OREANDA-NEWS. Fitch Ratings has assigned E.ON Generacion SLU (E.ON Generacion) an expected Long-term Issuer Default Rating (IDR) of 'BB-(EXP)' and senior secured rating of 'BB(EXP)'. The Outlook on the Long-term IDR is Stable.

The expected ratings reflect the proposed group and capital structure pending its acquisition by Macquarie Group and Wren House, expected in 1Q15. The ratings do not take into consideration the current group perimeter and financial profile of E.ON Generacion and its links with E.ON SE (A-/Rating Watch Negative). The final ratings are contingent on the completion of the acquisition, and on the receipt of final documents conforming materially to the preliminary financing documentation, including the terms and conditions of shareholder loans.

E.ON Generacion's IDR of 'BB-(EXP)' reflects the inherent exposure of its generation business to volatile wholesale electricity prices and the fairly small size of its asset base in Spain. The expected ratings also take into account the mix of advantageously located (Los Barrios coal plant), efficient and fast-response (hydro, including pumping) assets that mitigate its wholesale electricity price exposure.

We foresee E.ON Generacion deleveraging from the sizeable post-acquisition level to a moderately leveraged credit profile in 2018. The main drivers for deleveraging are regulatory receivables monetisation, coal destocking but also structurally positive pre-dividend free cash flows and cash sweep mechanism embedded in the financing documentation.

Fitch expects above-average recovery prospects for the prospective lenders under the proposed secured financing, which is reflected in the rating uplift of the facilities above the IDR.

KEY RATING DRIVERS
Small Power Producer in Spain
E.ON Generacion is a pure electricity generator focused on the Spanish market. Its generation portfolio comprises hydro, coal and CCGT plants with a total installed capacity of 3.3GW, of which only 1.3GW is expected to contribute to future cash flows over the rating horizon. The CCGTs are currently not running due to low demand and overcapacity in the Spanish market. Fitch is not considering any contribution from the subsidiaries involved in supply activity.

E.ON Generacion's market share of 3% is small, especially when considering the concentrated generation market in Spain. The group relies on few key plants, resulting in operational risk associated with asset concentration.

Hydro/Coal Support Cash Generation
Hydro plants represent a sound profitability base, due to their fundamental position in the merit order and high margins. We expect financial results of these plants to be based on long-term average production levels, lower than the exceptionally high levels reported in 2013-14. Around half of the group's hydro capacity is pumping hydro (361MW), making most of its earnings on the spread between peak and off-peak prices and on the balancing market. Conventional hydro can optimise production timing and to some extent take part in balancing market.

Fitch expects Los Barrios coal plant to retain its strategic importance for the reference area, which is characterised by grid technical constraints expected to persist over the rating horizon of 2015-2018. This feature allows the plant to achieve significant premium on pool prices, thus supporting its profitability. Puente Nuevo's coal plant future over the medium term is uncertain after losing its subsidised status in January 2015 and a consequent drop in the plant's margins.

Fitch expects coal plants to contribute around 50%-60% of EBITDA, with the bulk of the contribution to come from Los Barrios and the remainder from hydro plants. CCGTs bring a negligible contribution over the rating horizon. We assume that should capacity payments available to CCGTs be removed by the regulator, the company would mothball the plants at manageable additional expenses.

High Market Price Volatility
Spanish electricity pool prices are heavily exposed to hydrological and wind conditions, which increased day-ahead price volatility in recent years on higher installed renewable capacity. Fitch assumes long-term average weather conditions when making its price assumptions. The group typically hedges its production for at least one year ahead, thus partly locking in its gross margin for 2015 and, to a lesser extent, for 2016. Hedging is usually rolled over but it cannot offset long-term price trends.

We consider that the impact of the current low oil price environment should be mitigated in Spain by the almost absent contribution of gas plants to electricity price formation. Some degree of impact cannot be ruled out for peak prices, particularly if low commodity prices persist.

E.ON Generacion is exposed to market risk, and does not benefit from the mitigation enjoyed by its vertically integrated peers. However, the diversification, location and flexibility of the group's plants allow it to offer balancing and ancillary services, with significant premium over baseload prices for Los Barrios and for pumping hydro over recent years.

Slight Recovery of Market Fundamentals
Fitch is assuming a slight increase in electricity demand in Spain over the rating horizon, in line with our expectation of moderate GDP growth. The Spanish (Iberian) electricity system is characterised by significant overcapacity and limited interconnection with France, which we expect to continue. We believe that overcapacity would be reduced over the medium term by the recovery of electricity demand and the reduction of CCGT and coal installed capacity, due to ongoing mothballing.

