OREANDA-NEWS. Fitch Ratings has assigned an expected rating of 'BBB-(EXP)' to DONG Energy A/S' proposed callable subordinated capital securities. The proposed securities qualify for 50% equity credit. The final rating is contingent on the receipt of final documents conforming materially to the preliminary documentation reviewed. A full list of DONG's ratings is available at the end of this commentary.

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 OF THE NOTES
Ratings Reflect Deep Subordination
The proposed notes are rated two notches below DONG Energy's Long-term Issuer Default Rating (IDR; 'BBB+'/Outlook Stable) given their deep subordination and consequently, the lower recovery prospects in a liquidation or bankruptcy scenario relative to the senior obligations. The notes only rank senior to the claims of equity shareholders.

Equity Treatment Given Equity-Like Features
The proposed securities qualify for 50% equity credit as they meet Fitch's criteria with regards to deep subordination, remaining 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, affording DONG Energy greater financial flexibility.

Equity credit is limited to 50% given the cumulative interest coupon, a feature considered more debt-like in nature.

Effective Maturity Date 2040
While the proposed notes are due in 3015, Fitch deems the effective, remaining maturity as 2040, in accordance with the agency's hybrid criteria. From this date, the coupon step-up is within Fitch's aggregate threshold rate of 100bps, but the issuer will no longer be subject to replacement language, which discloses the company's intent to redeem the instrument at its call date with the proceeds of a similar instrument or with equity. According to Fitch's criteria, the equity credit of 50% would change to 0% five years before the effective remaining maturity date. The issuer has the option to redeem the notes on the first par call date in 2020 and on any coupon payment date 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 by Fitch. Despite the 50% equity treatment, Fitch treats coupon payments as 100% interest. The company will be obliged to make a mandatory settlement of deferred interest payments under certain circumstances, including the payment of a dividend. This is a feature similar to debt-like securities and provides the company with reduced financial flexibility.

KEY RATING DRIVERS FOR DONG ENERGY
Successful Deleveraging
The February 2014 equity increase by DKK13bn (EUR1.7bn) together with other elements of the implemented 2013-14 Financial Action Plan (FAP) allowed the company to strengthen its balance sheet. The FAP included non-core asset disposals of DKK14.4bn in 2013 (higher than DKK10bn planned within the FAP), reduction of stakes in operating projects, such as the London Array wind farm (proceeds of DKK5.8bn), cost reductions by DKK1.4bn and restructuring of the Energy Markets division. This led to the revision of the company's Outlook to Stable in February 2014.

Stronger Credit Ratios
DONG Energy improved its credit ratios in 2013-2014, mainly thanks to the FAP implementation. FFO net adjusted leverage improved to 1.5x in 2014 from a weak 6.5x in 2012. Fitch projects FFO net adjusted leverage will remain below 3x in 2015-2016 thanks to the equity increase, which mitigates the impact of negative free cash flow (FCF) due to the large capex plan for 2015-2016. This is well below our negative rating guideline of close to or above 4x. The FAP implementation mitigates some of the challenges associated with the assumed large capex plan, a difficult operating environment for utilities, and weakened market conditions for oil and gas exploration and production (E&P).

Leading Market Positions
The ratings reflect DONG Energy's leading position in electricity and heat generation (number five in the Nordic region, number one in Denmark), its position as the largest off-shore wind power generator in Europe and leading position in the Danish electricity and gas distribution and supply.

Large Wind and E&P Exposure
Despite its presence across most of the value chain, wind power and oil and gas E&P dominate DONG Energy's profile with 47% and 39% of 2014 EBITDA after hydrocarbon tax, respectively. Fitch expects both segments' share of EBITDA to remain dominant by 2016 due to ambitious investment plans, resulting in negative FCF. With the current subsidy schemes and preferential dispatch, DONG Energy's wind power operations benefit from quasi-regulated revenue and cash flow visibility. The increasing exposure to one power generation source that could be subject to unfavourable changes in future subsidy schemes exposes the ratings to regulatory risk.

