OREANDA-NEWS. Fitch Ratings has affirmed Electricity North West Limited's (ENW) Long-term Issuer Default Rating (IDR) at 'BBB+', with a Stable Outlook, senior unsecured rating at 'A-' and Short-term IDR at 'F2'. The agency has also affirmed North West Electricity Networks plc's (NWEN) Long-term Issuer Default Rating (IDR) at 'BBB', and revised the Outlook to Negative from Stable. A full list of rating actions is at the end of this release.

ENW's 'BBB+' rating reflects tougher electricity distribution regulation from April 2015, partly offset by expected incentive revenues and totex outperformance over RIIO-ED-1. Estimated average credit metrics are within the rating guidelines for ENW, but not for NWEN, which also has limited gearing headroom. This is reflected in the revision of the Outlook to Negative. However, NWEN is looking at a range of remedial measures to improve post-maintenance interest coverage ratio (PMICR). Assuming one or more of these measures brought the PMICR back within rating guidelines, Fitch would expect to revise the Outlook back to Stable.

KEY RATING DRIVERS
Tougher Regulation from April 2015
Ofgem published final determinations for slow-tracked electricity distribution network operators (DNOs) under the 2015-23 RIIO-ED1 price control in November 2014. While the business risk has increased with respect to its predecessor (DPCR5), we view the regulatory settlement as broadly ratings neutral across the sector. Although depreciation has been extended to 45 years from 20 years for new assets, this is mitigated by an eight-year transitionary period. Ofgem has committed to funding a proportion of pension deficits over 15 years and to retain uncertainty mechanisms and re-openers from DPCR5.

The Competition and Markets Authority (CMA) has given permission for appeals against the price control, with a provisional determination due in late July and final determination in September/ October. The issue is complex and there is a range of outcomes from positive to negative, depending on the appellant. However, there is no impact on base revenues in FY16. There is a potential risk of retrospective change, but the timing of the appeal, the fact that the CMA is already investigating the residential energy supply market and decision in August 2014 not to extend the terms of reference of the investigation to the DNOs, suggest that the risk is limited.

Expected Incentives, Totex Outperformance
ENW has steadily earned incentive revenue over DPCR5. The 2014 data for customer interruptions (CI) and customer minutes lost (CML) are together worth nearly GBP10m of incentives in additional revenues. There is scope for ENW to achieve continued outperformance, even if targets have been tightened against DPCR5 and are subject to a sharing factor, unlike the previous price control. We have applied a haircut of 30% in forecasts from FY18 to management incentive revenue forecasts.

Totex allowances are around 6% less than in DPCR5. However, ENW is staggering framework agreements (construction, materials & business services) with suppliers to give more certainty and better prices to suppliers. Management projections of totex outperformance, mainly from capex, average 2.9% pa over ED-1. These are back-ended and look conservative. Examples of cost-saving include refurbishment rather than replacement of transformers and the reintroduction of oil insulated ring main units to switchgear.

Midco Debt Refinanced
NWEN issued GBP200m of 15-year fixed rate notes at 4.07%-4.17% and GBP105m of 20-year Index Linked Notes at 1.4%-1.5% real in the US private placement market last November. NWEN received GBP120m in December 2014 with the remaining GBP185m due in June just ahead of the outstanding bond maturity. ENW restructured GBP66m of GBP200m index linked swaps in January 2015, removing the mandatory break of July 2016 and introducing a seven-year pay as you go profile, benefiting PMICR.

Credit Metrics, Opco & Midco
Fitch believes that ENW's credit metrics are within the rating guidelines and that there is ample gearing headroom. However, with estimated average PMICR of 1.3x and gearing of 83%, NWEN's PMICR is currently below guidelines and it also has limited gearing headroom. This is reflected in the revision of the Outlook to Negative. However, the company is currently looking at a range of remedial measures. Assuming this brings PMICR back within guidelines of 1.4x, this would be sufficient for us to revise the Outlook back to Stable.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for ENW include:
- RPI of 2.0% for FY15 and flat 2.5% from FY16. Our assumption is of a 1.13% cost of debt in FY15 and flat 1.4% from FY16. This takes the cost of debt lower each year under Ofgem's iBoxx trombone mechanism, starting at 2.55% in FY16 and falling to 2.06% by FY23. This implies a nominal cost of new debt of 3.13% for FY15 and 3.9% from FY16 onwards.
- Substantially increased assumptions for LIBOR, with an expected steady rise in rates through 2023, from 1.5% in FY16 to 3.0% in FY23.
- We work with management incentive revenues, related to CI's and CML's for FY15 and FY16. Fitch assumes a haircut of 30% to assumed incentive revenues from FY18.
- Stressing the numbers by running a flat 1.5% RPI vs 2.5% RPI and with leverage driving the estimates, ENW's average PMICR moves only very slightly, but at the same time estimated dividends over the eight-year regulatory period are lowered to GBP228.5m from GBP291.8m. For NWEN, there is no change in PMICR ratios, although dividends over the eight-year regulatory period are lowered from GBP295.7m to GBP222.9m.

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- ENW: PMICR above 2x and a decline in RAV based leverage below 60% on sustainable basis.
- NWEN: An upgrade at its operating subsidiary, ENW, would support an upgrade along with an improvement in PMICR above 1.6x and a decline in RAV based leverage below 75% on sustainable basis.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- ENW: PMICR below 1.6x and RAV based leverage over 74% on a sustainable basis.
- A marked deterioration in operating and regulatory performance or adverse changes to the regulatory framework that may affect the company's cash flow generation.
- NWEN: PMICR below 1.4x and RAV based leverage over 84% on a sustainable basis.

LIQUIDITY
As at 31 March 2015, ENW had unutilised committed facilities of GBP50m and GBP161m of cash and short-term deposits. This includes GBP45m of fixed income deposits expiring in the coming months, where the longest dated maturity is September 2015 for GBP25m of the total. With no significant debt maturing before 2022, existing liquidity is sufficient to absorb estimated negative cash flow (post dividends) until then.

As at 31 March 2015, NWEN had cash and cash equivalents, all readily available, of GBP121.6m. NWEN also had GBP92.6m drawnunder the GBP150m capex facility maturing August 2016 and an undrawn liquidity facility of GBP40m. Assuming the capex facility is renewed, this gives the midco sufficient liquidity to absorb estimated negative cash flow (post dividends) until the end of RIIO-ED-1.

FULL LIST OF RATING ACTIONS
Electricity North West plc
-Long-term IDR affirmed at 'BBB+', Stable Outlook
-Senior unsecured rating affirmed at 'A-'
-Short term IDR affirmed at 'F2'

North West Electricity Networks Limited plc
-Long-term IDR affirmed at 'BBB', Outlook revised to Negative from Stable

ENW Finance plc
Senior unsecured guaranteed notes affirmed at 'A-'

ENW Capital Finance plc
-Senior secured guaranteed notes affirmed at 'BBB+'
Bonds issued by ENW Finance plc, a financing subsidiary of ENW, are for the benefit of ENW and are guaranteed by ENW, and bonds issued by ENW Capital Finance plc are guaranteed by NWEN, ENW's immediate parent.