Fitch Affirms Iberdrola S.A. at 'BBB '; Outlook Stable
The affirmation is based on our expectation of the successful delivery of the current business plan to 2016. Iberdrola made good progress enhancing the group's long-term sustainability and financial strength in 2014. Fitch's rating case assumes the completion of the potential merger of UIL Holdings (UIL) with Iberdrola's US subholding, Iberdrola USA (BBB/Positive). The merger would marginally improve the group's business profile due to the regulated nature of UIL's business. However, it would also lead to a slight deterioration in consolidated group's capital structure because of slightly higher leverage and minority dividend leakage.
We consider the financial leverage and coverage metrics are well placed within the guidelines for a 'BBB+' rating. We estimate funds from operations (FFO) adjusted net leverage at 4.4x and FFO interest coverage at 5.1x for 2015-2018 on average. This is based on management's commitment to maintain a balanced approach to growth, diversify away from merchant risk and focus growth on networks and renewables in stable regulatory frameworks (US, UK and Mexico). We also view positively the company's financial target of net debt to EBITDA at 3.5x.
KEY RATING DRIVERS
Satisfactory Delivery of Business Plan
Management is committed to deliver its target plan until 2016. This is supported by the high predictability of the group's cash flows. Around 53% of the consolidated EBITDA comes from the regulated activities and another 23% comes from quasi-regulated activities, including renewables and long-term contracted generation earnings. The volatility of the liberalised business is well managed in the short term. The main uncertainties in the business plan relate to the group's performance in Brazil, which is suffering from depressed macroeconomics and persistent drought. Brazil's contribution to consolidated EBITDA (Elektro) was EUR299m, 4% of total EBITDA at end-2014. The 39% equity participation in Neoenergia accounted for EUR35m in dividends for the consolidated group at end-2014.
Iberdrola managed to reduce its debt to EUR25.3m at end-2014 from EUR26.4m at end-2013 and moderately improved leverage and coverage credit metrics in 2014. This was mostly due to the Spanish 2013 tariff deficit (TD) securitisation of EUR1.2bn and strong cash flow generation offsetting around a EUR1bn negative impact on debt from foreign exchange.
Beyond 2016, we expect a shift to a steeper organic growth depleting excess capital build up in the group. Growth would still be focused on the areas offering long term stability and predictability, specifically networks and renewables. The dividend policy may be revised upwards. We expect management to maintain financial discipline in a potential new context of growth.
UIL Merger Marginally Positive
In Fitch's view the potential UIL acquisition would only marginally improve Iberdrola's consolidated credit profile given its small size relative to the consolidated group, the regulated nature of UIL's businesses and the predominant use of Iberdrola USA's equity and cash to finance the acquisition. This is partially offset by UIL's slightly more leveraged capital structure having a limited impact on consolidated leverage and additional dividend leakage to minorities. A recent negative draft determination from the Connecticut state regulator could represent a moderate negative adjustment in Iberdrola's expected profitability and a delay in the timeframe of the transaction, in our view.
The transaction is in line with the group's overall strategy, which allocates 57% of the investment efforts to networks, of which 22% is in the US. In terms of structural subordination, the transaction increases the external debt raised at the operating company level in the US, although the impact is manageable and within the limits allowed by our methodology.
Increasing Political Risk
Some uncertainties are arising from the upcoming general elections in Spain and the new energy strategy being formulated by the recently elected UK government. Increased political focus on the energy policy could lead to changes in the long-term energy strategy for both countries. In Brazil, the government has demonstrated support in mitigating the effects of the severe drought.
The change of the UK government following the 2015 elections gave rise to some regulatory changes and uncertainties in the UK energy sector. Specifically, the new government has recently announced the end of on-shore wind subsidies one year earlier than previously, in April 2016 instead of 2017. The government also indicated that it will focus more on energy affordability and the impact of policy decisions on consumer bills. However, the broader longer-term energy strategy remains uncertain.
General elections will take place in Spain in November. Regional and local elections in May this year have created a more fragmented political landscape where coalitions are more likely to be formed. The energy policy could be subject to review based on new views gaining weight in parliament.