Easing Political and Regulatory Risk
Recent reforms implemented in Spain have largely resolved the industry's tariff deficit. In a financially more balanced and sustainable electricity system we would expect regulatory and political risk to decrease. E.ON Generacion has limited exposure to regulatory risk, and further cuts of capacity payments would likely result in management mothballing or decommissioning its CCGTs, which are not contributing to cash flows even under the current capacity mechanism.

New Financing Package Considered
The proposed financing package is only related to E.ON Generacion without any link to the other activities (renewable and regulated assets) of E.ON Espana, which is in the process of being acquired by Macquarie European Infrastructure Fund IV (60%) and an entity managed by Wren House Infrastructure (40%). The proposed financing package includes a seven-year EUR275m bullet term loan B (TLB), a six-year EUR20m revolving credit facility (RCF) and a six-year EUR60m facility for operational guarantees. The proposed capital structure of E.ON Generacion will also include a sizeable shareholder loan, which has been considered as equity within Fitch's criteria based on the current documentation draft.

The financial documentation includes cash sweep and lock-up provisions and a two-year dividend blocker. Funds can be distributed to shareholders (through dividends or repayment of shareholder loans) only if a leverage test is passed (net debt to EBITDA of less or equal to 2.0x). The cash sweep leads to the repayment of a substantial part of the TLB during the rating horizon, while the debt service coverage ratio (DSCR) covenant at 1.1x provides limited additional protection to lenders, in our opinion.

Working Capital Monetisation
E.ON Generacion has EUR68m of regulatory receivables related mainly to the tariff deficit and the subsidies of Puente Nuevo, EUR20m of receivables related to gas sales (discontinued activity) and a coal inventory of around EUR70m that will be used by Puente Nuevo in the next few years, as per our rating case. The monetisation of these assets is a key driver for the expected debt reduction over the rating horizon, as cumulative cash inflow from working capital is expected to be in excess of EUR150m over 2015-2018. This means that the expected deleveraging is, to some extent, not reliant on market dynamics (pool prices) being favourable over the short to medium term.

Post-acquisition Deleverage
Fitch forecasts a funds from operations (FFO) net adjusted leverage of around 2.7x at end-2015 after receivables monetisation and cash sweep, down from estimated 3.6x at transaction closing. The ratio is expected to peak in 2016 (at around 3.5x), when we expect EBITDA to be hit by the planned outage of Los Barrios plant, before decreasing thereafter to around 2.1x in 2018, due to working capital inflow and expected positive free cash flow.

KEY RATING ASSUMPTIONS
-Moderate improvement of baseload electricity prices in Spain over the rating horizon driven by normalised weather conditions and slight recovery in demand
-Achievement of a sizeable premium over baseload prices for Los Barrios and pumping hydro, although lower than that reported historically
-Non-recurring costs of around EUR70m, mainly due to decommissioning activity, non-recurring financial expenses and transition costs
-Cash inflow of around EUR150m from working capital assets monetisation over the rating horizon
-Capital expenditure of around EUR140m for the period, including a largely pre-funded selective catalytic reserve investment at Los Barrios (but not at Puente Nuevo)
-Significant reduction of gross debt and dividends distribution in line with the cash sweep mechanism over the rating horizon

RATING SENSITIVITIES
Positive: Future developments that could lead to a positive rating action include:

FFO net adjusted leverage below 2.5x and FFO interest cover above 4.5x on a sustained basis, supported by stronger electricity market fundamentals in Spain and sustainable higher margins for E.ON Generacion hydro and coal plants

Negative: Future developments that could lead to negative rating action include:

-FFO net adjusted leverage above 3.5x and/or FFO interest cover below 3.0x on a sustained basis, as a consequence of lower working capital release, negative market evolution and/or substantially lower margins than currently expected by Fitch
-Material adverse changes to the regulatory framework, including wholesale market and capacity payments, leading to a change in our view on the system's sustainability and company's operating environment

LIQUIDITY AND DEBT STRUCTURE
Fitch assesses E.ON Generacion's post-acquisition liquidity position as adequate. The proposed bullet EUR275m TLB would be fully drawn at closing, with EUR30m of those proceeds pre-funding a cash reserve which can only be used for the 2015-2016 environmental capital expenditure requirements at Los Barrios. We view this as restricted cash in our rating case.

The provisions of the draft financing documentation allow the complete distribution of the aggregate retained excess cash flow every year for debt repayment (cash sweep mechanism) and, secondly, distribution to shareholders (provided the leverage test is passed). However, in line with shareholders' stated financial policy, we believe that a reasonable cash balance (in the range of EUR20m) will be retained on the balance sheet and maintained broadly stable throughout the rating horizon. In addition, the financing package includes a proposed EUR20m RCF that will be mainly available within the rating horizon. We forecast this liquidity position will be sufficient to cover all the operational requirements within the rating horizon.