OREANDA-NEWS. Fitch Ratings has assigned Kazakhstan-based Limited Liability Partnership Kazakhstan Utility Systems (KUS) Long-term foreign and local currency Issuer Default Ratings (IDR) of 'BB-'. A National Long-term Rating of 'BBB+(kaz)' has also been assigned. The Outlook is Stable.

The ratings reflect KUS's solid credit metrics, stable regional market share, its vertical integration and a benign regulatory regime at present. However, the ratings are constrained by uncertainties in the regulatory regime post 2015, the company's small size compared with its CIS rated peers, weak liquidity and limitation to corporate governance.

KEY RATING DRIVERS

Solid Credit Ratios
KUS's ratings are underpinned by the company's solid credit metrics and stable financial profile. Its EBITDA margin averaged 30% over 2011-2014 while funds from operations (FFO) gross adjusted leverage was modest at below 2.0x and FFO interest coverage was on average 9.0x. Although we expect moderate tariff growth and volume growth below our CPI and GDP forecasts, respectively, KUS's financial metrics are likely to remain strong with FFO gross adjusted leverage of around 2.0x and FFO interest coverage of above 4.0x over 2015-2018. Fitch expects KUS to remain well placed relative to CIS and international peers based on these metrics.

Vertical Integration
The company is integrated across the electricity value chain with the exception of fuel production and transmission, which gives the company access to markets for its energy output and limits customer concentration. KUS derives its EBITDA mostly from electricity distribution (51% of 2014 EBITDA) and electricity and heat generation (46%), with minor contribution from supply (2.7%). The heat generation business is loss-making due to regulated end user tariffs which are kept low for social reasons. Fitch expects both the generation and distribution segments to remain the main cash flow drivers for the group.

Stable Regional Market Share
KUS's business profile benefits from the company's near-monopoly position in electricity generation, distribution and supply in the central part of Kazakhstan (Karaganda region) and South Region, which are highly-populated (25% of country population). Energy deficit in South Region where the company generates around 23% of EBITDA supports demand for KUS's services there.

However, the business profile is constrained by the company's small operations, for example, its market share is less than 4% share of the country's electricity generation volumes, 3% by installed capacity, and 8.5% by lengths of lines. The company is thus smaller compared with Ekibastuz GRES-1 (BB+/Stable, with 15% market share in electricity generation), but similar in size to CAEPCo (BB-/Stable).

Cheap Fuel Supports EBITDA
Kazakh coal prices are significantly below international market rates, reflecting the low calorific content and high ash content of coal used domestically as well as low transport costs. To protect energy affordability, the coal price charged to utilities is reflected in tariff caps for electricity. An unexpected and significant increase in the price of coal above Fitch's current inflationary estimates would have a negative impact on EBITDA, if not reflected in electricity tariffs, although we consider this unlikely.

Moderate Capex
KUS's capex programme is aimed at increasing the company's ageing generation capacity by 2016, as well as upgrading its distribution network. Capacity expansion is expected by the company to be moderate and will depend on approved tariffs. The company estimates the investment programme of KZT51bn over 2015-2018, including maintenance capex on average of around KZT8bn over 2015-2019.

Credit metrics may weaken towards Fitch's trigger for a negative rating action if the company increases capex on expansion plans or potential M&A activity, but these will depend on market conditions, including the availability of funding and the tariffs set for new assets. In our rating case we assume capex for 2016-2018 to be in line with the historical average, which will result in slightly negative free cash flow (FCF) generation over 2016-2018.

Post 2015 Regulatory Uncertainties
Generation tariffs in Kazakhstan, which are set to cover KUS's fixed and variable costs and the majority of its capex requirements, are currently approved until end-2015. The post-2015 electricity generation tariff regime is uncertain. The company expects that the government will approve tariffs for 2016 and beyond during 2H15.

Existing regulation provides for the implementation of a two-tier tariff regime from 2016, with the government setting cap tariffs for the energy and capacity components for a seven-year period with possible annual revisions. Fitch expects that tariffs for generators will continue to reflect fuel and other cost inflation while capacity payments will cover capex needs. The electricity capacity market should ensure economically sound returns on investments and provide incentives for the construction of new generation assets or expanding current capacity.

Electricity distribution tariffs could switch from the 'benchmarking' methodology introduced in 2013 to long-term tariffs (five years) approval based on the 'cost plus allowable profit margin' methodology. Long-term (five years) heat generation and sales tariffs based on the same methodology are also under consideration to replace the present annual approval practice. Fitch views positively the potential switch to long-term tariff approval and a better framework for the heat business.

Weak but Manageable Liquidity
Fitch views KUS's liquidity as weak, but manageable. At end-July 2015 short-term debt amounted to KZT10.4bn (25% of company's total debt) against cash and cash equivalents of KZT3.8bn, supplemented by unused committed credit facilities of KZT3.4bn from Development Bank of Kazakhstan (BBB/Stable). The majority of short-term debt is liabilities to Falah Investment B.V. (private equity fund) of USD86.4m. KUS has signed a loan agreement with SB JSC Sberbank of Russia (BBB-/Negative) for KZT16.3bn (USD86.4m) at end-July 2015 to cover its liabilities to Falah. We assume that a shareholder loan would be provided, if needed.

All KUS's debt (bank loans, mostly secured) are raised at operating companies' level. We also expect additional facilities for funding the company's capex to be raised at the operating companies' level. However, the company is centrally managed, including its treasury functions, across operating subsidiaries by a single management board; we therefore focus on the consolidated group in our credit analysis. If unsecured debt is issued at the KUS (holding) level without guarantees from operating companies, especially if secured debt exceeds 2x EBITDA, we may consider such holdco debt as structurally subordinated, potentially affecting the debt rating (ie this could be notched down from the consolidated profile's IDR).

FX Exposure
All revenues and nearly all costs are denominated in KZT. KUS's current forex exposure is limited to the liabilities to Falah, which are maturing in 2015 and expected to be repaid by the local currency-denominated loan from Sberbank. All future borrowings are expected by the management to be raised in local currency, thus limiting FX exposure.

Privately Owned
Fitch views corporate governance at KUS as weaker than many larger state-owned Kazakh corporations rated in the 'BB' category. KUS's supervisory board is chaired by Dinmukhamed Idrisov (who owns Ordabasy Group PEF LLP - a private equity fund), a different name to the individual listed in the company's audited accounts as 99% owner of KUS's equity. We view the concentrated private ownership and a potential non-disclosure of related-party transactions as a rating weakness. However, the company is taking steps to improve transparency by going public over the medium term.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
- Electricity volume growth below Fitch forecasted GDP of 1.8%-4% over 2015-2018.
- Tariffs growth as approved by the regulator for 2015 and below inflation.
- Capex in line with what has been approved by the regulator for 2015 and with the historical average for 2016-2018.
- Inflation-driven cost increase.
- No dividends for 2015-2018.

RATING SENSITIVITIES

Positive: Rating upside as limited in the foreseeable future, although future developments that could lead to positive rating action include:
- Long-term predictability of the regulatory framework, with less political interference and a cost-reflective heat segment in a stronger operating environment.
- Increased transparency of the ownership structure and generally stronger corporate governance.

Negative: Future developments that could lead to negative rating action, include:
-Weaker-than-expected financial performance or financial guarantees for parent debt, leading to FFO gross adjusted leverage persistently higher than 3x (2014: 2.2x) and FFO interest coverage below 4.5x (2014: 10.0x).
- Committing to capex without sufficient available funding, worsening overall liquidity position.