We view the group's regulatory risk exposure as reducing overall. Significant reforms have been completed in Spain and the new eight-year price controls introduced in the UK for both electricity transmission and distribution. The risks of upcoming reviews in US networks are factored into Fitch's rating case through conservative assumptions.
Potential Tariff Surplus
We believe that the sector could register a tariff surplus from 2015 following close to zero contribution to TD in 2014. The improvement in the system's sustainability is markedly cost-driven, although some additional relief could come from revenues if initial positive signs in increased electricity demand materialise.
However, the outstanding EUR27bn of historical debt still raises some risks. Future decisions on where to allocate potential surpluses (i.e early cancellation of outstanding debt, lower end-users tariffs or speed-up of needed investments in networks and renewables) will be relevant for measuring the government's commitment towards the system's financial strength.
In December 2014 Iberdrola cashed in EUR1.2bn of 2013 TD. At the end of March, the temporary deficit pending collection is EUR309m. Collection will occur throughout the year through the Comision Nacional de Mercados y la Competencia settlements. If any new TD was generated from 2014 in the system, Iberdrola's share would be 15% compared with 35% previously.
Persistent Weak Market Dynamics
Market conditions remain weak, affecting pool prices, spark and dark spreads and expected gross margins in the liberalised business in Spain and the UK. Fitch's base case stresses earnings for this business line applying our conservative expectations on prices and spreads. In addition, given the results of the Competition Markets Authority investigation in the UK and its suggestion to introduce a price cap as a temporary solution, we expect UK supply margins could reduce again.
However, Iberdrola's strong market position and flexible low-cost generation assets in Spain support above-average profitability in the liberalised business even in the context of persistent weak market dynamics. In the long term, Iberdrola is well positioned to keep capturing strong generation margin per MWh in a context of demand recovery, moderate reduction of overcapacity in Spain and upward pressure on CO2 prices.
Supportive Renewables
Iberdrola's credit profile is further enhanced by renewables business with support mechanisms. The renewables division contributed EUR1.3bn in 2014 (19% of 2014 EBITDA), 12% less than the previous year due to the adjustment of its 5.5GW of Spanish wind capacity that left almost 50% of the installed capacity without premium.
Despite previous negative precedents, the regulatory framework for renewables in Spain brings stability and visibility, as it targets strict adherence to the principles of reasonable return and financial sustainability of the electricity system.
In the UK, the early ending of the on-shore wind subsidy one year earlier is one of the drastic measures already taken by the new government. However, the change will have a limited impact on Iberdrola. A substantial part of Iberdrola's onshore wind projects pipeline will benefit from the grace period because their permits are at a well advanced stage.
A new offshore wind project, East Anglia One, is expected to start operations in 2019, and secured the 15-year price under the new contracts for differences regime. We expect UK renewables to generate steady cash flows in the medium to long term.
Adaptive Financing Model
Iberdrola's management intends to optimise the group's capital structure. The plan is to bring leverage at the major subsidiaries in line with a sound investment grade rating level or the level acceptable by the regulator. This would be achieved via down-streaming of inter-company loans rather than raising external debt in order to avoid structural subordination.
In our view, there is no immediate rating impact from the proposed changes. However, we will monitor the structural subordination and subsidiary leverage. Leverage substantially exceeding the group level may prompt us to reconsider the application of the Parent and Subsidiary Rating Linkage criteria to the rated subsidiaries, Scottish Power Ltd (SPL) and Scottish Power UK plc (SPUK). We expect the progression towards the target capital structure to be gradual.
Scottish Power Aligned
The IDRs of SPL and SPUK are currently aligned with Iberdrola's IDRs based on Fitch's Parent and Subsidiary Rating Linkage methodology as Fitch assesses the operational, strategic and legal links between the two companies to be strong. SPL and SPUK continue to exhibit stronger credit profile than their parent, Iberdrola.
On a standalone basis, SPUK and SPL's credit profiles are stronger than Iberdrola's as they benefit from the moderate leverage and strong business mix. In 2014, around 63% of consolidated EBITDA came from the regulated electricity distribution and transmission networks and another 16% from the quasi-regulated renewables business. A more volatile competitive supply and generation business contributed the remaining 19%.
