OREANDA-NEWS. Fitch Ratings has assigned E.ON Generacion SLU (E.ON Generacion) final Long-term Issuer Default Rating (IDR) of 'BB-' and senior secured rating of 'BB'. The Outlook on the Long-term IDR is Stable.

The final ratings reflect E.ON Generacion's capital structure after the completion of its acquisition by Macquarie European Infrastructure Fund IV and an entity managed by Wren House Infrastructure in March 2015. The final ratings take into account the executed inter-creditors agreement (ICA), senior facilities agreement (SFA) and the terms and conditions of shareholder loans.

The IDR reflects the inherent exposure of the company's generation business to volatile wholesale electricity prices and the fairly small size of its asset base in Spain. The ratings also consider the mix of advantageously located (Los Barrios coal plant), efficient and responsive (hydro, including pumping) assets that mitigate the company's wholesale electricity price exposure.

We expect E.ON Generacion to deleverage from a sizeable post?acquisition level of 3.3x to a fairly low leveraged credit profile in 2018. The main drivers of deleveraging are regulatory receivables monetisation, coal destocking but also structurally positive pre-dividend free cash flows (FCF) and a cash sweep mechanism embedded in the financing documentation.

Fitch expects above-average recovery prospects for the lenders under the final secured financing, which is reflected in a single-notch rating uplift of the facilities above the company's IDR.

KEY RATING DRIVERS

Small Power Producer in Spain
E.ON Generacion is a pure electricity generator focused on the Spanish market. Its generation portfolio comprises hydro, coal and CCGT plants with a total installed capacity of 3.3GW, of which only 1.3GW is expected to contribute to future cash flows over 2015-2018. The CCGTs are currently not running due to low demand and overcapacity in the Spanish market. Fitch is not considering any contribution from the subsidiaries involved in supply activity.

E.ON Generacion's market share of 3% is small, especially when considering the concentrated generation market in Spain. The group relies on few key plants, resulting in operational risk associated with asset concentration.

Hydro/Coal Support Cash Generation
Hydro plants represent a sound profitability base, due to their fundamental position in the merit order and high margins. We expect financial results of these plants to be based on long-term average production levels, lower than the exceptionally high levels reported in 2013-14. Around half of the group's hydro capacity is pumping hydro (361MW), making most of its earnings on the spread between peak and off-peak prices and on the balancing market. Conventional hydro can optimise production timing and to some extent take part in balancing market.

Fitch expects Los Barrios coal plant to retain its strategic importance for the reference area, which is characterised by grid technical constraints expected to persist over the rating horizon of 2015-2018. This feature allows the plant to achieve significant premium on pool prices, thus supporting its profitability. Puente Nuevo coal plant's future over the medium term is uncertain after losing its subsidised status in January 2015 and a consequent drop in the plant's margins.

Fitch expects coal plants to contribute around 50%-60% of E.ON Generacion's EBITDA, with the bulk of the contribution to come from Los Barrios and the remainder from hydro plants. CCGTs bring a negligible contribution over the rating horizon. We assume that should capacity payments available to CCGTs be removed by the regulator, the company would mothball the plants at manageable additional expenses.

High Market Price Volatility
Spanish electricity pool prices are heavily exposed to hydrological and wind conditions, which increased day-ahead price volatility in recent years on higher installed renewable capacity. Fitch assumes long-term average weather conditions when making its price assumptions. The group typically hedges its production for at least one year ahead, thus partly locking in its gross margin for 2015 and, to a lesser extent, for 2016. Hedging is usually rolled over but it cannot offset long-term price trends.

We consider that the impact of the current low oil price environment should be mitigated in Spain by the almost absent contribution of gas plants to electricity price formation. However, some impact cannot be ruled out for peak prices, particularly if low commodity prices persist.

E.ON Generacion is exposed to market risk, and does not benefit from the mitigation enjoyed by its vertically integrated peers. However, the diversification, location and flexibility of the group's plants allow it to offer balancing and ancillary services, with significant premium over base load prices for Los Barrios and for pumping hydro over recent years.

Slight Recovery of Market Fundamentals
Fitch is assuming a slight increase in electricity demand in Spain over 2015-2018, in line with our expectation of moderate GDP growth. The Spanish (Iberian) electricity system is characterised by significant overcapacity and limited interconnection with France, which we expect to continue. We believe that overcapacity would be reduced over the medium term by the recovery of electricity demand and the reduction of CCGT and coal installed capacity, due to ongoing mothballing.

Easing Political and Regulatory Risk
Recent reforms implemented in Spain have largely resolved the industry's tariff deficit. In a financially more balanced and sustainable electricity system we would expect regulatory and political risk to decrease. E.ON Generacion has limited exposure to regulatory risk, and further cuts of capacity payments would likely result in management mothballing or decommissioning its CCGTs, which are not contributing to cash flows even under the current capacity mechanism.

Financing Package Supports Deleverage
The final financing package is only related to E.ON Generacion without any link to the other activities (renewable and regulated assets) of E.ON Espana, which has been acquired by Macquarie European Infrastructure Fund IV (60%) and an entity managed by Wren House Infrastructure (40%).

