OREANDA-NEWS. Fitch Ratings has affirmed Northern Ireland-based Phoenix Natural Gas Limited's (PNG) Long-term Issuer Default Rating (IDR) at 'BBB', senior secured rating at 'BBB+' and Short-term IDR at 'F3'. The Outlook is Stable. The agency has also affirmed the GBP275m bond issued by Phoenix Natural Gas Finance Plc at 'BBB+'. The bond is guaranteed by PNG, and is therefore rated at the same level as PNG's senior secured rating.

The affirmation reflects Phoenix's robust performance within the current regulatory framework (2014-2016) based on a higher number of connections and the successful implementation of cost efficiencies, and also the comfortable headroom within the rating guidance until the end of the price control.

The next catalyst for the ratings will be any official communication from the regulator (UREG) in regards to the future price control starting from 2017. Fitch expects the allowed weighted average cost of capital (WACC) to decline below the current 7.5%, but it remains to be seen if UREG will adjust any other remuneration mechanisms such as the profile adjustment or introduce any incentive revenues similar to the RIIO framework implemented by Ofgem. The draft determination is expected to be published in March 2016. Based on the proposed regulatory framework Fitch will re-evaluate PNG's business risk.

KEY RATING DRIVERS

Strong Projected Financial Profile
In 2014 PNG outperformed UREG's estimates in terms of domestic residential connections and it has implemented a series of operational efficiency measures which should lead to costs being aligned to the level allowed in the current price control. PNG's post maintenance interest cover (PMICR) is projected to remain around 2x over the current price control, higher than Fitch's guideline of 1.5x for the ratings. Fitch expects net debt-to-total regulatory value (TRV) to remain at the guidance level of 70%. Over the previous price control it had fallen into the mid-50's before rising to 70% following a special dividend payment of GBP90m in June 2013.

Projected Deterioration of Metrics
PNG's current pre-tax WACC is guaranteed at 7.5% up to end-2016 as per PNG's existing licence. However, it is expected that the WACC post-2016 will be set at a much lower level, reflecting a more mature network with a reduced risk profile, a lower cost of debt environment (although PNG's debt structure does not benefit from cheaper sources of financing such as index-linked products) and a regulatory precedent set for the UK gas distribution networks (RIIO-GD1 vanilla WACC was initiated at 4.2%). As a result of a lower WACC PMICR is projected to decrease significantly, possibly to below the current rating guidance of 1.5x.

Leverage at or below 70%
Fitch expects leverage to stay at around 70% in the short- to medium-term following the GBP90m dividend that was paid in June 2013. The tightening of the dividend lock-up provision to 72.5% in the new term facilities from 77.5% in the existing bond places it closer to Fitch's guidelines of 70%. There is also a dividend lock-up within the secured bond at 1.4x PMICR.

KEY RATING ASSUMPTIONS
- RPI of 2% for 2015 and 2016
- Leverage will be maintained around 70% throughout the forecast horizon due to a prudent dividend policy
-Our base case is in line with UREG's final determination assumptions for 2014-2016 on the number of connections, volumes, tariffs and expenditure allowances
-From 2017 the allowed WACC will decline as part of the new price control. We expect further communication from UREG in this respect during 2015 and the draft determination is expected to be published in March 2016

RATING SENSITIVITIES

Positive: Future developments that could lead to a positive rating action include:
- The outcome of the post-2016 price control leading to a material improvement in the company's credit metrics and providing predictability of the regulatory regime

Negative: Future developments that could lead to a negative rating action include:
- A deterioration in financial metrics whereby net debt-to-TRV rises above 70% on a sustained basis and PMICR decreases below 1.5x, for example as a result of lower WACC for the new price control starting in 2017

LIQUIDITY AND DEBT STRUCTURE

Fitch views PNG's liquidity as sufficient up to FY16. It is supported by the company's cash position of GBP12.5m at 30 June 2014, available capex and working capital facilities of GBP67m due in August 2018 and projected neutral free cash flow before dividends. There are no debt maturities until July 2017 when the GBP275m secured bond matures, followed by August 2018 when the GBP169.6m term facility matures.