OREANDA-NEWS. Fitch Ratings has assigned a 'BBB+' rating to Comision Federal de Electricidad's (CFE) USD1.25 billion bond issuance due 2024, which was issued on Oct. 24, 2013.

KEY RATING DRIVERS

CFE's rating incorporates the company's position as the largest electricity generator in Mexico and its monopoly on transmission and distribution activities, which makes it strategically important for the country. Also reflected are CFE's strong linkage with the Mexican government, and the government's implicit support. CFE's foreign and local currency Issuer Default Ratings (IDR) are at the same level as Mexico's sovereign rating. CFE's ratings also incorporate high debt levels, unfunded pension liabilities, negative free cash flow (FCF) during the cycle, and risk of political interference.

Strong Linkage With Government

CFE is a state-owned productive enterprise with greater budgetary and financial independence of the Mexican federal government. Previously, CFE's budget needed to be approved by the Ministry of Energy, the Ministry of Finance and ultimately by the Congress. The relationship between CFE and the government is strong and extends beyond its ownership. CFE is governed by a board of directors, which includes the ministers of energy, finance, economy, and environment and natural resources; also includes the undersecretary of electricity Sener, four independent members, and the minister of the national executive committee of the single union of electrical workers in Mexico. In addition, the government directly sets electricity tariffs to all electricity users except the high tension industrial users and establish subsidies for specific customers.

Strategically Important For The Country

CFE will maintain the monopoly on distribution and transmission activities; nevertheless, the reform enables the company to enter into agreements with private investors to develop, finance and operate infrastructure in these subsectors on its behalf. Regulatory framework forbids granting concession to private parties in these segments. While CFE's monopoly position decreases competitive risks and other risks related to business operations, the company's electricity generation will face competition after the energy reform.

Energy Reform Opens Sector

The energy reform intends to create an open and competitive wholesale market. High tension industrial users will be allowed to enter into bilateral contracts with new private investors (NPIs), independent power producers (IPPs) or CFE. Fitch estimates that CFE might not see high tension industrial demand decline during the 12-18 months after reform's secondary rules disclosure, as almost all IPPs are currently under contract with CFE and termination clauses are limited. At the end of 2013, the high tension industrial users represented 18.5% of CFE's total revenues (versus a 17.3% average over the past nine years). The opening of electricity generation to the private sector improves prospects for a decline in tariffs over the medium term for high tension industrial users.

Fitch believes CFE could be able to offer competitive rates for those industrial users to compete against NPIs, through the import, transport to CFE plants, and sell to third parties, of natural gas, by five pipelines located in the north of the country which will be contracted by CFE under 25-year agreements. Participation in the marketing of natural gas not only will represent an additional source of income, but also will be a fundamental tool to reduce electricity generation cost.

Risk Of Political Interference

The electricity rates settlement by the government, to all electricity users except the high tension industrial users, exposes the company to regulatory risk and political interference. However, in addition to material subsidies to agricultural and residential sectors, CFE's tariff structure also includes monthly fuel cost adjustments for approximately 75% of revenues, which allows CFE to partially offset costs increases. CFE is partially exposed to fuel prices, fluctuations in production costs and unfavorable tariffs, which at times could be set below operating costs for a specific class of customer.

High Leverage With Manageable Debt Maturity Profile

As of Sept. 30, 2014, total on-balance sheet debt was MXN344 billion and unfunded pension liabilities amounted to MXN559.2 billion. Debt maturity profile is manageable, with MXN83.5 billion maturing within the next two years, of which MXN56 billion is short-term, compared to MXN65.3 billion in cash. FCF has been negative during the last five years, mainly due to subsidies in the tariffs and high capital expenditures.

RATING SENSITIVITIES

An upgrade of CFE could result from an upgrade of the sovereign, increased financial support from the government, significant improvement in credit profile, and/or a sharp and extended generation of positive FCF. Negative rating actions could be triggered by a downgrade of the sovereign's rating, the perception of a lower degree of linkage between CFE and the sovereign due to the Energy Reform in conjunction with a levered capital structure, and failure to offset declining profit margins resulting from the loss of high tension industrial customers.

Fitch currently rates CFE as follows:

--Long-term IDR 'BBB+'; Outlook Stable;
--Local currency long-term IDR 'A-'; Outlook Stable;
--National long-term rating 'AAA(mex)'; Outlook Stable;
--National scale short-term rating 'F1+(mex)';
--Notes outstanding in foreign currency 'BBB+';
--National scale debt issuances 'AAA(mex)';
--Short-term Certificados Bursatiles Program 'F1+(mex)'.