OREANDA-NEWS. June 30, 2015. Fitch Ratings has affirmed Italian utilities group Acea SpA's Long-term Issuer Default Rating (IDR) at 'BBB+' with Stable Outlook and Short-term IDR at 'F2'. Its Long-term senior unsecured rating is also affirmed at 'BBB+'.

The affirmation reflects Acea's updated business plan confirming the group's strategic focus on regulated businesses and its commitment to a balanced financial structure. The ratings further reflect Acea's positive results in 2014 amid a recessionary economy in Italy. The water sector (41% of the group's reported EBITDA in 2014) benefits from an improvement in the visibility of the regulatory framework, which we expect to continue in the new regulatory period starting in 2016.

Our updated forecasts show average funds from operations (FFO) adjusted net leverage of around 4.4x and FFO interest coverage of 5.1x for the period 2015-19, within the guidelines for the current rating. Our projections do not factor in external growth, hence potential acquisitions, depending on the size and funding, could impact the ratings.

KEY RATING DRIVERS

Largely Regulated Multi-utility
Acea is one of the largest Italian multi-utilities, focused on the central part of Italy. The regulated activities (mainly integrated water services and electricity distribution) contributed to 76% of its reported EBITDA in 2014, with the balance related to environment (8%) and energy (15%), which includes both generation and supply. This diversified business profile allowed the group to achieve robust growth in 2014, notwithstanding weak market conditions in Italy.

Updated Business Plan
In June 2015 the new CEO (appointed in 2014) of the group presented the updated business plan for 2015-19. Focus has been placed on the digital transformation of the group (project Acea 2.0), whose implementation is expected to be completed by 2016.

Total efficiencies over 2015-19 have been set at EUR70m (annual recurring efficiencies of EUR30m from 2019), which we view as a reasonable target, considering that the projects will involve all the main business areas of the group and clear KPIs have been set. We will closely monitor the evolution of working capital, for which management expects a significant reduction mainly on the back of new billing systems and the cash-in of pending settlements in the water sector. We see some execution risk in the billing system implementation and thus assume no benefits in our rating case.

Expected capex amount to EUR2.3bn (vs. EUR2.4bn of the previous 2014-18 plan), of which around 80% will be invested in regulated businesses. Management expects significant growth in the environment business, with treated volumes rising to 1,811 kTons in 2019 from 774 kTons in 2014 and EBITDA more than doubling to EUR114m in the same period. We see this target as ambitious, considering both the execution and volume risks, and our rating case includes lower growth.

Management has defined a dividend payout range of 50%-60% across the period and expects the business plan to generate cumulative slightly negative (post-dividend) free cash flows (FCF), while it forecasts leverage (net debt-to-EBITDA) to decrease to 2.6x in 2019 from 2.9x in 2014, due to an expected CAGR of EBITDA of 3.8% for 2014-19.

Positive 2014 Results
In 2014 Acea's reported EBITDA (which included the net income of equity-consolidated water companies) increased to EUR717m (up 6.3% on restated 2013 results). A strongly positive contribution came from regulated water services, where EBITDA rose 4.1% to EUR292m, reflecting a new tariff framework and positive adjustments related to previous years.

The energy segment reported 21.7% EBITDA growth, solely due to sales activity, aided by decreasing pool prices in the free market and compensation for unpaid energy bills in the enhanced protection market.

FCF of EUR158m in 2014 benefitted from moderate capex and cash dividends of EUR316m and EUR44m respectively. As a consequence Fitch's adjusted net debt fell to EUR2,571m in 2014 from restated EUR2,706m in 2013, with FFO adjusted net leverage decreasing to 4.1x in 2014, well within the current rating guidelines.

Improving Predictability in Water Regulation
Acea's regulated water activities contribute more than 40% of the group reported EBITDA. Tariffs for 2014-2015 have been defined in line with the rules set in the Metodo Tariffario Idrico (MTI) and approved for the main water companies of the group (with a provisional approval for Ato5, managing water services in one of the Lazio areas). Tariffs allow for the recovery of operating costs (including a certain percentage of unpaid receivables), a real before-tax return on capital and potential accelerated depreciation in case of relevant investment plans.

