Fitch Affirms National Grid at 'BBB'; Outlook Stable
The ratings reflect the regulated and diverse business profile of NG, NGET and NGG, as well as financial metrics remaining within Fitch's guidelines due to, among other things, outperformance against price controls.
KEY RATING DRIVERS
Low Business Risk
NG and its regulated subsidiaries enjoy a strong and predictable cash flow profile, reflecting low regulatory and business risk. In FY13/14, over 94% of group's operating profit came from the regulated activities in the UK and the US. The regulatory frameworks are well established, mature and transparent. The group benefits from significant geographical and business diversification.
Outperforming Price Controls
Meaningful outperformance is expected in the second year of the UK price controls (RIIO-T1 and RIIO-GD1) at above the base return. Fitch expects NGET to be the main contributor due to totex outperformance driven by capital efficiencies. We also expect moderate totex outperformance at gas DNOs. Cash interest costs remain low and Fitch expects continued cost of debt outperformance versus IBOXX-linked allowance.
Fitch believes that RIIO will continue to place pressure on NGG's and NGET's cash flow profiles because of tougher output and efficiency challenges and a lower IBOXX-linked weighted-average cost of capital. High expectations are set for the rest of the price control by the regulator, making it more difficult to achieve outperformance.
Reductions In Totex Allowances
As part of Ofgem's annual iteration process, totex allowances for both NGET and NGG were reduced for the remainder of the regulatory period via an uncertainty mechanism. For NGET, the reduction was around 20% and related mainly to load-related capex, reflecting lower actual spend in FY13/14. Actual capex could, however, rise depending on the future energy scenario and the need to connect new generation.
For NGG, uncertainty expenditure of GBP2bn was taken out of the regulatory allowances. The main drivers of capex increase for NGG are incremental entry or exit connections, although there are no major projects currently planned. Further scope for capex increases relates to the Industrial Emission Directive and site security. While lower totex going forward would be a credit-positive for both NGET and NGG, we take into account the possible impact of higher expenditure.
Solid Financial Performance Expected
We forecast NGET's net debt/regulatory asset value (RAV) to average at 64% and post maintenance interest cover ratio (PMICR) to average at 2.2x for the remainder of the regulatory period (FY14/15-FY20/21), comparing favourably with our guidelines of 67.5% and 1.7x.
Fitch forecasts NGG to maintain an average net debt/RAV (gearing) at 62%, which is weak for an 'A-' IDR. While we expect an exceptionally strong average PMICR of around 3.3x, a fall in PMICR to below our guidelines combined with the weak net debt/RAV could put the rating under pressure.
Fitch notes that NGET's and NGG's financial profiles are marginally sensitive to short periods of low inflation due to large proportion of index-linked and floating rate debt. Prolonged periods of very low inflation or deflation could put pressure on the operating companies' financial profiles, in particular, gearing, as RAV could grow at a slower pace than net debt. This scenario, however, is considered unlikely at the moment.
We conservatively forecast NG's funds from operations (FFO)-adjusted net leverage at 5.4x on average for the next four years. Fitch also estimates average FFO interest cover at 4.1x. These ratios are well within our guidance for a 'BBB' IDR.
To preserve UK subsidiaries' gearing at the level recommended by the regulator (60% for NGET and 64% for NGG) during the RIIO investment cycle, NG may decide to reduce their upstream cash distributions. This, in turn, could lead to additional funding requirements at NG level to meet debt maturities and dividend payments. Re-distribution of debt within the group would not in itself lead to higher consolidated leverage, but could negatively affect the interest cover ratio due to higher cost of debt, and ultimately put pressure on NG's ratings.
Major US Rate Filings
Major rate case filings in New York and Massachusetts are planned for 2015 and 2016, which are expected to significantly improve US total returns. The 2015 cases include Massachusetts Electric Distribution (Massachusetts Electric Company and Nantucknet Electric), KEDNY (Brooklyn Union Gas Company) and KEDLI (KeySpan Gas East Company), which contribute around 11%, 15% and 13% to the total US rate base respectively. A rate case filing for Massachusetts Gas Distribution (Boston Gas Company and Colonial Gas company) is scheduled for 2016.
The US businesses target consistent delivery of 95% of allowed returns on equity (ROE), similar to the long-term level demonstrated by best-in-class US utilities. In FY13/14 US assets achieved a 9% ROE versus the 9.8% allowed level, which amounts to 92% of allowed returns. Weaker performance at 8.5%-8.9% ROE is expected in FY14/15 due to higher costs associated with electricity and gas businesses (main leakages and repair activities).
Fitch views NG's flexibility to carry out new regulatory filings under its US businesses as credit-positive. This view reflects the protection it affords to allowed ROE from additional capital costs, pension costs and storm-related costs, following the severe weather conditions that have historically affected its US operations. At the same time reopeners could result in more challenging returns on equity and cost recoveries from US regulators.
