OREANDA-NEWS. June 17, 2015. Fitch Ratings has upgraded Russian utility company PJSC Inter RAO's Long-term Issuer Default Ratings (IDR) to 'BBB-' from 'BB+'. The Outlook on the Long-term IDRs is Negative. A full list of rating actions is available below.

The rating action is driven by the upgrade of Inter RAO's standalone rating to 'BB+' from 'BB', reflecting improved credit metrics and Fitch's expectations that the company will maintain a robust financial profile over 2015-2018. The standalone rating also incorporates the company's strong market position, multiple assets, fairly strong efficiency compared with the Russian average and expected contribution to cash flow stability of operations under capacity supply agreements (CSA).

At the same time, Fitch assesses the inherent risk in the unpredictable regulatory framework of the Russian utilities sector as high, which constrains Russian utilities' standalone ratings to speculative-grade.

Inter RAO's 'BBB-' rating incorporates a one-notch uplift for state support from its standalone rating of 'BB+' due to the continued strength of the ties between the company and the Russian Federation (BBB-/Negative), its indirect majority shareholder (51.12%). The Negative Outlook is constrained by that of the sovereign's.

KEY RATING DRIVERS

Robust Financial Profile
Inter RAO reported stronger-than-expected financial results for 2014, and we expect it will maintain a solid financial profile over the forecast horizon of 2015-2018, driven mainly by the commissioning of new CSA projects with favourable economics, cost optimisation and firmer performance of the supply business. This supported an upgrade of its standalone rating to 'BB+' from 'BB'.

We forecast funds from operations (FFO) net adjusted leverage to remain below 1.5x over 2015-2018 and FFO fixed charge cover to be above 7x from 2016. This is despite our assumptions of largely modest electricity price growth from 2015 below inflation and high interest rates for new debt. Although the company forecasts a significant moderation of capex from 2017 to about maintenance levels following the completion of the investment cycle in CSA projects over 2015-2016, we assume capex over 2017-2018 will remain in line with the average over 2011-2014.

Positive FCF Expected
In contrast to most other Russian utilities rated by Fitch, we expect Inter RAO to reach positive free cash flow (FCF) from 2016, mainly driven by the completion of its substantial investment programme. We expect FCF to remain negative in 2015. The planned completion of expansion capex should contribute to Inter RAO's ability and financial flexibility to adapt to potential external economic or regulatory shocks. We consider the company's dividend policy, which envisages a payout ratio of 25% of IFRS net income over 2016-2018 as moderate, and include dividend payments in our FCF calculation.

Strong Business Profile
The standalone rating is underpinned by Inter RAO's strong market position as the third-largest power generation company in Russia and among the largest utilities in Europe by installed electric capacity and the largest domestic power retail company as well as by its virtual monopoly in cross-border power trading.

Inter RAO accounted for 13% of the Russian electricity generation market and 15% of the Russian electricity supply market in 2014. It operates multiple assets, which should reduce the risk of cash flow volatility due to, for example, unexpected outage. We assess the efficiency of the group's assets as being above the Russian average.

CSAs Drive EBITDA Growth
Stable earnings and a guaranteed return for capacity sales under CSAs (typically for 10 years from plant commissioning) are the key factors that mitigate Inter RAO's exposure to market risk, support stable cash flow generation and enhance its business profile. Fitch estimates that the newly commissioned units operating under CSAs contributed above 20% of Inter RAO's 2014 EBITDA and that they should contribute above 40% of company's EBITDA by 2016-2017 once all new capacity under the CSA framework is commissioned. The company expects 13%-14% rate of return on its newly built projects.

Gas Dominates Fuel Mix
Inter RAO's fuel mix is dominated by gas (78% in 2014) followed by coal (21% in 2014). From 2016 almost all the company's gas needs will be supplied by Rosneft Oil Company under a 25-year contract signed in 2012 providing for annual gas supplies of up to 35bcm.

