OREANDA-NEWS. Fitch Ratings has revised Kazakhstan-based Joint Stock Company Sevkazenergo's (Sevkazenergo) Outlook to Negative from Stable and affirmed its Long-term foreign currency Issuer Default Rating (IDR) at 'BB-'. A full list of ratings actions is available at the end of this commentary.

The Negative Outlook reflects expected deterioration of the company's credit metrics over 2015-2018 as a result of the Kazakh tenge's devaluation by more than 30% in the past three days. Sevkazenergo is subject to foreign currency fluctuation risks, with 34% of its debt denominated in US dollar (as of 20 August 2015) and all revenue generated in local currency. This may result in a breach of Fitch's negative rating guidelines of funds from operations (FFO) adjusted gross leverage of 3.0x in 2015 and FFO interest coverage of 4.5x over 2015-2018. In addition, the company's liquidity position is weak.

The Negative Outlook also reflects lack of ring-fence provisions around Sevkazenergo from its sole shareholder Central-Asian Electric-Power Corporation (CAEPCo, BB-/Negative), which credit metrics are also likely to be adversely affected by the tenge devaluation. Sevkazenergo's ratings are aligned with those of CAEPCo reflecting its position as one of two key operating subsidiaries within the CAEPCo group, contributing 37% of group EBITDA. The 'BB-' rating reflects Sevkazenergo's vertical integration, stable regional market share and access to cheap regulated coal supplies.

KEY RATING DRIVERS

Tenge Devaluation Worsens Financials
The recent Kazakhstan tenge devaluation has weakened Sevkazenergo's credit profile, due to a currency mismatch between the company's debt and revenues and the absence of hedging to reduce foreign exchange risk exposure. At 20 August 2015, 34% of the company's outstanding debt was denominated in US dollar, versus all local currency-denominated revenue. The amount of cash denominated in US dollars was negligible at 20 August 2015.

We expect the devaluation to increase Sevkazenergo's FFO gross adjusted leverage to above 3x in 2015 and reduce FFO interest coverage to below 4.5x over 2015-2018, other things being equal. This may result in a breach of Fitch's negative rating guidelines in 2015-2018.

Generation Dominates Despite Integration
Sevkazenergo is one of the CAEPCo's key operating subsidiaries. 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. Sevkazenergo covers electricity and heat generation, distribution and supply in Petropavlovsk regions, which is responsible for 3% of electricity generation in Kazakhstan. Despite integration, Sevkazenergo's EBITDA is dominated by generation services, which accounted for 94% of company's EBITDA in 2014.

Cheap Fuel Supports EBITDA
Kazakh coal prices are significantly below international market rates, reflecting their regulated nature and low transport costs. An unexpected and significant increase in the price of coal above Fitch's current inflationary driven estimates of 7%-9% annually would have a negative impact on EBITDA, although we consider this unlikely. Fuel costs are reflected in power tariff caps to protect energy affordability and the coal price charged to utilities is regulated annually, limiting price exposure.

Solid CFO, Negative FCF Expected
Fitch expects Sevkazenergo to continue generating healthy cash flows from operations on average of KZT7.3bn for 2015-2018 but its ambitious capex and dividends payments are likely to result in negative free cash flow (FCF) of around KZT2bn p.a. over the same period. Fitch expects Sevkazenergo to rely on new borrowings to finance cash shortfalls. Sevkazenergo estimates capex of KZT46bn over 2015-2019 for the modernisation of its ageing infrastructure, which will likely need additional funding.

High Leverage Expected
We expect Sevkazenergo's ambitious investment programme of KZT37bn over 2015-2018 to be partially debt-funded, and therefore forecast its average FFO adjusted gross leverage to remain elevated at 2.9x over the same period. However, Sevkazenergo's investment programme has some flexibility until 2016 (committed capex of KZT7bn for 2015) and will depend on approved tariffs afterwards. The company expects maintenance capex on average of KZT3bn over 2015-2019.

The capex programme aims to modernise about 50% of Sevkazenergo's ageing 1960s generation capacity by 2017, as well as upgrade the company's distribution network. Capacity will expand by a moderate 15% to 2017 but additional benefits will be smaller losses in production and distribution of heat and electricity.

Loss-making Heat Business
The heat distribution business is loss-making due to large heat losses and regulated end-user tariffs, which Fitch assumes are kept low for social reasons (heat generation is reported within overall generation and cash flow-accretive). We expect tariffs to gradually improve but to remain low in general.

