OREANDA-NEWS. June 09, 2015. Fitch Ratings has affirmed SPP - distribucia, a.s.'s (SPPD) Long-term Issuer Default Rating (IDR) at 'A-' and senior unsecured rating at 'A'. The Outlook on the IDR is Stable.

The affirmation is supported by SPPD's strong business profile as the national gas distribution system operator (DSO), the regulated nature of its operating cash flows and strong expected credit metrics, assuming steady gross debt and dividends that will continue to be maximised in the forecast period. At the same time, Fitch views the Slovak regulatory framework as less mature than other Western European regimes with less robust tariff setting and volume risk. The rating is constrained by the consolidated profile of SPP Infrastructure, a.s. (SPPI), which we view as commensurate with the low end of the 'A' rating category.

KEY RATING DRIVERS
SPP Infrastructure Constraint
SPPD is directly fully owned by SPPI, whose ultimate shareholders are the Slovak Republic (51%, A+/Stable, through Slovensky plynarensky priemysel, a.s. (SPP)) and Energeticky a prumyslovy holding, a.s. (EPH, 49% plus management control). We believe that the shareholder agreement in place for SPPI, which also defines its dividend policy and maximum leverage for SPPI and each of its subsidiaries, provides some ring-fence protection from its shareholders. This can be changed without the consent of the creditors of SPPI and its subsidiaries, but there is an emerging track record for the shareholders' agreement.

The key financial and strategic policies are set by the shareholder agreement for SPPI as a whole and we therefore view its consolidated profile as a credit factor for the subsidiaries and a limiting factor for SPPD's IDR. We view SPPI's consolidated profile as commensurate with the low end of the 'A' rating category. This also reflects eustream, a.s.'s rating (A-/Stable), which contributes around 57% of SPPI's preliminary pro-forma EBITDA (EUR948m for 2014). SPPD contributes around 24% and the contracted storage business less than 20%.

Strong Business Profile
SPPD's unconstrained credit profile continues to be supported by its strong business profile as the national distribution system operator (DSO), the regulated nature of its operating cash flows and expected credit metrics (funds from operations (FFO) adjusted net leverage up to 3.0x), assuming steady gross debt, with dividends to continue to be maximised in the forecast period. Fitch views the Slovak regulatory framework as less mature than other western European regimes, with less robust tariff setting and volume risk.

Regulatory Environment Exposed to Political Risk
The current (third) regulatory framework has been in place since 2012 with the regulatory period stretching until 2016. Distribution tariffs aim to cover operating costs and also secure a fair profit margin for the DSO. However, there is notable volume risk in the household and SME segments representing 66% of revenues. This is due to variable (volume linked) tariff components of at least 40% depending on the particular tariff and lack of subsequent correction mechanism. Revenues from large (industrial) customers do not vary significantly with volume changes. The warm winter of 2014 led to a substantial decrease in distributed gas volumes. However, the impact on SPPD's EBITDA was mitigated mostly by fixed tariff components and also by cost cutting. We do not expect the new regulatory period to be significantly more challenging for the company.

Tariff Mechanism Robust Only Formally
Tariff setting is based on the calculation of an average tariff, which serves as a basis for the calculation of tariffs for individual groups of consumers depending on their gas consumption. The average distribution tariff is calculated based on eligible opex and depreciation, and fair profit - weighted average cost of capital (WACC) times regulatory asset base (RAB). WACC and volume assumptions are updated annually, somewhat limiting the volume risk. The RAB is fixed for the current regulatory period, at a level lower than the net book value of fixed assets. This gives little incentive for investments, which have effectively been at the maintenance level since 2009. The tariffs are fixed until the end of 2016.

Developed Asset Base
Low capex also reflects the very high infrastructure penetration in the country (over 94% of population has access to piped natural gas) and a relatively modern network (44% polyethylene). The prospective upward revaluation of the RAB to reflect the net book value of assets may be hindered by the social considerations and we therefore do not assume this in our forecasts. Eligible depreciation is nevertheless commensurate with accounting depreciation and adjusted annually for assets put into operation. SPPD meets its legal quality standards and has never been required to pay stated fines or customer compensations.

Concentrated Counterparty Risk
Shippers are responsible for billing and receivable collection in Slovakia, while SPPD requires either a bank guarantee or a deposit covering at least two months of distribution fees from each shipper to minimise its credit risk. SPP remains the dominant supplier in Slovakia and SPPD's key counterparty representing around 68% of its revenues for 2014. Despite the concentration, we view the company's receivable collection risk as low.

Limited Direct Exposure to Transit Flow Disruption
We view SPPD's direct exposure to a potential temporary disruption of Russian natural gas flows across Ukraine as modest, as evidenced by the events of January 2009 when flows were halted for 15 days, but SPPD's EBITDA was not affected. This was partially due to the required prioritisation of supplies to households and small commercial customers whose tariffs include sizeable volume-linked component. Supplies to large customers were curtailed, but their distribution tariffs are largely fixed. SPPD is charged with system balancing and assurance of uninterrupted supply for at least 30 days for households, for which it maintains physical inventories.

A longer-term disruption would be mitigated by utilisation of gas storage capacities, reverse flows and imports through other interconnectors put in place since 2009, which we believe would support unconstrained gas consumption and thus distribution in the country in most scenarios. However, SPPD's credit profile would not be immune to a long and significant decrease in distributed volumes, in addition to the potential vulnerability through its membership in SPPI.

Adequate Leverage
SPPD's debt is dominated by senior unsecured EUR500m notes due 2021. The notes' rating, which is one notch above SPPD's IDR, reflects our criteria for Recovery Ratings including the assumption for above-average recoveries in case of default, which we typically apply for regulated network utilities in certain markets. We expect that with a steady debt level around EUR600m, FFO net adjusted leverage will remain up to 3x and FFO interest cover over 10x.

KEY ASSUMPTIONS
-Capital expenditure of EUR30 to EUR40m per year, in line with SPPD's own expectations.
-All profits paid as dividend to SPPI to the extent that the leverage ratio of either SPPD or SPPI does not exceed 2.5x net debt/EBITDA as stipulated in the shareholders' agreement.
-No material changes for the fourth regulatory price control starting in 2017, including a flat RAB and allowed regulatory return. This does not reflect any particular expectations about the on-going discussions with the Slovak regulator, RONI, the outcome of which should be published by the end of 2015. We will review our estimates in line with the regulatory outcome once published.

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- SPPI's credit profile strengthening and/or weaker links with SPPI.
- SPPD's unconstrained credit profile could improve if FFO adjusted net leverage decreased to below 1.5x on a sustained basis assuming the current business risk profile. An improved regulatory framework could be positive for the company's business profile.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- SPPI's credit profile weakening, affecting SPPD.
- SPPD's unconstrained credit profile would worsen if FFO adjusted net leverage increased to above 3.0x on a sustained basis assuming the current business risk profile. Any deterioration in regulatory predictability would be negative for SPPD's business profile.

LIQUIDITY
At the end of FY14, SPPD had cash and cash equivalents of EUR232m, but we expect the company to operate with around EUR30m of cash. We consider any deposits in the cash pooling as dividends. There are no short term debt maturities and we expect SPPD to continue to generate strong operating cash flows. Interest rate and FX risks are limited.