Significant Hedging
The E&P segment is cyclical and has high business risk, including exposure to production disruptions. The high volatility of earnings of the E&P segment (price risk) is reduced by the natural hedge with oil-linked gas purchase contracts in gas midstream (for DONG Energy's oil production) and financial hedging, with a high hedge ratio for the next two years on a rolling basis. However, exposure to this segment is large compared with other integrated European utilities.

Revised E&P Targets
In August 2014, DONG reduced its long-term ROCE targets for E&P to around 12% on average for 2015-2020 from 20% previously. Furthermore, E&P is no longer driven by a specific volume target up to 2020 but will maintain a strong focus on value creation and increasing capital discipline in E&P capex. The revision was driven by some challenges facing the segment including weaker than expected exploration results, lower gas prices, changed hydrocarbon tax frameworks and delays in some projects.

Fitch expects this revision to lower DONG's exposure to the E&P segment in the five-year rating horizon, which the agency views as positive for the company's business profile. Fitch believes that if oil prices were to stay at their current low level in the medium term, this could lead to a reduction in E&P capex.

Regulated and Quasi-Regulated Business
DONG Energy's regulated and quasi-regulated business accounts for about 35% of EBITDA after hydrocarbon tax, which supports cash flow visibility. The main components are electricity and gas distribution, wind farms subject to fixed tariffs or green certificates and heat production and biomass subsidies. The share of thermal power after its fall in the past few years is marginal at 3% of 2014 EBITDA after hydrocarbon tax. Most remaining thermal power EBITDA comes from regulated heat production and biomass subsidies.

State Ownership
DONG Energy remains majority-owned by the Kingdom of Denmark ('AAA'/Outlook Stable/'F1+'), although the February 2014 equity increase decreased the state's stake in the company to 57.3% from 81% (the state currently holds 58.8%). Although the state did not directly participate in the equity increase, it will purchase DONG Energy's shares from new investors at pre-agreed terms if there is no IPO of the company before annual accounts for 2017 are published. Fitch views DONG Energy's links to the government as weak and so rates the company on a standalone basis, in accordance with the agency's parent and subsidiary rating linkage methodology.

KEY ASSUMPTIONS
--The E&P segment's cash flow after tax for 2015-2016 subject to extensive hedging (at oil and gas prices close to 2014 levels);
--No major improvement in the profitability of Thermal Power and Energy Markets businesses;
--Capex in line with management guideline for net investment of DKK35-40bn for 2015-2016 (assuming that 50% stakes in wind farm investments are sold to co-investors/third parties);
--Highly negative FCF for 2015-2016 due to large capex
--No dividends paid to shareholders in 2015;
--New hybrid issuance of EUR600m with 50% of equity credit issued in 2015 replaces the EUR600m hybrid issue with 50% equity credit issued in 2005.

RATING SENSITIVITIES
Positive: Rating upside is limited due to the company's business profile. Future developments that could lead to positive rating action include:
--FFO net adjusted leverage well below 3x on a sustained basis and a substantial increase in contribution of stable, regulated earnings to total EBITDA.

Negative: Future developments that could lead to negative rating action include:
--FFO net adjusted leverage close to or above 4x on a sustained basis;
--Substantial reduction in the extensive hedging of the E&P segment leading to higher cash flow volatility;
--Deterioration in DONG Energy's operating environment (for instance, revision of offshore wind support schemes).

LIQUIDITY AND DEBT STRUCTURE
At end-March 2015 DONG Energy had available liquidity of DKK37.7bn comprising DKK24.1bn of unrestricted cash and cash equivalents (including liquid and highly-rated fixed-income securities) and undrawn committed revolving credit facilities for DKK13.6bn that are due in 2018. This liquidity was sufficient against short-term debt of DKK3.3bn and projected negative FCF of about DKK15bn in 2015 (after incorporating the impact of proceeds from wind farm partnerships from third parties).

FULL LIST OF RATINGS
Long-term IDR 'BBB+'; Outlook Stable
Senior unsecured rating 'BBB+'
Subordinated capital securities' rating 'BBB-'
Proposed subordinated capital securities assigned an expected rating 'BBB-(EXP)'.