The final financing package includes a seven-year EUR275m bullet term loan B (TLB), a six-year EUR20m revolving credit facility (RCF), a six-year EUR20m facility for operational guarantees and an optional additional guarantee facility up to EUR40m uncommitted under the current SFA. The final capital structure of E.ON Generacion also includes a EUR454.7m shareholder loan, which we consider as equity under Fitch's criteria.

The financial documentation includes mandatory cash sweep for debt prepayment based on leverage, a two-year dividend blocker and lock-up provisions. After the initial two-year period, funds can be distributed to shareholders (through dividends or repayment of shareholder loans) only if a leverage test is passed (net debt-to-EBITDA of less than or equal to 2.0x) and so long more than 50% of the TLB is outstanding, every EUR of dividend must be matched with an additional EUR of debt repayment. The EUR68m receivable from the Comision Nacional de los Mercados y la Competencia (CNMC) is dedicated entirely to debt prepayment. Finally, excluded subsidiaries' (supply co) cash flows upstreamed to E.ON Generacion are added for cash sweep purposes up to EUR50m. Nevertheless, our rating approach does not include any cash flow coming from excluded subsidiaries.

The cash sweep should lead to the repayment of a substantial part of the TLB during 2015-2018, while the debt service coverage ratio (DSCR) covenant at 1.1x provides limited additional protection to lenders, in our opinion.

Working Capital Monetisation
E.ON Generacion has EUR68m of regulatory receivables related mainly to the tariff deficit and the subsidies of Puente Nuevo, EUR20m of receivables related to gas sales (discontinued activity) and a coal inventory of around EUR70m that will be used by Puente Nuevo in the next few years, as per our rating case. The monetisation of these assets is a key driver for the expected debt reduction over 2015-2018, as cumulative cash inflow from working capital is expected to be in excess of EUR150m over 2015?2018. This means that the expected deleveraging is, to some extent, not reliant on market dynamics (pool prices) being favourable over the short- to medium-term.

Strong Deleverage Post Acquisition
Fitch forecasts a funds from operations (FFO) net adjusted leverage of around 2.1x at end?2015 after receivables monetisation and cash sweep, down from 3.3x at transaction closing. The ratio is expected to peak at around 2.5x in 2016, when we expect EBITDA to be hit by the planned outage of Los Barrios plant, before decreasing to around 1.4x in 2018, due to working capital inflow and expected positive FCF.

Upside to our base case could come from supply co dividends inflows, which are contractually allocated to debt reduction and excluded in our analysis. E.ON Generacion is well-positioned at the current rating level with substantial rating headroom especially towards the end of 2018.

KEY ASSUMPTIONS

--Moderate improvement of base-load electricity prices in Spain over 2015-2018, driven by normalised weather conditions and a slight recovery in demand
--Achieving a sizeable premium over base-load prices for Los Barrios and pumping hydro, although lower than that reported historically
--Non-recurring costs of around EUR70m, mainly due to decommissioning activity, non?recurring financial expenses and transition costs
--Cash inflow of around EUR150m from working capital assets monetisation over 2015-2018
--Capital expenditure of around EUR140m for 2015-2018, including a largely pre?funded selective catalytic reserve investment at Los Barrios (but not at Puente Nuevo)
--Significant gross debt reduction and dividends distribution in line with the cash sweep mechanism over 2015-2018 of around EUR140m
--Minimum cash target of EUR40m at year-end

RATING SENSITIVITIES
Positive: Future developments that could lead to a positive rating action include:
-FFO net adjusted leverage below 2.5x and FFO interest cover above 4.5x on a sustained basis, supported by stronger electricity market fundamentals in Spain and sustainable higher margins for E.ON Generacion hydro and coal plants

Negative: Future developments that could lead to negative rating action include:
--FFO net adjusted leverage above 3.5x and/or FFO interest cover below 3.0x on a sustained basis, as a consequence of lower working capital release, negative market evolution and/or substantially lower margins than currently expected by Fitch
--Material adverse changes to the regulatory framework, including wholesale market and capacity payments, leading to a change in our view on the system's sustainability and on the company's operating environment

LIQUIDITY

Fitch assesses E.ON Generacion's post?acquisition liquidity position as adequate. The final bullet EUR275m TLB has been fully drawn at closing, with EUR30m of those proceeds pre-funding a cash reserve which can only be used for the 2015?2016 environmental capital expenditure requirements at Los Barrios. We view this as restricted cash in our rating case.

The provisions of the draft financing documentation allow the complete distribution of the aggregate retained excess cash flow every year for debt repayment (cash sweep mechanism) and, secondly, distribution to shareholders (provided the leverage test is passed). However, a EUR40m minimum cash balance requirement has been included under the SFA. This amount was equity-funded at closing on top of the EUR30m capex reserve and we expect it to be the total cash on balance sheet by the end of 2018 when distributions will not be constrained by dividend lockers and leverage test.

In addition, the financing package includes a final EUR20m RCF that will be available in 2015-2018. We forecast this liquidity position will be sufficient to cover all the operational requirements during this period.