OREANDA-NEWS. Fitch Ratings has assigned Italy-based utilities group Snam SpA (Snam) a Long-term Issuer Default Rating (IDR) of 'BBB+', a Short-term IDR of 'F2' and a senior unsecured rating of 'BBB+'. The Outlook on IDR is Stable.

The ratings mainly reflect Snam's incumbent position in regulated gas network activities in Italy, in a regulatory environment which we view as generally supportive and transparent. Negligible exposure to volume risk and non-regulated activities results in predictable operating cash flows, as demonstrated in the last three years notwithstanding the challenging economic environment in Italy and political interference (Robin Hood Tax for energy companies).

The ratings also take into account the negative impact of the pending regulatory determination on weighted average cost of capital (WACC), which will be partially offset by the recent abolition of the Robin Hood Tax. Fitch expects Snam to grow in gas distribution through upcoming tenders, which is likely to slightly increase leverage and year-on-year volatility for the group's credit metrics.

For the period 2015-2018 Fitch expects an average funds from operations (FFO) adjusted net leverage of 6.5x, FFO interest coverage of 6.1x and a net debt/regulatory asset base (RAB) of 54%. We see these ratios as consistent with the 'BBB+' rating.

The rating of senior unsecured debt instruments could theoretically benefit from a one-notch uplift from Snam's IDR given the group's regulated business profile. However, the uplift is not applicable in this case due to the constraint represented by the rating of the Republic of Italy (BBB+/Stable).

KEY RATING DRIVERS

Incumbent in Regulated Gas Activities
Snam is the dominant gas transmission system operator in Italy. Transmission activities contribute around 60% of consolidated EBITDA. The group is also involved in gas distribution (25%) and storage (13%) with negligible contribution from regasification and non-regulated activities.

Snam's strong business profile is supported by regulated activities backed by a transparent regulatory framework with a sound track record and insulation from gas volume risk. Snam reported stable EBITDA of around EUR2.8bn over the 2012-2014 period, notwithstanding a substantial decline in gas consumption in Italy (more than 20% over 2010-2014, adjusting for ambient temperature changes).

The group's key shareholder is CDP RETI (28.98%, BBB/Stable), which appoints six out of nine members of Snam's Board of Directors and is in turn owned (59.1%) by publicly owned Cassa Depositi e Prestiti (BBB+/Stable), confirming the strategic relevance of the group for Italy.

Regulation Supportive and Transparent
The group's activities are regulated by Autorita' per l'Energia Elettrica, il Gas ed il Sistema Idrico (AEEGSI) with regulatory periods of four years (transport and regasification, period 2014-2017 and storage, period 2015-2018) and six years (distribution, period 2014-2019). The tariff definition mechanism allows revenues to cover the remuneration of the regulatory asset base (RAB; with extra premium for strategic investments), depreciation and operating costs (with an efficiency factor) and includes an annual update for inflation. The general framework has been consistently applied with minimal differences across the various regulated businesses of the group.

Regulatory Determination Expected to Reduce WACC
The AEEGSI is currently revising the drivers of WACC used to remunerate the RAB for all regulated activities of gas and electricity, and published a consultation document in June 2015. The redetermination will be effective from 2016 and could be positive as long as it increases visibility and stability of returns for utilities companies, although most likely starting from a lower level of WACC. Fitch is assuming a WACC outcome of around 5% for transport and distribution activities compared with the current respective 6.3% and 6.9% and a WACC slightly below 6% for gas storage compared with the current 6%. We forecast this would lead to a 10% year-on-year drop in EBITDA for Snam in 2016.

Fitch does not expect major changes to the general framework (apart from a more selective approach on investments), since Italy compares well with European countries in terms of the low share of infrastructure costs on end users' energy bills (slightly less than 20%)

Tenders Awaited in Gas Distribution
Snam has a portfolio of more than 1,400 concessions in gas distribution. Concessions in Italy have mostly expired, but companies are entitled to run existing activities until a new tender procedure is started. We expect the tender process for gas distribution concessions to result in the considerable consolidation of the sector from 7,000 municipalities to 177 pools of municipalities (Ambiti Territoriali Minimi (ATEM)). New tendering could start by end of 2015 following severe delays, although further delays are possible in our view.

We consider concession renewal risk rather limited for Snam as the group has a significant competitive advantage compared with much smaller operators active in the same ATEMs. The risk of loss of concession is mitigated as outgoing operators are entitled to receive a reimbursement value ('valore industriale di realizzo') broadly in line with the RAB.

Fitch notes that management plans to increase Snam's market share in gas distribution to more than 40% (from around one third of the market), with a related potential net investment of around EUR1bn during the whole horizon of the tenders (currently estimated at four to five years).

Limited visibility on the tenders' evolution could bring volatility to Snam's credit metrics in a given year.

