OREANDA-NEWS. Fitch Ratings has affirmed South African state-owned Rand Water's National Long-term rating and senior unsecured rating at 'AA+(zaf)'. The agency has also affirmed the 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 once from the sovereign's rating (Long-term local currency Issuer Default Rating BBB+/Negative), 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. Rand Water continues to maintain its strong regional position as the main bulk water distributor in the greater Gauteng province.

Fitch views Rand Water's standalone profile at 'AA(zaf)', reflecting a favourable cost-reflective regulatory tariff structure over the medium term that is balanced by large capex plans (excluding government-funded growth capex), which according to our projections will likely lead to a deterioration of credit ratios by 2018. The lack of an independent regulator exposes the tariff determination to political risks and the company faces counterparty concentration.

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

Further, the Rand Water Board of Directors is appointed by the Minister of Water and Sanitation. The government's ownership of Rand Water is further entrenched through the approval of the company's capex programme and the setting of its borrowing limit, which is revised on an annual basis.

Borrowing limits approved by the Minister of Finance in June 2013 are ZAR5.8bn for core water infrastructure projects, which expire on 30 June 2018. The borrowing limit allows the utility to raise an additional ZAR5.8bn during this five-year period. In FY14 the utility raised an additional ZAR1bn of debt bringing the total debt for the financial year ended June 2014 to ZAR2.5bn. Consequently, Rand Water has ZAR4.8bn headroom remaining under the current borrowing limit and we do not envisage a breach of this borrowing limit in the next three years.

Natural Monopoly Position
The credit profile of Rand Water is supported by its regional monopoly position in the greater Gauteng region. Local municipalities and local authorities owned by the state make up almost 90% of Rand Water's water sales, with its largest customer being the City of Johannesburg (Long-term local currency rating: BBB/Stable).

Expansion of Service Area
The Department of Water and Sanitation has consolidated 12 water boards into nine regional water utilities to better address the challenges of water supply. This consolidation strategy has translated into expansion of Rand Water's areas of operation. Once completed the number of consumers in the supply area served by Rand Water is expected to increase by 58% to approximately 19 million.

During the year under review Rand Water's service area was extended to include the Bushbuckridge Water Board while the upper Vaal and the entire area of Mpumalanga province will follow a phased approach. Fitch views the expansion area as neutral for Rand Water provided the standalone financial profile does not deteriorate. We do not expect the Department of Water and Sanitation to lean on the utility to take on additional debt to fund the rural capex, which cannot be recovered through a tariff or to continue to increase the service area beyond the utility's capabilities.

Fitch expects the likely outcome will be a combination of funding from the utility and the government via a regional bulk infrastructure grant. The process is evolving and we will monitor it over FY16. However, we currently do not expect it to affect the ratings. Rand Water is completing its due diligence to consider the various factors that could impact the financial profile of the utility before these additional areas can be included into the service area.

Supportive Tariff Structure
The tariff structure and annual tariff approvals take into consideration all cost drivers, capex, as well as the socio-economic profile of the local service area. As a result Rand Water is able to recover most of its operational costs within the current tariffs. Fitch therefore expects Rand Water to maintain a fairly stable operating margin.

Large Capex Funded Externally
Rand Water's capex plan increased to ZAR13bn (previously ZAR12.2bn) over the next five years as the utility aims to increase capacity and replace its ageing infrastructure. This is after the utility spent ZAR2.2bn in FY14, against a budgeted ZAR2.3bn. In line with rapid increase in water demand in FY14, which recorded a peak day demand of 4,923 megalitres per day (Ml/d) against a system capacity of 5,300 Ml/d and average daily demand of 4,183 Ml/d, from a growing population in urban areas, Fitch views the capex ramp-up as an logical, but not a risk-free, move.

The company anticipates that it will fund most of the capex externally, given its established access to the domestic capital market. However, as a result we expect funds from operations (FFO) adjusted net leverage to increase to over 2.5x by 2018 from 1.2x in 2014 (excluding the growth capex and government grants). The expected weaker credit metrics are still commensurate with peers in this capital-intensive industry.

Capex Delays Possible
It is possible that the complexity of delivering an investment programme of such scale will lead to delays and, consequently, slower ramp-up of leverage. However, in the past five years Rand Water spent 90% and over of the capex budget, which demonstrates the utility's capability for implementing infrastructure projects. The utility has flexibility to delay approximately 30% of total capex that is uncommitted.

LIQUIDITY & DEBT STRUCTURE
Liquidity is supported by a cash balance of ZAR872m and a committed facility of ZAR500m as of 30 June 2014. There are no major debt maturities in the medium term. Although Fitch expects negative free cash flow due to capex, spending will be contingent on obtaining funding. On 5 December 2013 Rand Water raised two bonds namely RW23, RW28 for ZAR335m and ZAR665m, which fall due 10 December 2023 and 10 December 2028 respectively.

At FYE14 Rand Water had ZAR2.5bn available under the ZAR5bn domestic medium-term note programme.