Fitch considers the current regulatory framework as reasonably supportive and views favourably the rules enhancing the role of the regulator (AEEGSI, Autorita per l'Energia Elettrica, il Gas ed il Servizio Idrico) in governing the sector. Additional details such as standardising concession terms and an incentive system for quality will likely be introduced by the regulator in the short term. We expect the current framework to be confirmed in the new regulatory period, as prolonged visibility is needed to bridge the infrastructural gap of the water sector.

New Electricity Distribution Regulatory Period
In Italy the fourth regulatory period for electricity distribution (around one third of the group's EBITDA) will end in 2015. Fitch expects the broad framework to remain in place. However, the regulator is revising the inputs of the formula to define the (real pre-tax) weighted average capital cost (WACC) for both electricity and gas regulated activities starting from 2016. Based on the first consultation document published in June 2015, we believe there could be a meaningful reduction (around 150 basis points) from the current level of (real pre-tax) WACC of 6.4% for electricity distribution.

The impact of this revision on the financials of the group should be manageable, considering that the tariff regulatory asset base (RAB) of electricity distribution is worth around EUR1.5bn for Acea and is expected to remain broadly stable over the business plan horizon.

Credit Ratios Coherent with Ratings
Fitch expects the main credit ratios of the group to remain in line with current rating guidelines over the business plan period. Fitch has factored in some conservative considerations mainly related to regulatory determination, the pace of development of the environment business and working capital evolution. In such a scenario Fitch estimates that FFO net adjusted leverage would average 4.4x for the 2015-19 period, with an FFO interest coverage of 5.1x.

Management has stated that they will likely pursue external growth in the water sector. The broad sector is in need of consolidation in Italy, due to the average small size of players, and the government is gradually introducing incentives to facilitate the process, albeit with little success.

Currently we are not factoring in specific external growth initiatives for Acea, due to the lack of visibility on potential transactions and on their funding (mergers vs. debt-funded acquisitions). Management's approach to leverage is rather conservative, while majority shareholder, the City of Rome, would consider diluting its stake in Acea to accommodate its growth ambitions.

Parent and Subsidiary Linkage
Acea is 51%-owned by the City of Rome (BBB/Negative). We view legal, operational and strategic ties between the parent and its subsidiary as overall limited. While five Board members out of nine are appointed by the City of Rome, Acea's credit exposure to its majority shareholder has reduced substantially between 2011 and 2014 and dividend payout has been reasonable, as confirmed in the updated business plan.

Based on these factors, we would allow a two-notch rating differential between the parent and Acea. This means that should the City of Rome be downgraded to 'BBB-', Acea would be allowed to keep its current rating to the extent that the standalone profile of the company is unaffected by the downgrade of the city. However, we would undertake another review should the rating differential increase further.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Acea include:
- EBITDA growth for regulated sectors reflecting a return on capital invested of around 5%
- EBITDA growth of the environment division at a CAGR of around 10%
- A low single-digit reduction of the energy division's EBITDA
- A decrease of the tax rate to consider the recent cancellation of the Robin Hood Tax in Italy
- Moderately positive evolution of working capital, mainly reflecting the settlements to be received in the water sector with no impact assumed from the new billing system
- Capital expenditure of EUR2.3bn across the business plan
- Dividends payout at the upper end of the 50%-60% range
- No major acquisitions

RATING SENSITIVITIES

Positive: future developments that may lead to a positive rating action include:
- FFO net adjusted leverage below 4.0x on a sustained basis
- Shift in the activities' mix towards regulated and a proven track record of predictability of water regulation

Negative: Future developments that could lead to negative rating action include:
- An increase of FFO net adjusted leverage above 5.0x and FFO interest coverage below 3.5x over a sustained period, for example as a result of debt-funded acquisitions
- Adverse regulatory changes or a shift in the activities' mix towards unregulated, affecting the predictability of cash flows
- A downgrade of the City of Rome leading to deterioration in the credit profile of the company

LIQUIDITY

Acea's liquidity is adequate. At end-March 2015 the group had readily available cash of EUR892m. As a consequence of the sizeable cash available, the group decided not to undertake undrawn committed credit lines at the same date. The cash level compares comfortably with debt maturities of EUR52m for April-December 2015 and EUR257m for 2016, while FCF is expected to be negative for EUR129m in these two years. Acea accessed the bond market in July 2014 with a 10-year EUR600m bond and reported gross debt (EUR3,177m at end-March 2015) has an average maturity of more than seven years.