OREANDA-NEWS. Fitch Ratings has affirmed Wales & West Utilities Limited's (WWU) and Wales & West Utilities Finance plc's (WWUF) senior secured ratings as follows:

WWU
Class A bank debt: affirmed at 'A-'; Outlook Stable
Class B bank debt: affirmed at 'BBB'; Outlook Stable

WWUF
Class A bonds: affirmed at 'A-'; Outlook Stable
Class B bonds: affirmed at 'BBB'; Outlook Stable

The affirmation reflects WWU's strong operational and regulatory performance in the first two years of the new price control (RIIO-GD1, eight-year period starting on 31 March 2013), with cost outperformance above the company's target levels. WWU's credit profile continues to be supported by low business risk stemming from the supportive and transparent UK regulatory framework. Fitch expects most of the company's credit metrics to remain commensurate with the ratings during GD1. The senior secured ratings benefit from the structural enhancements embedded in the secured covenanted financing model.

WWU's financial profile is constrained by index-linked hedging which generates net cost rather than benefit. The net cost is ultimately reflected in the cash flows as indexation accretion is paid down every three years. Fitch views an increase in the negative cash impact from the swap portfolio as a rating risk, as it could put pressure on the company's credit metrics.

KEY RATING DRIVERS
Low Business Risk
WWU is the sole owner and operator of the gas distribution network (GDN) in Wales and the south-west of England, regulated by Ofgem. The company's operating cash flows are highly predictable due to the long-term regulatory framework. Although output and efficiency targets are tougher and allowed returns are lower under RIIO than under the previous price control, the regulatory framework remains supportive and transparent.

Secured Financing Structure
The senior secured ratings benefit from structural enhancements afforded by financing covenants, ring-fencing (including dividend lock-up covenants), debt service reserve liquidity, standstill regime and the control over the shares in WWU.

Solid Regulatory Performance
During the first regulatory year, WWU performed adequately on most outputs, outperforming on gas leakages, customer satisfaction and fuel poor network connections. The absolute size of financial reward for output outperformance in FY14 was around GBP3.93m, with no financial penalties incurred. WWU ranked third on totex outperformance among all the GDNs in FY14.

Totex outperformance in FY14 was 15%, as reported by Ofgem in the first year annual GD1 report. According to the company's preliminary assessment, totex outperformance in FY15 was around 19%. WWU believes it could achieve an average totex outperformance of 14% during GD1, which is materially above Fitch's assumption last year of 9%. Retention of outperformance within the business and a limited increase in equity distributions is credit positive.

Credit Ratios within Guidance
Fitch expects net debt to RAV to average 65% for class A debt and 75% for class B debt during the eight-year GD1 period. This is comfortably within our guidance of 70% and 77.5%, respectively. Average PMICR (excluding swaps) is also expected to remain above the downgrade guidance, at around 1.6x for class A debt and 1.4x for class B debt. We anticipate actual PMICR to reach its peak at the beginning of GD1 and to gradually reduce towards the end of price control due to a shrinking 'fast money' pot. This is because of the annual 7.1% increase in replacement expenditure capitalisation rate set out in final determinations.

Value Loss through Index-Linked Swaps
As at 30 December 2014, WWU's capital structure included RPI index-linked swaps with a notional principal of GBP1bn. These were initially put in place as a hedge against inflation-linked revenue. The portfolio is deeply out-of-money and the company incurs net costs of carrying the swaps in its capital structure. Deferred RPI indexation payments provide only a short-term benefit to the cash interest due to three-year mandatory pay-down provisions.

Fitch views WWU's index-linked swap portfolio as a rating risk. A costly extension of 2018 and 2020 mandatory swap breaks (GBP140m notional in each of the years) or an RPI exceeding 3% could put additional pressure on the company's cash flows. Conversely, a change in the company's financial strategy could alleviate the pressure.

PMICR including annual swap costs (treating accretion as part of the annual interest) is considerably lower than PMICR excluding swaps impact. According to our calculations, which incorporate multiple assumptions on the level of RPI, swap renegotiation fees and LIBOR, PMICR including annual swap costs becomes too low for the class A bank and bond ratings from 2019. Should our assumptions materialise and should net swap costs increase beyond the level consistent with the current ratings, we may reconsider the ratings. We would take into account the headroom under gearing ratio, which helps absorb the net swaps impact.

Cost of Debt Mismatch Unfavourable
The cost of debt allowed under GD1 takes into account the change in real market rates as it is based on the iBoxx 10-year simple trailing average index. Conversely, WWU's cost of debt has very little floating-rate exposure. At 30 December 2014 the company's total borrowings, including the impact of hedging, comprised 40% fixed rate debt and 56% fixed real rate debt. This mismatch is a disadvantage for the company at present, when the market rates are low as it leaves less headroom for WWU to outperform its allowed cost of financing. However, if market rates went up, the mismatch would turn into an advantage.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Allowed cost of debt in line with current Ofgem's assumptions (2.72% real in FY15 and 2.55% real thereafter)
- Average RPI increase of 2.8% over the eight-year GD1 period
- Totex outperformance of 11.5% on average for the whole RIIO-GD1
- Annual incentive income of GBP2.6m on average for the whole RIIO-GD1 (in 09/10 prices)
- 4.5% fixed rate on the new bank/bond debt financing

RATING SENSITIVITIES
Class A
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
-Leverage less than 65% and PMICR (excluding swaps) in excess of 1.6x
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
-Failure to achieve expected operational performance leading to leverage in excess of 70% and PMICR (excluding swaps) consistently below 1.4x
-Significant increase in net swap costs leading to significant weakening in PMICR (including net swaps cost) and leverage approaching 70%

Class B
Positive: Future developments that could lead to positive rating actions include:
-Leverage less than 73% and PMICR (excluding swaps) in excess of 1.3x
Negative: Future developments that could lead to negative rating action include:
-Leverage in excess of 77.5% and PMICR (excluding swaps) less than 1.1x

LIQUIDITY
As at 30 December 2014, WWU's total liquidity amounted GBP352.4m, including cash and cash equivalents of GBP42.4m, undrawn committed revolving facility of GBP150m (expiring in December 2018) and undrawn EIB bullet loan of GBP160m (maturing in December 2026). Liquidity also includes a debt service reserve facility of GBP70m, and an operating reserve facility of GBP20m. The nearest contractual maturities include a swap accretion payment of GBP86.9m in March 2016 and a GBP200m class A bond maturing in December 2016. Fitch expects negative free cash flow in the year ending 31 March 2016 to be around GBP27m.