OREANDA-NEWS. August 03, 2015. Fitch Ratings has downgraded SSE PLC's Long-term Issuer Default Rating (IDR) to 'BBB+' from 'A-'. The Outlook is Stable. Fitch has also downgraded SSE's senior unsecured debt to 'BBB+' from 'A-', and subordinated notes, including all outstanding hybrid issuance, to 'BBB-' from 'BBB'. The Short-term IDR has been affirmed at 'F2'.

The downgrade reflects headwinds across the business with lower regulated distribution earnings under the RIIO-ED1 price control, gas price weakness lowering dark spreads and upstream profitability, adverse changes to renewables remuneration and margin pressure in supply. It also reflects the recent upstream gas acquisition which adds to Fitch-expected leverage being above the guidance for the previous rating. SSE has an increasingly inflexible capital structure, and its dividend policy remains aggressive.

KEY RATING DRIVERS
Regulated, Hedged Cash Flow Profile
SSE's cash flow is highly regulated, with 45% of EBITDA from networks and an estimated 29% from renewables. It is the only UK player in electricity transmission, electricity distribution and gas distribution, with a regulatory asset value of GBP7.35bn split 24%, 43% & 33%, respectively. SSE allocates 60% of capex to networks and the percentage of regulated earnings will likely increase. With no recovery currently implied in UK forward prices and limited capacity payments from October 2018, Fitch assumes no real recovery in generation. SSE has commodity exposure as a competitor in electricity & gas supply markets. However, renewables provide a hedge to an increase in power prices. Conversely, low generation earnings are partly offset by regulated earnings.

Regulatory Pressure in Electricity Distribution
Following Ofgem's final determination last November, Fitch has lowered EBITDA estimates in electricity distribution, although this is partly offset by strong growth in transmission EBITDA in FY16. A potential source of uncertainty is the Competition & Markets Authority's (CMA) appeal of the RIIO-ED-1 price control, with a final determination due in September/October 2015. The issue is complex and there is a range of outcomes from positive to negative. Electricity distribution contributed 30% of FY15 EBITDA.

Renewed Pressure in Supply
Despite freezing bills until July 2016, SSE's customer losses have continued, particularly in electricity. SSE was one of the last companies to cut gas tariffs this year. The price cut may mean lower supply margins in FY16 and market share of the independent suppliers has risen to 12.6% from 9.0%. The level of customer losses and margins suggest that competition is alive and well. CMA proposals in July for potential price caps on the most expensive tariffs and fresh efforts to move customers off standard variable tariffs suggest that pressure on supply margins may continue. It may also take time before customer trust in energy suppliers is restored. Supply contributed 17% of FY15 EBITDA.

Challenges in Generation, Renewables
Conventional generation remains challenged by weak gas prices and increases in Carbon Price Support, lowering dark spreads. SSE has contracts for 4.4GW of capacity for 2018/19 peak demand, but at low prices. The failure of 2.8GW of capacity to win contracts questions its long-term viability. The positive offset is potentially lower capex in that SSE will only invest in assets successful at the next capacity auction in December 2015.

Driven by a substantial capacity build, onshore wind has masked weakness in conventional generation and been a key contributor to earnings growth. SSE chose not to participate in the first contracts for difference (CFD) auction for new renewables capacity in February 2015. The CMA's July proposals to look for better value for customers from the CFD mechanism imply this may continue, suggesting lower growth and capex in renewables in the long term. The UK government has brought forward the end of the Renewables Obligation (ROC) subsidy for onshore wind by a year to April 2016. The change does not affect SSE's current construction projects of 475MW. However, the permitting process has been shifted from central to local government, which may further delay the process. Renewables account for an estimated 29% of FY15 EBITDA.

Limited Flexibility in Capital Structure
SSE's equity cushion has been shrinking under the impact of continued asset impairment losses and an aggressive dividend policy. The risk is that a continuation of these trends would take hybrid equity credit beyond 30% of adjusted equity, possibly as early as FY16. Unless generation assets are successful at the next capacity auction in December or there is a substantial take up of scrip rather than cash dividends, this is a real possibility. We believe that there is limited scope for SSE to issue further hybrids that may aid leverage metrics and following the upstream gas acquisition, we expect FFO net adjusted leverage to be above 4.0x during FY16-FY18. However, SSE may have some flexibility around its target of asset disposals of GBP1bn.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for SSE include recurring asset impairment losses of GBP600m in FY16 and GBP300m in FY17, lower UK corporation tax rate of 19% from FY18 (from 20%), assumed dividend growth based on Fitch RPI estimates of 2.5% from FY17 & 20% scrip take up; asset disposals of GBP200m in each of FY16 and FY17. We also include the recent gas upstream acquisition from Total, funded by debt, for GBP565m.

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- Expected FFO net adjusted leverage of 4.0x, FFO fixed charge cover of 3.5x, on a sustainable basis.
- Significant regulatory outperformance, recovery in generation and supply market or more support for renewables improving the business risk.
- The debt ratings may be upgraded by one notch if we deemed regulated EBITDA to contribute to above half of the company's total. Fitch typically notches up debt ratings of regulated networks due to our higher recovery prospects assumption.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Underperformance across the businesses, for example failure to win generation capacity market contracts for FY19.
- Expected FFO net adjusted leverage of more than 4.5x, FFO fixed charge cover below 2.5x, on a sustainable basis.

LIQUIDITY AND DEBT STRUCTURE
As at 31 March 2015, SSE had cash and cash equivalents of GBP1,512.3m plus committed lending facilities of GBP1.5bn, GBP150m of uncommitted bank lines and a GBP15m overdraft bank facility. Around GBP700m of term loans mature in FY16. Of these loans, GBP200m matures in June 2016 and GBP500m matures in September 2016. In FY16 free cash flow is expected to be around negative GBP650m. However, Fitch expects SSE to access debt markets to ensure that it has available committed borrowings & facilities equal to at least 105% of forecast borrowings over a six- month rolling period and liquidity is adequate until September 2016.