OREANDA-NEWS. Fitch Ratings has affirmed Centrica plc's Long-term Issuer Default Rating (IDR) at 'A-', Stable Outlook and assigned its deeply subordinated EUR750m and GBP450m hybrid securities' rating at 'BBB'. The proposed securities qualify for 50% equity credit. A full list of rating actions is at the end of this commentary.

The affirmation reflects our updated expectation for oil and gas prices, the change in Centrica's dividend policy and hybrid issuance, and the company's interim management statement.

The rating for the hybrid capital securities reflects the highly subordinated nature of the notes, considered to have lower recovery prospects in a liquidation or bankruptcy scenario. The equity credit reflects the structural equity-like characteristics of the instruments including subordination, maturity in excess of five years and deferred interest coupon payments. Equity credit is limited to 50%, given the notes' cumulative interest coupon, a feature considered more debt-like in nature.

The notes' rating and assignment of equity credit are based on Fitch's hybrid methodology, dated 25 November 2014 ("Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis" available on www.fitchratings.com).

KEY RATING DRIVERS FOR THE NOTES

Ratings Reflect Subordination
The notes are two notches lower than Centrica's IDR in view of their subordination and consequently, the lower recovery prospects in a liquidation or bankruptcy scenario relative to the senior obligations of the issuer.

Equity Treatment
The securities qualify for 50% equity credit as they meet Fitch's criteria with respect to deep subordination, effective maturity of at least five years, full discretion to defer coupons for at least five years and limited events of default. These are key equity-like characteristics, giving Centrica greater financial flexibility.

Effective Maturity Date
While the proposed notes are due in 2076 and 2075, Fitch deems the effective maturity date as 2041 (for the EUR-denominated notes) or 2045 (for the GBP- denominated notes) in accordance with the agency's hybrid criteria. From these dates, the coupon step-up is within Fitch's aggregate threshold rate of 100 bps, but the issuer will no longer be subject to replacement language, which discloses the company's intention to redeem the instrument at its call date with the proceeds of a similar instrument or equity. According to Fitch's criteria, the equity credit of 50% would change to 0% five years before the effective maturity date. The issuer has the option to redeem the notes on the first call date in 2021 (for the EUR denominated notes) or 2025 (for the GBP denominated notes) and on any coupon payment thereafter.

Cumulative Coupon Limits Equity Treatment
The interest coupon deferrals are cumulative, which results in 50% equity treatment and 50% debt treatment of the hybrid notes. The company will be obliged to make a mandatory settlement of deferred interest payments under certain circumstances, including the declaration of a cash dividend. This is a feature similar to debt-like securities and reduces the company's financial flexibility.

KEY RATING DRIVERS FOR CENTRICA

E & P Hit by Oil Prices
Earnings forecasts are driven lower by substantially weaker oil prices, based on Fitch's latest view of an oil price in 2015 and 2016 of USD55 and USD65 against USD80 previously. The impact is to lower E & P EBITDA estimates by 20% for both years. The estimates also reflect Fitch's latest view of lower NBP (National Balancing Point) UK gas prices for 2015 and 2016 of USD6 per thousand cubic feet versus USD8 previously. However, the rating case also assumes that a working capital outlay on collateral calls for gas purchases of GBP640m at end-2014 is reversed by end-2015. With lower capex and cash tax, Centrica is cutting cash production costs and targeting neutral cash flow in E & P over 2015-16.

Uncertain UK Residential Supply
Fitch expects a recovery in 2015 earnings due to a normalisation of temperatures and gas volumes. More than 80% of supply EBITDA in 2014 was from gas, mainly residential, where consumption in 1Q15 was 10% higher yoy. Centrica achieved an EBIT margin of 5.1% in 2014 and continues to target after-tax supply margins of 5% (6.4% EBIT). However, their largest competitor SSE, with a price freeze in place through 2016, does not expect supply margins to recover to these levels soon.

Although wholesale gas prices have fallen, the biggest uncertainty remains the outcome of the Competition and Markets Authority investigation, with initial findings due in mid-late June and the final report due to be published by December, after UK elections in May 2015, an additional source of uncertainty. It remains to be seen if the independents continue to gain market share. The uncertainties are reflected in the wide range of earnings estimates for supply in 2016.

Measures to Protect Balance Sheet
Management has taken measures to protect the balance sheet from the impact of earnings pressure in E & P. These include substantial cuts to capex, with group capex over the 2015-18 period expected at GBP4.5bn against a previous figure for 2013-16 of GBP6.9bn, and the GBP1bn hybrid issuance. Asset disposals to date have raised about half of the planned GBP1bn. Centrica has changed dividend policy and introduced a scrip dividend, with effect from April 2015. We assume that the latter lowers the cash cost of dividends by 20%. These measures offset the credit impact of earnings pressures in E & P.

New Senior Management Team
A new CEO started in January, while a permanent CFO has yet to be nominated. A full strategic review is underway, covering outlook and sources of growth, portfolio mix and capital intensity, operating capability and efficiency and the group's financial framework, and is due to be presented alongside the group's interim results in July.

KEY ASSUMPTIONS

-Fitch's latest oil & gas price deck with implications for capex as outlined above
-Effective 30% cut to dividend forecasts, based on Centrica's decision to cut the final 2014 dividend (announced in February 2015)
-New hybrid issuance of GBP1bn (April 2015) with 50% equity content
-A recovery in UK residential supply earnings due to a normalisation of temperatures and gas volumes

RATING SENSITIVITIES

Negative: Future developments that could result in a negative rating action:

-Funds from operations (FFO) adjusted net leverage sustainably above 3x (2015E: 2.61x), for example, due to debt-funded acquisitions, and FFO fixed charge cover below 5x (2015E 5.34x)
-Substantial increase in E & P capex, further increasing cash flow sensitivity to commodity price volatility
Fitch intends to review guidelines following the strategic review to reflect the possible changes in the business profile and operating environment.

Positive: Future developments that could result in a positive rating action:
-FFO adjusted net leverage of sustainably below 2x and FFO fixed charge cover above 6x

LIQUIDITY AND DEBT STRUCTURE

Centrica's liquidity position remains sound. As of 31 December 2014, Centrica had unrestricted cash and cash equivalents of GBP374m plus available committed credit facilities of GBP3,751m (of which GBP2,271m mature in 2019 and GBP1,391m mature in 2017). This is more than sufficient to meet operating requirements & debt maturities of GBP641m over the next 24 months. We expect Centrica to generate positive free cashflow in 2015-18.

FULL LIST OF RATING ACTIONS

-Long-term IDR affirmed at 'A-', Outlook Stable
-Senior unsecured rating affirmed at 'A-'
-Short-term IDR affirmed at 'F2'
-Subordinated notes assigned 'BBB'.