Fitch Affirms JSC Federal Grid Company UES at 'BBB-'; Outlook Negative
FedGrid's rating continues to incorporate state support to reflect relatively strong operational and strategic and to a lesser extent legal ties between the company and its ultimate majority indirect shareholder, Russian Federation (BBB-/Negative), as per Fitch's Parent and Subsidiary Rating Linkage methodology. Although we continue to assess the state support as commensurate with the two-notch uplift to FedGrid's 'BB+' standalone rating, Russia's rating of BBB-/Negative currently limits the uplift to one notch. The Negative Outlook on FedGrid's Long-term IDRs mirrors that on the sovereign.
FedGrid's standalone rating of 'BB+' benefits from its monopoly position in electricity transmission in Russia and low volume risk but is constrained by high risk inherent in the Russian regulatory framework.
KEY RATING DRIVERS
'BB+' Standalone Rating
FedGrid's standalone rating is driven by its position as the owner and operator of the national monopoly electricity transmission grid in Russia, and its relatively low volume risk as well as improved cash flows and margins. However, uncertainty and unpredictability inherent in the Russian regulatory framework as well as high political risk in the tariff-setting mechanism, constrains Russian utilities' standalone ratings to sub-investment grade. FedGrid's standalone profile is also constrained by the company's extensive capex due to its modernisation and development needs, which are likely to result in continued negative free cash flow.
Low Leverage But Weaker Coverage
FedGrid reported better than expected 2014 financial results, mainly driven by cost optimisation. The Fitch calculated 2014 EBITDA margin increased to around 59.2% from 55.7% in 2013. While we expect FedGrid's leverage metrics to remain solid, we forecast its coverage ratios will breach Fitch's negative rating guidelines over 2015-2018. We forecast funds from operations (FFO) net adjusted leverage to remain below 3.0x over 2015-2018 and FFO interest cover to stay below 3.5x. This is based on our assumptions of modest electricity tariffs growth largely below inflation and high interest rates of 12% for all new debt to be raised over 2015-2018. However, we expect moderation of inflation coupled with continued implementation of cost optimisation measures to soften pressure on interest coverage in the medium term.
State Support
Russia's 'BBB-' rating limits the current uplift to FedGrid's standalone rating to one notch for state support. However, we continue to view the strength of the state support to be commensurate with a two-notch uplift in accordance with Fitch's Parent and Subsidiary Rating Linkage methodology. This is due to the fact that we continue to assess the strategic, operational, and to a lesser extent legal ties between the company and the Russian Federation as fairly strong. The strength of the ties is underpinned by the company's position as the national electricity transmission grid operator, its inclusion in the list of strategic enterprises that subject the company to special bankruptcy and insolvency procedures as well as special procedures regarding voting shares sale or dilution, and a track record of tangible state support. This includes an equity injection of RUB60.6bn over 2009-2014 to fund the company's capex and state pension fund financing of long-term infrastructure projects with long-dated CPI-linked infrastructure bonds of RUB100bn in 2014 and RUB40bn in 2015. Moreover, after the transfer of the state's stake in FedGrid to Russian Grids in 2013, the Russian government signed a shareholders agreement with Russian Grids to retain control of FedGrid.
Low Business Risk
FedGrid's revenue depends on electricity transmission tariffs, which are approved until 2019 and are mostly linked to CPI. The company faces limited volume risk as the current electricity transmission tariffs are set based on, among other factors, customers' declared electricity capacity needs and not on actual electricity consumption. Customers declare their capacity needs for a five-year period, but they are reviewed and adjusted annually. FedGrid bills actual capacity if the customer exceeds its declared capacity.
FedGrid's business profile benefits from a moderately diversified and stable customer base of above 440 customers at end-2014, including distribution and independent grid companies, power-selling organisations and certain industrial customers. The gradual switch to tariff calculations based on actual capacity with the simultaneous introduction of capacity reservation payments is under discussion.
Capex Subject to Market Conditions
FedGrid has an extensive investment programme of RUB278bn (net of value-added tax) over 2015-2018 that we expect will be mostly debt funded. However, the company's capex has some flexibility and could be adjusted to market conditions (i.e. unfavourable interest rates, etc.). In 2014 the company demonstrated its capex flexibility decreasing it by more than 40% yoy to RUB74bn from the average of RUB133bn over 2009-2013. We do not expect a significant capex increase in the medium term.