Although cash flows generated by the regulated networks are generally stable and predictable, transition to the new, tougher RIIO-ED1 price control from April 2015 will cause a downward shift in the networks' EBITDA. This is due to lower allowed weighted average cost of capital and higher demanded outputs. According to our estimates, networks' EBITDA could reduce by around 2%-5% in 2015. After 2015 we expect networks' EBITDA to grow at around 2.5% driven by inflation and relatively high capex.
KEY ASSUMPTIONS
- Successful execution of Iberdrola USA and UIL Holdings merger in 2015 (pro-forma 2015 with merger from January)
- EBITDA of EUR7.1bn in 2015 from EUR7bn in 2014 and CAGR of around 4% up to 2018. This is due to UIL's EBITDA contribution of above EUR300m, slightly lower earnings from liberalised generation, steady contribution from networks and moderate growth in renewables.
- Capex and acquisitions net of disposals of EUR4.3bn on average for 2015-2016 and EUR4.8bn on average for 2017-2018 (Fitch definition of capex, which includes intangible capex and capitalised costs compared to Iberdrola's reporting).
- No new TD in Spain from 2014. Some temporary tariff adjustments are affecting the short term.
- An additional 200 bps added to the average current effective interest rate for new debt issuance.
- Dividends maintained at EUR0.27 per share in 2015 and 2016 and revised upwards from 2017. A scrip issue is assumed in line with its historical level. However, this will be offset by large treasury stock re-purchase in order to avoid dilution and maintain a stable number of shares.
RATING SENSITIVITIES: IBERDROLA
Positive: Future developments that could lead to positive rating action include:
- Over-performance on our expectations with capital structure targets supporting FFO adjusted net leverage substantially below 3.5x and FFO interest coverage above 5.0x on a sustained basis.
Negative: Future developments that could lead to negative rating action include:
- Underperformance on our expectations with an increase of FFO adjusted net leverage up to and above 4.5x and FFO interest coverage below 4.0x on a sustained basis.
- Deterioration of the operating environment or further government or regulatory measures in the key areas of operation substantially reducing cash flows.
RATING SENSITIVITIES: SCOTTISH POWER
Should SPL and SPUK exhibit standalone credit profile materially weaker than the group we could reconsider our rating approach under the parent and subsidiary methodology.
LIQUIDITY
As of 31 March 2015, Iberdrola had cash and cash equivalents of EUR1.9bn, plus available committed credit facilities of EUR5.9bn maturing in 2016 and onwards. At end 1Q15, liquidity position was equivalent to over 24 months of the company's financing needs, including our expectations of positive to neutral FCF and the one-off EUR500m cash payment for the potential merger of Iberdrola USA and UIL.
In line with its objective to optimise liquidity, Iberdrola executed several restructuring transactions in 2014 and 1Q15 with the aim of aligning the group's liquidity buffer with the new improved operating scenario and optimising associated financial costs. As a result there has been a reduction in committed credit lines of around EUR2.3bn with an increase in duration compared with December 2013. Despite these adjustments, we maintain our view of strong liquidity position.
FULL LIST OF RATING ACTIONS
Iberdrola, S.A.
Long-term Issuer Default Rating (IDR) affirmed at 'BBB+'; Stable Outlook
Short-term IDR affirmed at 'F2'
Senior unsecured affirmed at 'BBB+'
National senior unsecured rating affirmed at 'AAA(mex)'
Iberdrola International BV
Senior unsecured rating affirmed at 'BBB+' Commercial Paper rating affirmed at 'F2'
Subordinated notes rating affirmed at 'BBB-'
Iberdrola Finanzas, S.A.U.
Senior unsecured affirmed at 'BBB+'
National senior unsecured rating affirmed at 'AAA(mex)'
Iberdrola Finance Ireland Limited
Senior unsecured affirmed at 'BBB+'
Scottish Power Limited (SPL)
Long-term IDR affirmed at 'BBB+'; Stable Outlook
Short-term IDR affirmed at 'F2'
Senior unsecured affirmed at 'BBB+'
Scottish Power UK (SPUK)
Long-term IDR affirmed at 'BBB+'; Stable Outlook
Short- term IDR affirmed at 'F2'
Senior unsecured affirmed at A-'
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