We believe that supplier concentration risk is mitigated by domestic gas prices in Russia being regulated by the Federal Tariff Service (FTS) as well as by the long-term nature of the contract with Rosneft and by high interdependence between the company and Rosneft. This is due to the latter's contracted supplies to Inter RAO accounting for about 62% of its 2014 gas production. In 2014 Rosneft produced 56.7bcm of gas.

Manageable FX Risks
We assess Inter RAO's currency risk as manageable due to the company's generation of a reasonable portion of revenue in foreign currency and strong financial profile, which has significant headroom to absorb FX shocks. Inter RAO remains exposed to foreign currency fluctuations as about 32% of its total debt at end-2014 was denominated in US dollars and euro. Although only around 8% of revenues are dollar-linked or dollar-denominated, it amounted to about RUB57bn in 2014, which is sufficient to cover its foreign currency-denominated debt of RUB34bn. As of end-2014, 26% of cash and cash equivalents of around RUB21bn were denominated in US dollars and euro, partially mitigating the company's FX exposure.

Sufficient Liquidity
Inter RAO is better positioned in liquidity compared with its Russian peers, most of which achieve a satisfactory liquidity profile mainly because of their reliance on credit lines from Russian banks, albeit at high interest rates. Inter RAO's cash position of RUB81.7bn at end-2014 was sufficient to cover its short-term maturities of RUB42.9bn. Its debt repayment schedule is not onerous and is fairly balanced. The group also has access to uncommitted credit facilities of RUB94bn (RUB40bn at Inter RAO group's level). We do not consider Inter RAO's portfolio of equity stakes valued at about USD252m as imminent liquidity but believe that asset disposals could serve as an additional cushion for capex funding or debt repayment.

One-Notch Uplift for State Support
Inter RAO's 'BBB-' rating benefits from a one-notch uplift for state support as we continue to assess the strategic, operational, and to a lesser extent legal ties between the company and its ultimate majority shareholder, the Russian Federation, as fairly strong. This is due to strategic importance of Inter RAO to the country's electricity production and supply as well as the track record of tangible state support, provided largely in kind. The Negative Outlook on Inter RAO's Long-term IDRs reflects that of the sovereign's.

Unpredictable Regulatory Framework
Russia's unpredictable and inconsistent regulatory framework is characterised by political interference and frequent changes in the tariff-setting mechanisms and is a key credit risk for Russian utilities. The high regulatory risk constrains the utilities' standalone ratings to speculative-grade. Since Inter RAO mainly operates in non-regulated markets, we expect regulatory changes to have a more limited impact compared with Russian regulated network utilities. Nevertheless, we expect any tariff changes in the regulated segment and/or political risk, for example, the tariff freeze for regulated utilities in 2014 or elections in 2012, to have an indirect adverse impact on competitive markets.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
- Domestic GDP decline of 4.5% and inflation of 15% in 2015
- Electricity consumption to decline slower than GDP contraction
- Electricity tariffs to increase below inflation
- Debt split by FX assumed to be in line with 2014 breakdown
- Capex in line with management's forecast over 2015-2016 and in line with the historical average from 2017
- Dividend payments of 25% of IFRS net income over 2016-2018

RATING SENSITIVITIES

Positive: Future developments that could lead to positive rating action include:
- A revision of the sovereign's Outlook to Stable
- A more transparent and predictable regulatory framework, coupled with the company's strong financial profile, which could be positive for the standalone rating.

Negative: Future developments that could lead to negative rating action include:
- Evidence of weaker state support and/or Russia's downgrade
- Aggressive debt-funded acquisitions and/or more ambitious capex programme resulting in deterioration of the financial profile (eg FFO net adjusted leverage above 2.5x and FFO fixed charge cover below 5x on a sustained basis), which could be negative for the standalone rating.

FULL LIST OF RATING ACTIONS

Long-term foreign and local currency IDRs: upgraded to 'BBB-' from 'BB+', Outlook Negative
Short-term foreign and local currency IDRs: upgraded to 'F3' from 'B'
National Long-term rating: upgraded to 'AA+(rus)' from 'AA(rus)', Outlook Stable