Long-Term Tariffs
At present, FedGrid's tariffs are approved by the Federal Tariff Service for 2015-2019 assuming annual tariff growth in the range of 4.5%-7.5% from 1 July, linked to the CPI estimated by the Ministry of Economic Development of Russian Federation. The company expects its 2016-2019 tariffs growth rates to be re-adjusted as a result of higher CPI growth rates comparing with those estimated at end-2014. We conservatively forecast the long-term tariffs to grow on average 2% below Fitch forecasted inflation of 11.2% in 2015 and 6.0%-8.0% over 2016-2017.
Regulatory Framework
Since FedGrid mainly operates in regulated markets, we consider regulatory changes have a serious impact compared with Russian generating utilities, which are less exposed to regulated markets. 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. Since the long-term regulatory asset-based principles in electricity transmission tariff setting were introduced in 2010, which supported increased cash flows and margins, the government has revised the regulation and tariff levels several times to help keep end-user prices down due to political/social reasons. The high regulatory risk constrains the utilities' standalone ratings to sub-investment grade.
RATING SENSITIVITIES
Negative: Future developments that could lead to negative rating action include:
- Evidence of weaker state support and/or a downgrade of Russia.
- More ambitious capex programme resulting in deterioration of the financial profile (eg FFO adjusted net leverage exceeding 3.5x and FFO interest coverage below 3.5x on a sustained basis) could be negative for the standalone rating.
Positive: Future developments that could lead to positive rating action include:
- Revision of the sovereign's Outlook or an upgrade. If Russia is upgraded to 'BBB', FedGrid's rating is likely to revert to incorporation of a two-notch uplift for state support provided that the links with the state remain unchanged.
- Evidence of stronger state support (eg significant and consistent equity injections, state guarantees for FedGrid's debt, cross default provisions) coupled with an upgrade of Russia.
- A more transparent and predictable regulatory framework, coupled with the company's strong financial profile, which could be positive for the standalone rating.
For the sovereign rating of the Russian Federation, FedGrid's parent, the following rating sensitivities were outline by Fitch in its rating action commentary as of 3 July 2015:
Negative:
- A renewed bout of exchange rate volatility, leading to broader financial sector instability requiring greater public financial support to the banking sector.
- A return to low oil prices and/or continued recession in 2016, complicating the task of fiscal consolidation.
- Faster than forecast depletion of international reserves, reflecting larger than expected capital flight and/or accelerated dollarisation domestically.
- An intensification of sanctions or a geopolitical risk event.
The Outlook is Negative. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a positive rating change.
Positive:
- A reduction in tensions with the international community, resulting in an unwinding of sanctions and renewed access for Russian entities to international capital markets.
- A sustained recovery in the oil price, coupled with an easing of macroeconomic and financial stress.
LIQUIDITY AND DEBT STRUCTURE
Adequate Liquidity, No FX Exposure
FedGrid's cash position of RUB42.3bn at end-2014 is sufficient to cover its short-term maturities of RUB30bn. Its debt repayment schedule is not onerous and is relatively balanced at about RUB25bn annually on average. The group also has access to uncommitted credit facilities of RUB152.5bn mainly from major Russian banks. Forecasted negative free cash flow over 2015-2016 will add to funding requirements. FedGrid is not exposed to foreign currency fluctuation risk as all of its debt at end-2014 was denominated in local currency.
KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Domestic GDP decline of 3.5% in 2015 and growth of 1.0%-1.5% in 2016-2017 and inflation of 11.2% in 2015 and 6.0%-8.0% over 2016-2017
- Moderate electricity transmission tariff growth, below inflation
- Cost inflation in line with expected CPI
- Capital expenditure in line with management's forecasts
- Dividend payments of 10% of IFRS net income over 2016-2018
FULL LIST OF RATING ACTIONS
JSC Federal Grid Company UES
Long-term foreign and local currency IDRs affirmed at 'BBB-'; Outlook Negative
Short-term Foreign Currency IDR affirmed at 'F3'
Long-term National Rating affirmed at 'AAA(rus)'; Outlook Stable
Senior unsecured local currency rating affirmed at 'BBB-'
Federal Grid Finance Ltd
Senior unsecured local currency rating affirmed at 'BBB-'
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