OREANDA-NEWS. August 11, 2015. Fitch Ratings has affirmed Gas Natural SDG, S.A.'s Long-term Issuer Default Rating (IDR) at 'BBB+' with a Stable Outlook. A full list of rating actions is at the end of this rating action commentary.

The affirmation is based on our expectation of deleveraging following the acquisition of Chile's largest utility company Compania General de Electricidad SA (CGE, AA-(cl)/Stable) for EUR2.5bn in late 2014. According to our projections, Gas Natural's funds from operations (FFO) adjusted net leverage will be above negative rating guideline of 4.0x at end-2015 but should return to a level commensurate with the rating (below 4.0x) in 2016-2017. This is thanks to our projections of positive free cash flow and a slight growth in FFO in this period.

We assume no large debt-funded acquisitions. We expect the company's updated business plan for 2016-2018, which will be delivered in late 2015, to communicate a continuation of the deleveraging trend following the CGE acquisition. Failure to bring FFO adjusted net leverage down to below 4x in 2016 may lead to negative rating action.

KEY RATING DRIVERS
CGE Acquisition
Fitch affirmed Gas Natural's ratings in October 2014 following the company's announcement of the acquisition of a 96.7% stake of Chile's CGE for EUR2.5bn. The rating action reflected our view that the CGE acquisition will have a moderately positive impact on Gas Natural's business profile, due to increased geographical diversification, the Chilean utility's high share of regulated activity in EBITDA as well as our expectation of de-leveraging following the acquisition.

Chile (A+/Stable) is one of the highest-rated Latam countries with a predictable regulatory regime. As a result of the acquisition, Gas Natural has changed its mix of Spanish versus international business to 49:51 from 56:44, reducing the company's exposure to the Spanish market, which has been subject to unfavourable regulatory changes in the past few years.

We consider CGE a sensible strategic fit for Gas Natural due to its focus on natural gas distribution and electricity distribution and transmission, the highly regulated character of its revenues and its leading market position in Chile. Fitch expects a moderate reduction in the profitability of CGE's natural gas distribution business due to planned changes to regulations and the bulk of synergies only crystallising from 2017.

Temporarily Weaker Credit Metrics
The acquisition has temporarily increased Gas Natural's FFO adjusted net leverage above our negative rating guideline of 4x. This eliminates rating headroom. The negative impact of the CGE acquisition on leverage was mitigated by two hybrid bond issues totalling EUR1.5bn issued in November 2014 and April 2015, for which we allocate 50% equity credit.

We project FFO adjusted net leverage to return to a level commensurate with the rating (below 4.0x) in 2016 and to improve further in 2017, due to deleveraging in line with the company's current strategy.

Balanced Business Profile
The ratings are supported by Gas Natural's integrated strong business profile in both gas and electricity. A significant portion of the company's earnings (52% of 2014 EBITDA) are regulated and mainly derived from its gas and electricity distribution activities in Spain and Latam, providing cash flow visibility. This is despite the 2012-2014 regulatory changes in Spain that reduced regulated earnings.

The CGE acquisition will slightly increase the share of regulated EBITDA. In addition, about 5% of 2014 EBITDA was quasi-regulated, comprising mostly long-term contracted generation in Latam.

Easing Spanish Regulatory Risk
The recent reforms implemented in Spain for electricity and gas have successfully tackled the tariff deficit (TD) issue but also reduced regulated earnings of utilities. In a financially more balanced and sustainable electricity and gas system we expect regulatory risk to decrease. The company's 2014 revenues were reduced by EUR141m due to regulatory changes, of which 70% is from electricity distribution. Fitch expects pending reforms (ie, remaining parameters for electricity distribution, capacity payments and mothballing) to affect future earnings to a lesser extent.

Potential Tariff Surplus
We believe that the sector could register an electricity 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.

In our opinion, after successful contention of the 2014 TD, the Spanish electricity market should have limited need for future substantive regulatory change.

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 gas, we acknowledge the existence of a system surplus since 1H15 that has to be dedicated to amortise the existing gas tariff deficit, which is nevertheless far lower than the electricity market's.

Increasing Political Risk
Some uncertainties are arising from the upcoming general elections in Spain in December. 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.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- EBITDA of around EUR5.3bn in 2015 with a CAGR of around 2.5% for 2016-2018. This is considering fairly stable performance of current operations in Europe, particularly regulated electricity and gas distribution; significant growth in Latam regulated activities. We expect the impact of lower margins in LNG supplies to be partially mitigated by higher volumes due to new procurements contracts and higher fleet activity.
- Accomplishment of the EUR300m efficiency programme by 2015 and no further efficiencies.
- Growing leakage due to dividends paid to minorities over the period. Our estimate for 2015 is around EUR250m.
- New debt is issued with a cushion of +200bps over the borrowing cost of recent issuance.
- Capex of EUR2bn on average for 2015-2018.
- No further M&A activity has been considered.
- Dividends as per the company's current strategic plan based on a 62% pay-out ratio.

RATING SENSITIVITIES
Positive: Future developments that could lead to positive rating action include:
- Reduction of FFO adjusted net leverage to around 3.0x or below on a sustained basis and FFO interest coverage around 5.5x or above on a sustained basis.
- Improvement in the operating and regulatory environment in the main markets of operation.

Negative: Future developments that could lead to negative rating action include:
- FFO adjusted net leverage above 4.0x and FFO interest coverage below 4.5x on sustained basis.
- Substantial deterioration of the operating environment or further government measures substantially reducing cash flows.
- Substantial decrease in the share of regulated and quasi-regulated EBITDA leading to lower cash flow visibility.

LIQUIDITY AND DEBT STRUCTURE
Gas Natural's liquidity position remains strong. At end-June 2015 it had EUR2.2bn in cash and cash equivalents available plus available committed credit facilities of EUR7.2bn. This is sufficient to meet debt maturities for over 24 months. We forecast a declining amount of cash in hand with EUR3.6bn at end of 2014 to around EUR2.5bn over the rating horizon following the liability management strategy aimed at optimising financial results. We expect Gas Natural to generate positive FCF in 2015-2018.

Gas Natural's FX risk management policy is for local subsidiaries to raise debt in local currencies so that operating cash flow and debt are in the same currency. At end-June 2015, 76% of group debt was euro-denominated and 5% US dollar-denominated.

FULL LIST OF RATING ACTIONS

Gas Natural SDG, S.A.
Long-term IDR affirmed at 'BBB+', Outlook Stable
Short- term IDR affirmed at 'F2'

Gas Natural Fenosa Finance BV
Senior unsecured rating affirmed at 'BBB+'
Euro commercial paper programme rating affirmed at 'F2'
Subordinated hybrid capital securities' rating affirmed at 'BBB-'

Gas Natural Capital Markets, S.A.
Senior unsecured rating affirmed at 'BBB+'

Union Fenosa Financial Services USA LLC
Subordinated debt rating affirmed at 'BB+'

Union Fenosa Preferentes, S.A.
Subordinated debt rating affirmed at 'BB'