OREANDA-NEWS. Fitch Ratings has affirmed Southern Gas Networks plc's and Scotland Gas Networks plc's Long-term Issuer Default Ratings (IDRs) at 'BBB', senior unsecured ratings at 'BBB+' and Short-term IDRs at 'F3'. The Outlooks on the Long-term IDRs are Stable.

The affirmation reflects Southern Gas Networks plc's and Scotland Gas Networks plc's strong regulatory performance in the first two years of the new price control (RIIO-GD1, eight-year period from 31 March 2013). The ratings are also supported by low business risk stemming from a supportive and transparent UK regulatory framework. Fitch expects the companies' credit metrics to remain commensurate with the ratings during RIIO-GD1, in view of their discretionary dividend policy.

KEY RATING DRIVERS
Low Business Risk
Southern Gas Networks and Scotland Gas Networks, both owned by Scotia Gas Networks Limited (SGN), are the sole owners and operators of the gas distribution network (GDN) in Scotland and the south of England. The ratings reflect long-term cash flow visibility afforded by the UK gas distribution regulatory regime. Although output and efficiency targets are tougher and allowed returns are lower under RIIO-GD1 than under the previous price control, the regulatory framework remains supportive and transparent.

Strong Regulatory Performance
In the first year of RIIO-GD1 Southern Gas Networks and Scotland Gas Networks were among the top three performers on both outputs and totex. During the year ended 31 March 2014 (FY14) totex outperformance, adjusted for macro-economic factors and the timing of spend, was 16% each for Southern Gas Networks and Scotland Gas Networks. Full totex savings are retained by the networks for two years and then 33% of savings are shared with customers. In addition to totex savings, Southern Gas Networks and Scotland Gas Networks earned incentive income for customer satisfaction, stakeholder engagement, shrinkage and emissions in the amount of GBP7m and GBP2.4m respectively (according to Ofgem). Earned incentive income, net of sharing with customers, will be cashed in with a two-year lag.

Unadjusted totex outperformance in FY14, reported by Ofgem, was 25% for Southern Gas Networks and 29% for Scotland Gas Networks. This includes totex underspend related to timing issues (7% for Southern Gas Networks and 8% for Scotland Gas Networks in FY14), which is expected to unwind throughout the eight-year price control period. Performance remained strong in FY15. The networks will publish the details on their FY15 regulatory performance at the end of September 2015.

Fitch forecasts that both networks will be successful in generating totex outperformance of 15% for the rest of the price control period, an improvement from our previous expectation of 9%.

Dividend Distributions Drive Credit Profile
While the networks are achieving high levels of outperformance, all additional value creation is distributed to shareholders rather than being used for deleveraging. We consider the networks' financial discipline a major rating driver since it largely determines their financial profiles. Dividends have been reduced in the past when necessary and Fitch assumes that shareholders will moderate dividends when gearing or post maintenance interest cover (PMICR) headroom becomes tight.

Southern Gas Networks' and Scotland Gas Networks' dividends depend on the holding company Scotia Gas Networks Limited's (SGN) distributions. SGN distributes funds through dividends and shareholder loan interest payments. Shareholder loan interest payments are not entirely discretionary since the non-payment of the shareholder interest would result in liability build-up. Fitch recognises that the refinancing of the shareholder loan in May 2015 at a lower interest rate has increased the flexibility of distributions as annual interest payment has decreased to GBP46m from GBP67m.

Stretched Credit Ratios
Gearing for both Southern Gas Networks and Scotland Gas Networks is expected to remain at the upper end of Fitch's rating guideline due to high dividend payments. In FY16-FY21 we expect the gearing ratio to average 73% for both Southern Gas Networks and Scotland Gas Networks (excluding onerous debt). PMICR over the same period is forecast to average 1.5x for Southern Gas Networks and 1.7x for Scotland Gas Networks (including onerous debt) versus Fitch's downgrade rating guidelines of 1.5x. This incorporates our conservative cost of debt and dividend distribution assumptions.

Southern Gas Networks and Scotland Gas Networks have a lightly covenanted financial structure and benefit from a low embedded cost of debt, and are therefore well placed compared with other networks to perform better against the cost of debt allowance. Even with market rates remaining low, we expect Southern Gas Networks' and Scotland Gas Networks' embedded cost of debt to remain below the Iboxx index's 10- year average at least during the first half of the price control period, allowing for some financial outperformance.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Allowed cost of debt in line with Ofgem's current assumptions (2.72% in real terms in FY15 and 2.55% in real terms thereafter)
- Average RPI increase of 2.8% over the eight-year RIIO-GD1 period
- Totex outperformance on average of 15% for each of the networks for the remainder of RIIO-GD1
- Annual incentive income of GBP6m for Southern Gas Networks and GBP2m for Scotland Gas Networks for the remainder of RIIO-GD1 (in 09/10 prices)
- 4.6% fixed rate on the new bank/bond debt financing for Southern Gas Networks and 4.1% for Scotland Gas Networks
- Average annual dividend of GBP146m for Southern Gas Networks and GBP74m for Scotland Gas Networks for the remainder of RIIO-GD1

RATING SENSITIVITIES
Positive: Fitch's sensitivities do not currently anticipate developments with a material likelihood, individually or collectively, of leading to a positive rating action, particularly in view of management's own targeted leverage of above 70% net debt/regulatory asset value (RAV).

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Sustained PMICR of below 1.5x (reflecting interest component of onerous debt amortisation) due to lower-than-expected outperformance or incentive income and/or unfavourable financing strategy, which could lead to increased financing costs relative to the iBoxx
- Sustained high leverage in excess of 73% net adjusted debt/RAV (excluding onerous debt) driven by higher-than-expected dividend payments and/or lower-than- expected outperformance

LIQUIDITY
As at 31 March 2015, Scotland Gas Networks' and Southern Gas Networks' liquidity was sufficient with GBP325.1m of cash and short-term deposits at the holding company and a GBP350m revolving credit facility (fully undrawn as of end-March 2015) which expires in July 2019 and is shared by both networks as alternative borrowers. The networks also secured a GBP400m EIB loan to finance their investment programmes, with GBP35m drawn as of 31 March 2015. These provide at least 12 months of liquidity against upcoming 2015 external debt maturities of GBP447.3m at Southern Gas Networks and GBP1.1m at Scotland Gas Networks and projected negative free cash flow of GBP34.5m at Scotland Gas Networks and GBP74.8m at Southern Gas Networks.