Regulatory Uncertainty
The Kazakh authorities are currently considering draft legislation on the implementation of an electricity capacity market. When fully implemented, the capacity market should ensure an economically sound return on investment and provide incentives for construction of new generation assets or for expanding current capacity.

An effective launch of the capacity market should provide a stable revenue stream to fund utilities' investment programmes. A successfully functioning capacity market is likely to support the credit profiles of power generators. However, no final decision regarding a capacity market has been made.

Fitch expects that generation tariffs will continue to reflect fuel cost and other cost inflation while capacity payments will cover capex needs. Tariff caps for a seven-year period with possible annual revisions are currently under discussion.

Electricity distribution tariffs could switch from the 'benchmarking' methodology introduced in 2013 to long-term tariff (five years) approval using a 'cost plus allowable profit margin' methodology. Long-term (five years) approval based on the same methodology is also being considered for heat generation, distribution and sales tariffs, which are currently approved on an annual basis. While the potential switch to long-term tariff approval would bring more revenue predictability, until this new tariff system is approved, there remain uncertainties in the regulatory regime post 2015.

Dividends to Delay Deleveraging
Sevkazenergo's financial policy is to pay dividends, which could delay de-leveraging in the long term. However, we believe that should tariffs and volumes underperform, Sevkazenergo retains the flexibility to lower dividends to preserve cash. This was demonstrated in 2011 when the company cut its dividend payout ratio to 12% after 2011 results were adversely affected by an accelerated investment programme. Sevkazenergo's sole shareholder, CAEPCo, is currently considering a more flexible dividend policy, widening to 15%-50% of net profit from 30%-50%, although we expect it to be adequate to cover debt service requirements at CAEPCo. The company is expecting to pay about 25%-30% of net profit in the medium term.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Electricity volume growth in line with Fitch forecasted GDP of 2.5%-3.5% over 2015-2019.
- Tariffs growth as approved by the government for 2015 and in line with inflation, which Fitch forecasts at about 6%-8% in 2016-2019.
- Capex in line with company's expectations.
- Inflation-driven cost increase.
- Exchange rate of USD/KZT255 over 2015-2018

RATING SENSITIVITIES
Negative: Future developments that could lead to negative rating action include:
- Sustained slowdown of the Kazakh economy, further tenge devaluation, increase in coal prices that is substantially above inflation and/or tariffs materially lower than our forecasts, leading to FFO adjusted gross leverage persistently higher than 3x and FFO interest coverage below 4.5x.
- Committing to capex without sufficient available funding and worsening overall liquidity.

Positive: Future developments that could lead to a revision of the Outlook to Stable include:
- A stronger financial profile than forecast by Fitch supporting FFO adjusted gross leverage below 3x and FFO interest coverage above 4.5x on a sustained basis.

LIQUIDITY AND DEBT STRUCTURE

Refinancing Needs
Fitch views Sevkazenergo's liquidity as weak. At 20 August 2015, short-term debt amounted to KZT4.5bn against cash and cash equivalents of KZT1.4bn along with unused credit facilities of KZT1bn. The majority of short-term debt is working capital facilities, which are expected to be extended for one year.

According to management, the unused credit facilities limits could be redeployed between companies within the CAEPCo group. The CAEPCo group's treasury is co-ordinated centrally for the parent company and the subsidiaries. Fitch notes that at 20 August 2015, CAEPCo group's unused credit facilities amounted to KZT2.2bn.

At 20 August most of Sevkazenergo's debt was made up of secured bank loans (KZT17bn or 68%) and unsecured local bonds maturing in 2020 (KZT8bn in total or 32%). Sevkazenergo is exposed to interest rate risk since about half of its outstanding loans are drawn under floating interest rates.

Senior Unsecured Debt Aligned with Issuer Rating
Sevkazenergo's KZT8bn local senior unsecured bond is rated 'BB-' in line with its Long-term IDR as the bonds are issued at the operating company level, its overall leverage is not excessive and the level of encumbered assets compared to senior unsecured debt is low. At end-2014, pledged assets amounted to KZT57bn (out of KZT85bn).

FULL LIST OF RATING ACTIONS
Long-term foreign currency IDR affirmed at 'BB-'; Outlook revised to Negative from Stable
Long-term local currency IDR affirmed at 'BB-'; Outlook revised to Negative from Stable
National Long-term Rating affirmed at 'BBB+(kaz)'; Outlook revised to Negative from Stable
Local currency senior unsecured rating affirmed at 'BB-'