International Contribution Modest but Increasing
Outside Italy, Snam equity-accounts three main stakes in European transmission and storage companies. We expect dividends received by international associates to contribute around 6% to consolidated FFO over the period 2015-2018 and the weight of these stakes on Snam's Italian RAB to represent around 5% over the same period. A proportional consolidation of TIGF and TAG would leave Snam's credit ratios little changed.

Snam's stakes include Interconnector UK Ltd (31.5%, acquired in 2012 by two joint ventures 50-50% owned with Fluxys); TIGF SA (currently 40.5%, stake acquired in 2013), French gas transmission and storage; and TAG GmbH (84.47% of shares and 89.22% of economic rights), operating the Austrian section of the pipeline bringing Russian gas from Austrian/Slovak border to Italy.

The group could also evaluate the opportunity to acquire a minority stake in Trans-Adriatic Pipeline (TAP), given the strategic relevance of this project to the development of a transit gas market in Italy. This potential investment should have limited impact on the cash flows of the company, in Fitch's view.

Credit Ratios Consistent with 'BBB+'
Snam's BBB+ IDR incorporates conservative assumptions, including lower WACC assumptions from 2016, a low inflation environment, operating costs evolution, the inclusion of acquisitions related to the tenders in gas distribution and a broadly flat cost of debt. Based on these assumptions, we expect the FFO net adjusted leverage for the period 2015-2018 to average 6.5x, with an FFO interest coverage of 6.1x. We also factor in an average net debt/RAB of 54% in the same period, which takes into account the equity stakes held in associates.

Fitch believes that capex represents the main source of flexibility for the group to avoid deterioration of its credit ratios in case of unforeseen negative events. Snam has materially revised downward its capex plan in the last years (from EUR6.7bn in 2012-2015 to EUR5.1bn in 2015-18) in response to changes in the market and regulatory tightening on new investments' remuneration (as occurred with storage). On the other hand Fitch acknowledges that a significant reduction of dividends is unlikely, even after taking into account the expected reduction of WACC.

Improving Funding Conditions
Snam's cost of debt was 3.2% at end-2014 and factored in the issue of EUR6bn bonds in 2012 (when the yields on Italian issuers were high), as a consequence of its ownership unbundling from Eni SpA (A/Stable), which used to fund the company through intercompany loans. We expect interest coverage ratios to benefit from the refinancing of expensive bonds and debt portfolio optimisation in a low interest rate environment.

Reducing Tax Burden
Snam's future cash flows will benefit from the abolition of the so-called Robin Hood Tax. Snam's tax rate will decrease from 2015, benefiting from the cancellation of the 6.5% tax surcharge on the income of Italian energy companies. Snam will not be able to claw back the amounts already paid but it will nevertheless benefit from a positive impact of EUR100m annually (compared with 2014).

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Snam include:
- Inflation gradually rising to about 1% until 2018;
- Reduction of the WACC for gas transport and distribution to around 5% and for gas storage to below 6% from 2016 onwards;
- Operating costs rising slightly more than inflation;
- Cost of debt expected at 2.9% in 2015 and broadly flat thereafter;
- Tax rate benefiting from Robin Hood Tax's cancellation;
- Inclusion of acquisitions related to the tenders in gas distribution of EUR250m per year in the period 2016-2018 with additional proportional contribution to EBITDA and capex;
- Flat dividends.

RATING SENSITIVITIES

Positive: An upgrade is not likely in the next 24 months due to the expected reduction of regulated return and consequent decrease of operating cash flow. However, future developments that could lead to a positive rating action include:
- FFO net adjusted leverage declining below 6.0x on a sustained basis, assuming an unchanged business risk profile.

Negative: Future developments that could lead to a negative rating action include:
- Deterioration of FFO net adjusted leverage to above 6.75x, FFO interest coverage below 4.0x or net debt/(RAB+Associates) approaching 65% over a sustained period, for instance as a result of the regulatory review or higher-than-expected investments for gas distribution concession tenders;
- Growing exposure to unregulated activities, upward revision to Snam's dividend policy or material debt-funded acquisitions abroad;
- A downgrade of the Italian sovereign rating to 'BB+' from the current 'BBB+', which would lead to a downgrade of Snam's Long-term IDR to 'BBB' in line with Fitch's approach to eurozone sovereign and corporate links.

LIQUIDITY

Fitch assesses Snam's liquidity position as solid. The company's cash on balance at end-March 2015 amounted to EUR74m with an undrawn RCF of EUR3.95bn, which would comfortably cover negative projected free cash flow of around EUR700m in 2015-2016 and short-term debt maturities of around EUR1.6bn until end-March 2016.

The group's funding structure is standard with debt raised at the level of the parent company. The group's gross outstanding debt was EUR13.5bn at end-March 2015. To align the interest profile with the frequency of WACC update by the regulator (once every two years), Snam aims to have two-thirds of outstanding debt in fixed-rate and an average debt maturity of around five years. Bonds issued under the medium-term notes programme remain the main debt facilities (around 75% of total debt) and Fitch expects the group to continue to tap the capital markets to refinance the bonds expiring in the short- to medium-term.