OREANDA-NEWS.  Fitch Ratings has assigned Canal de Isabel II Gestion, S.A.'s (Canal, BBB+/Stable) EUR500m 10-year corporate bond a final senior unsecured rating of 'BBB+'. The agency has also assigned a final senior unsecured rating of 'BBB+' to Canal's EUR1bn euro-medium term notes (EMTN) programme.

The bond is rated at the same level as Canal's Issuer Default Rating (IDR). Fitch typically rates the debt instruments (senior unsecured) of regulated network utilities one notch above the IDR, reflecting above-average expected recoveries in case of default. However, this uplift is not applied to Canal given that unlike most EU regulated utilities, the company does not own the assets, and furthermore, it operates under a less developed regulated revenue-setting mechanism. The bond has been issued under Canal's EUR1bn EMTN programme and has a fixed coupon of 1.68%. The bond proceeds will be used to repay short-term maturities and refinance some existing debt facilities.

The ratings reflect the company's low business risk profile as an asset operator and a provider of water and sewage services operating in a regional natural monopoly in Spain. Unlike most regulated network operators in the EU, Canal does not own the asset base. However, its investments are supported by concession value. The bond issuance improves the company's liquidity position, although Canal has some debt maturities in 2016-2017 that will need to be refinanced.

We assess the company's links with the Autonomous Community of Madrid (Madrid; BBB/Stable), a majority shareholder and the controlling ultimate parent, as moderate to strong, according to our parent and subsidiary linkage methodology. We therefore allow the company to be rated a notch above Madrid.

KEY RATING DRIVERS
Resilient and Regulated Business
Around 96% of EBITDA in FY13 was generated by regulated activities (Spain: 88% and Latam: 8%). Revenue growth is mainly driven by the regulated tariffs' yearly updates (linked to CPI) and water consumption, which introduces an element of volume risk. These aspects differentiate Canal from some water supply regulatory frameworks in the EU. Business risk arising from Latam activities is currently manageable but this factor is being monitored in case of significant growth.

Stable Net Leverage
Funds from operations (FFO) adjusted for dividends net leverage stood at 4.6x in 2013 and we expect it to remain broadly stable from 2014 to 2017 (average 4.6x). In Fitch's view the current tariff bucket structure and certain revenues' inelasticity to water consumption would support future revenues and EBITDA even in a scenario of depressed water consumption and low inflation. However, a prolonged deflationary period would have a negative impact on credit metrics, and lead to a FFO adjusted for dividends net leverage closer to our negative guideline of 5x. The general tariff increase for the Madrid region has been set at -0.1% for 2015, the same as for 2014 and down from 3.5% for 2013.

Risk of Political Interference
The decentralised regulatory environment for water companies in Spain is less robust and transparent than in some other European countries; however, it can be considered fairly stable and predictable, benefiting from a full cost-pass-through tariff mechanism. As water competences are at the region's and municipalities' level, the system is lacking a national independent regulator. We believe that there is a risk of political interference in tariff-setting.

Rating Link to Madrid
Our assessment reflects that Canal is acting on a commercial basis without the need for financial support from the parent. At the same time Canal does not upstream any cash to its parent other than dividends. Fitch takes some comfort from provisions in the framework agreement contract between Madrid and Canal that protect Canal interests (such as investment recovery in case of contract cancellation by Madrid and the economic re-balancing in case of greater-than-expected investments or lack of tariff increases). However, we acknowledge that Madrid can change the contract unilaterally as long as Canal is 100% publicly owned.

Potential changes to either the framework agreement established between Canal and its shareholders, the gross debt cap policy established by Madrid (at maximum EUR1.2bn), or the dividend policy (currently stated as within a 50%-80% pay-out ratio) are likely to have an impact on our assessment of the strength of the links between Canal and Madrid. Although possible, the privatisation of Canal is not expected in the near term and we consider it as an event risk. Privatisation is potentially both positive and negative for the company's credit profile.

Dividends Viewed as Non-discretionary
Although Canal has a concession agreement with Madrid to provide water and sewage services, the company does not pay a concession fee as is customary for this type of agreement. Fitch treats the dividends paid as a fixed non-discretionary operating charge similar to a concession fee. This is despite that the dividend policy (pay-out ratio with a floor of 50% and a maximum of 80%) or the contract does not include an explicit commitment to pay dividends.

In this context, FFO is reduced by dividends paid (or expected to be paid), resulting in weaker FFO credit metrics. In Fitch's opinion this adjustment helps to present a more realistic financial position of Canal, which is more comparable to other EU companies with similar characteristics that are more leveraged, due to the need to pay for their concessions (upfront or in form of annual fees).

Concentrated Portfolio of Concessions
Canal's concessions portfolio is heavily concentrated in one major concession that accounts for 68% of the total concessions book value. The concession to manage the Madrid water network has a 50-year duration expiring in 2062 and cannot be renewed. In Fitch's view this concentration risk is mitigated by the low-risk nature of the concession arrangement linked to essential, regulated activities and by parent being the owner of the assets under concession, hence aligning the interests of both parties.

Diversification will likely remain limited in the short- to medium-term as Canal's new investments are effectively constrained by the gross debt cap (EUR1.2bn) set by Madrid.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Current tariff structure is maintained and tariff growth rates are projected according to the estimated inflation for the previous year (2014: -0.1%; 2015: -0.1%; 2016: 0.5%; 2017: 1%).
- Stable population and customer base.
- EBITDA around EUR435m on average.
- EUR500m bond debut in 1Q15.
- Gross debt level close to EUR1.2bn cap.
- Capex of around EUR225m per year.
- 80% dividend payout ratio (at higher end of the company's dividend policy).

RATING SENSITIVITIES
Positive: Future developments that could lead to positive rating action include:
An upgrade of Madrid, together with stronger cash flow generation leading to FFO adjusted for dividends net leverage below 4x on a sustained basis. This could be due to higher-than-expected tariff increase and water consumption.

Negative: Future developments that could lead to negative rating action include:
-Weaker cash flow generation leading to an FFO adjusted for dividends net leverage above 5x on a sustained basis. This could be due to a worse-than expected operating environment including regulatory changes or higher dividends.
-A negative rating action on Madrid, which would likely trigger the same negative rating action for Canal. This is provided that the strength of the links between the two allows for a maximum of one notch differential.
-Failure to extend debt maturity profile or replenish liquidity

Fitch adjusts Canal's FFO calculations by deducting dividends to reflect our view of the non-discretionary nature of dividends outflow following the company's creation and restructuring in July 2012.

LIQUIDITY AND DEBT STRUCTURE
As of end-September 2014, total liquidity was EUR263.5m comprising EUR110.2m of unrestricted cash, EUR70m of short-term deposits, and EUR66m of available committed credit facilities and expected slightly positive free cash flow (FCF) of EUR17.3m. This was insufficient to cover short-term debt of EUR306m. After the EUR500m bond issuance in February 2015, the group's liquidity is sufficient to cover its short-term debt. The bond proceeds will be used to repay short-term maturities and refinance some existing debt facilities for a total amount of EUR529m. However, Canal has some debt maturities in 2016-2017 that will need to be refinanced.

We view Canal's liquidity position as weaker than other Fitch-rated utilities' in Spain that have more sizeable committed credit lines and higher levels of cash in hand.