating at 'F1+(zaf)'. The Outlook on the Long-Term rating is Stable.

The ratings, which are notched down one notch from the sovereign's rating, continue to reflect strong links between the company and the state, including the strategic importance of South Africa's water sector, and reflect a high level of implied support from the national government. Umgeni Water continues to maintain its strong regional position as the main bulk water distributor in the greater Durban region in the KwaZulu-Natal province.

Fitch views Umgeni Water's standalone profile at the same level as the support-driven rating, underpinning the 'AA+(zaf)' rating. This is due to the cost-reflective tariffs and strong credit metrics we expect over the medium term, balanced by large capex plans, which are partly funded by the government, lack of independent regulator exposing the tariff determination to political risks and counterparty concentration.

KEY RATING DRIVERS
Strong Shareholder Links
The strong links between fully state-owned Umgeni Water and the government are evident in Umgeni Water's status as a non-commercial entity, a zero dividend policy, its customer structure, which largely consists of municipalities, procurement of raw water from the Department of Water & Sanitation and direct grants from the government to certain Umgeni Water infrastructure projects. Fitch assumes that further tangible support would be provided, if needed.

In addition, Umgeni Water's 13 non-executive Board of Directors are appointed by the Minister of Water and Sanitation. The government's ownership of Umgeni Water is further entrenched through the approval of the company's capex programme and the setting of its borrowing limit. Borrowing limits approved by the Minister of Finance for core water infrastructure projects are ZAR2.2bn expiring in June 2015. A further ZAR300m is available on request by Umgeni Water. The agency does not envisage a breach of this borrowing limit.

Natural Monopoly Position
Umgeni Water's credit profile is supported by its regional monopoly position in the KwaZulu-Natal region. Local municipalities and local authorities make up almost 99% of Umgeni Water's sales, with its largest customer being eThekwini at around 75%. Although we view the counterparty concentration as a risk, it is mitigated by the good payment track record and the fact that this provides insulation from some end-users with weaker payment ability.

Expansion of Service Area
The Department of Water and Sanitation has consolidated 12 water boards into nine Regional Water Utilities in order to better address the challenges of water supply. This consolidation strategy has translated into expansion of Umgeni Water's areas of operation. Umgeni Water has completed its due diligence and the report is currently with the Minister of Water and Sanitation. The impact of this decision on Umgeni Water's financial profile has not been included into the rating case, as it is pending the Minister's decision. The process is evolving and we will monitor it over FY16. However, we currently do not expect it to affect the ratings.

Tariffs Structure
The tariff structure and annual tariff approvals take into consideration all costs drivers, and capex, and are weighted against the socio-economic profile of the local service area. Fitch expects EBITDA margins to decline to around 30% from 32% in FY14. The cost base is rising faster than inflation, especially in raw water, staff costs, chemicals and energy.

Large Capex Programme
Umgeni Water has embarked on a ZAR5.4bn capex plan over the next four years, of which 46% will be in support of rural development, and the balance will be for additional capacity and maintenance capex. Due to the developmental nature of the rural development projects, there is a need for government support via subsidy or grant funding for part of the projects which cannot be recovered through the existing tariff structure. However, should the grant funding be insufficient to support the full infrastructure project, Umgeni Water has some ability to defer parts of these investments should the need arise as around 50% of capex is uncommitted. In the short to medium term, funding needs are satisfied through cash reserves and the monetisation of short-term investments, as well as further bond issuance - possibly in 2016 and 2017 through the existing ZAR3bn DMTN programme (with ZAR2.4bn remaining available).

LIQUIDITY & DEBT STRUCTURE
Liquidity is supported by a cash balance of ZAR2.2bn and committed facilities of ZAR70m as of 30 June 2014. There are no major debt maturities in the medium term. However, Fitch expects negative free cash flow due to capex, especially before including government grants. Furthermore, implementation of capex will largely be contingent on the company obtaining funding.

RATING SENSITIVITIES
We consider there is a limited likelihood of positive rating action. Future developments that may, nonetheless individually or collectively, lead to positive rating action include:
- Strengthening of the standalone profile, particularly a significant improvement in negative free cash flow.
- Explicit government guarantee for Umgeni Water's debt.

Future developments that may, individually or collectively, lead to negative rating action include:
- Weakening linkages with the sovereign in conjunction with deterioration in FFO adjusted net leverage to over 2.0x and FFO interest cover to less than 4.0x on a sustained basis.