Structural Subordination
Most of the group's debt is raised at the operating company level, leading to significant structural subordination of NG's creditors to the creditors at the operating companies. NG's IDR of 'BBB' reflects both (i) our assessment of the consolidated group's credit quality, and (ii) structural subordination of holding company's creditors.
Hybrid Debt Issue
NGG Finance Plc's 2013 EUR1.25bn and GBP1bn subordinated hybrid securities are rated 'BBB-' with a 50% equity credit. The ratings reflect the highly subordinated nature of the notes, and their lower recovery prospects compared with senior bond holders in a liquidation or bankruptcy scenario. They also reflect the regulated nature of NG's business activities.
The equity credit reflects the structural equity-like characteristics of the instruments including subordination, effective maturity in excess of five years and deferrable interest coupon payments. Equity credit is limited to 50% given the cumulative interest coupon, a feature considered more debt-like in nature.
KEY ASSUMPTIONS
Fitch's key assumptions within our rating case include:
-RPI at 2.2% in FY14/15, 2% in FY15/16 and 2.5% thereafter
-Lower IBOXX index reflecting lower RPI
-Totex for FY14/15-FY20/21 of GBP9.2bn for NGET and GBP9.4bn for NGG
-Average UK RAV growth of 4.4% per annum for FY14/15-FY20/21, including NGET's RAV growth at 6.1% and NGG's RAV growth at 2.9%
-Average totex outperformance versus allowances for FY14/15-FY20/21 of 7% for both NGET and NGG
-Average cost of debt outperformance of 60 basis points for NGET and 90 basis points for NGG
-NG's capex of GBP13.9bn in FY14/15-FY17/18, including Nemo and NSN interconnectors
-NG's operating margin remaining flat based on the average historical level
-NG's average cost of debt at 5.2% and average cash cost of debt at 4.3% in FY14/15-FY17/18
RATING SENSITIVITIES
Taking into account the broader context of rated European peers, we have modified our rating guidance for NG.
Positive: The probability of a positive rating action is low given the large capex programme and a recent stricter regulatory regime. However, future developments that may, individually or collectively, lead to a positive rating action include:
NG: An improvement in its consolidated FFO interest coverage to 4.5x or higher and a reduction in FFO consolidated net leverage to below 5.0x, on a sustained basis
NGET: An improvement in PMICR to above 2.3x and a decline in RAV-based net leverage to below 55% on a sustained basis
NGG: An improvement in PMICR to above 2.5x and a decline in RAV-based net leverage to below 50% on a sustained basis
NGGH: A positive rating action on NGG accompanied by no material debt at NGGH
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
NG: A decline in consolidated FFO interest coverage to below 3.5x and an increase in FFO consolidated net leverage to 6.0x or higher on a sustained basis, and/or negative rating action on the rated UK operating companies
NGET: PMICR decreasing to below 1.7x and RAV-based net leverage increasing to over 67.5% on a sustained basis, or a negative rating action on the holding company
NGG: PMICR decreasing to below 1.9x and RAV-based net leverage increasing to over 62% on a sustainable basis, or a negative rating action on the holding company
NGGH: A negative rating action on NGG, issue of material quantity of debt by NGGH or a negative rating action on the holding company
LIQUIDITY AND DEBT STRUCTURE
Available liquidity at 31 March 2014 included available cash of GBP2.9bn and a total of GBP2.9bn of undrawn committed facilities. Fitch forecasts negative free cash flow at GBP1.2bn and debt maturities at GBP3.5bn at end-March 2014, GBP0.8bn of which relates to cash received under collateral agreements, repayable at any time.
In addition to undrawn committed facilities, in November 2014 the group also agreed a new long term RPI-linked EIB facility of GBP1.5bn and in September 2014 issued two bonds totalling USD900m from its Niagara Mohawk subsidiary. Therefore NG has sufficient liquidity for at least 12-18 months. It also has ready and diverse access to capital markets.
FULL LIST OF RATING ACTIONS
NG
Long-term IDR affirmed at 'BBB'; Outlook Stable
Short-term IDR affirmed at 'F2'
Senior unsecured debt affirmed at 'BBB+'
NGET
Long-term IDR affirmed at 'A-'; Outlook Stable
Short-term IDR affirmed at 'F2'
Senior unsecured debt affirmed at 'A'
NGG
Long-term IDR affirmed at 'A-'; Outlook Stable
Short-term IDR affirmed at 'F2'
Senior unsecured debt affirmed at 'A'
Commercial paper affirmed at 'F2'
NGGH
Long-term IDR affirmed at 'A-'; Outlook Stable
NGG Finance plc
Subordinated hybrid debt affirmed at 'BBB-'
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