OREANDA-NEWS. Fitch Ratings has affirmed Russia-based utilities company JSC RusHydro's (RusHydro) Long-term foreign and local currency Issuer Default Ratings (IDR) at 'BB+'. The Outlook is Negative. A full list of rating actions is available at the end of this commentary.

The Negative Outlook reflects Fitch's expectation of weakening RusHydro's credit metrics over 2014-2017, mostly due to the slowdown of the Russian economy and the company's extensive capex programme. This could result in the company breaching Fitch's revised negative rating guideline of funds flow from operations (FFO) adjusted net leverage above 3.0x over 2015-2017, implying limited financial headroom.

RusHydro's IDR incorporates a one-notch uplift for state support from its standalone rating of 'BB', due to relatively strong strategic, operational and, to a lesser extent, legal ties between the company and its majority shareholder, the Russian Federation (BBB-/Negative). The notching uplift is a bottom-up approach and revised from the previously applied top-down method to align Rushydro's rating approach with that of its Russian utilities peers.

KEY RATING DRIVERS

Shift to a Bottom-up Rating Approach
To align it with Russian utilities peers with comparable links with the sovereign, Fitch has revised RusHydro's rating approach to bottom-up, which reflects both the standalone profile of the company and state support, from the previously applied top-down approach. Fitch has also tightened its negative rating guideline of FFO-adjusted net leverage to 3.0x from 3.5x and FFO interest cover to 5x from 4.0x. This is to align RusHydro's rating guidelines with those of Russian sector peers as we assess the company's business profile to be comparable to that of similarly rated Russian utilities.

Negative Outlook Remains
The Negative Outlook reflects Fitch's expectation of deterioration in RusHydro's credit metrics over 2014-2017, mostly due to high capex at a time when the Russian economy is slowing down, which in turn would put the company at a disadvantage to its Russian sector peers. We expect FFO adjusted net leverage to have deteriorated to about 3x by 2014 from 2.2x in 2013 and exceed Fitch's revised negative rating guideline of 3x over 2015-2017, which implies limited financial headroom for the ratings. However, we believe that RusHydro has some capex flexibility to cancel or defer some projects if there is a risk of a substantial deterioration of its credit metrics.

State Support Continues
RusHydro's rating benefits from a one-notch uplift for state support to its standalone rating of 'BB', due to the relatively strong strategic, operational and, to a lesser extent, legal ties between the company and the state. RusHydro continues to receive tangible state support, albeit diminished since 2012. In 2012-9M14 the company received tangible state support of around RUB83bn, including a RUB50bn equity injection for the construction of four thermal power plants in the Far East and direct subsidies of RUB32bn as compensation for low tariffs in the Far East. In 2012 RusHydro was included in the list of strategic enterprises. At end-May 2014 President Vladimir Putin signed a decree which stipulated that direct state ownership must not fall below 60.5%. The consolidation of RusHyrdo's 69% stake in the financially weaker OJSC RAO Energy System of the East (RAO UES East) in 2011 worsened its operating and financial profile, underlining the negative implications of state involvement.

BB Standalone Rating
RusHydro's standalone rating of 'BB' reflects its solid market position as a leading, low-cost electricity producer in Russia on the back of its large portfolio of hydro power plants with installed electric power capacity of about 38GW. The standalone profile also reflects the company's exposure to regulated, but insufficient "cost plus" tariffs (particularly in the case of RAO UES East) that will remain a drag on RusHydro's profitability and cash flows. The standalone rating also factors in an uncertain regulatory framework in the medium-term and corporate governance limitations in the operating environment in Russia.

For 9M14 RusHydro reported revenue of RUB241bn, a 3.6% yoy growth, and EBITDA of RUB52bn, down 2% yoy, mainly driven by lower hydro power production, higher payroll expenses, including one-off bonus payments, higher electricity transmission tariffs and others.

Uncertainty in Regulatory Framework
The Russian regulatory regime for the utilities sector suffers from a limited track record of consistent implementation, is less transparent and more unpredictable than the regulatory regimes in western Europe. Although we expect the impact of a recent certain tariffs freeze for 2014-2015 on the company's credit metrics to be limited, it undermines the predictability of the regulatory framework and increases uncertainty over operations. Regulatory uncertainty is a key factor why Russian utilities' standalone ratings are capped at speculative-grade.

RATING SENSITIVITIES

Negative: Future developments that could lead to negative rating action include:
- Evidence of weaker state support
- Regulatory framework deterioration
- Tariffs freeze, aggressive debt-funded acquisitions and/or a more ambitious capex programme resulting in deterioration of the financial profile (eg FFO adjusted net leverage above 3.0x and FFO interest cover below 5x on a sustained basis), which could be negative for the standalone rating

Positive: Future developments that could lead to positive rating action include:
- An ability to implement expansionary capex while maintaining adequate credit metrics without breaching Fitch's negative rating guidelines, which would result in the Outlook being revised to Stable
- An upgrade is not likely in the next 12 - 18 months due to expected deterioration of the financial profile. However, if there is evidence of stronger state support (eg significant and consistent equity injections, state guarantees for RusHydro's debt, cross default provisions) or the company manages to improve its financial standing (eg FFO adjusted net leverage below 1.5x and FFO fixed charge coverage above 6.5x on a sustained basis), a positive rating action could be considered
- A more transparent and predictable regulatory framework, which could be positive for the standalone rating

LIQUIDITY AND DEBT STRUCTURE

At end-3Q14 RusHydro reported cash and deposits of around RUB45bn (excluding the remaining RUB37bn of cash injection received from the state in December 2012 for financing the Far East projects) that are sufficient to cover short-term debt of RUB34bn. Fitch expects RusHydro to continue to generate negative free cash flow in the medium term, owing to its substantial capex programme, which will, consequently, lead to new external funding needs. However, RusHydro has certain flexibility in its investment programme implementation and lack of available funding and/or material deterioration of the credit metrics would likely result in capex curtailment.

RusHydro has limited exposure to foreign currency risks; at end-3Q14 only 8% of RusHydro's debt is denominated in foreign currencies, mainly in USD, while almost all its revenues are in the local currency.

FULL LIST OF RATING ACTIONS

JSC RusHydro
Long-term foreign and local currency IDRs affirmed at BB+, Outlook Negative
Long-term National rating affirmed at AA(rus), Outlook revised to Negative from Stable
Local currency senior unsecured rating affirmed at 'BB+'

RusHydro Finance Limited
Local currency senior unsecured rating affirmed at BB+