OREANDA-NEWS. Fitch Ratings has affirmed Canal de Isabel II Gestion, S.A. (Canal) Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB+'. The Outlook on the Long-term IDR is Stable.

The affirmations reflect the company's low business risk profile as an asset operator and a provider of water and sewage services operating in a regional natural monopoly in Spain. Unlike most regulated network operators in the EU, Canal does not own the asset base. However, its investments are supported by its concession's value.

The ratings reflect our view of Canal's good performance for 2014 and 1H15, demonstrating strong revenues and earnings resilience despite current deflation, depressed water consumption and adverse foreign exchange (FX) rates for Latam revenues. Management's business plan update for 2015-2019 and our view of an improving operating environment support rating stability.

We assess the company's links with the Autonomous Community of Madrid (Madrid; BBB/Stable), a majority shareholder and the controlling ultimate parent, as moderate to strong, according to our parent and subsidiary linkage methodology. We therefore allow the company to be rated a notch above Madrid.

KEY RATING DRIVERS
Resilient and Regulated Business
A continued weak operating environment, with tariff decreases due to deflation and declining water consumption, reduced 2014 like-for-like revenues in Spain. The unfavorable FX rates have offset strong performance overseas. However, the full impact of new concessions being added to the existing portfolio resulted in positive y-o-y consolidated growth. Volume risk in Spain has also been partially absorbed by the fixed component of the tariff.

Moreover, cost efficiencies, allowed to be retained by the company, resulted in a moderate EBITDA growth of 1% in 2014, while new concessions at the beginning of the investment period contributed negatively. EBITDA in 2014 was largely generated by regulated activities (Spain: 90% and Latam: 7%). Business risk arising from Latam activities is currently manageable but could increase in case of rapid growth, which we view unlikely over the next five years.

Updated Business Plan
In June 2015, Canal updated its business plan for 2015-2019. The financial update includes a more favourable expected operating scenario for inflation and water consumption, new concessions (i.e 24-year Caceres concession in Spain), lower financial costs after the bond issue in February 2015, the crystallisation of cost efficiencies and a lower consolidated dividend pay-out ratio of 57% on average (compared with 72% previously).

Fitch has accordingly updated its forecasts but with our more conservative assumptions for inflation and water consumption as well as dividend pay-outs.

Improving Operating Environment
Our Fitch base case foresees 0.5% deflation in 2015 that would apply to tariffs updates in 2016 and before returning to a low inflation scenario from 2016. For water consumption, we still see depressed consumption up to 2017, albeit subject to some volatility due to climate conditions.

Improved Credit Metrics
Funds from operations (FFO) adjusted for dividends net leverage stood at 4.2x in 2014, down from 4.8x in 2013, and we expect it to improve between 2015 and 2019 (on average 3.9x). In Fitch's view the improving operating environment, current tariff bucket structure and certain revenues' inelasticity to water consumption would support future revenues and EBITDA. We expect free cash flow (FCF) to be slightly positive over the five-year rating horizon, contributing to a marginal net debt decrease.

Canal's leverage, adjusted for dividends, is in line with other peers. The rating case leverage trends towards our positive sensitivity for an upgrade by 2019. However, we continue to view the standalone credit profile of Canal as 'BBB+' due to structurally tight liquidity and political risk.

Prudent Financial Policy
In 2012, Canal's board committed to a cap on EUR1.2bn gross debt and a ceiling on 4.0x net debt-to-EBITDA. Moreover, Canal's shareholders agreed to a dividend policy with pay-outs in the range of 50%-80%. In January 2015, the board approved a reduction of dividend pay-out for 2015 that would allow limited de-leveraging.

We assess this policy as prudent and commensurate with the current ratings. We also note that following the bond issue in February, Canal's two covenanted bank facilities were cancelled.

Risk of Political Interference
The decentralised regulatory environment for water companies in Spain is less robust and transparent than in some other European countries; however, it is fairly stable and predictable, benefiting from a full cost-pass-through tariff mechanism. Our rating case assumes a broadly stable regulatory framework for water in Spain over the next five years. However, we see risk of political interference in tariff-setting.

Rating Link to Madrid
Our assessment reflects that Canal is acting on a commercial basis without the need for financial support from the parent. At the same time Canal does not upstream any cash to its parent other than dividends.

Provisions in the framework agreement contract between Madrid and Canal protect the latter's interests (such as investment recovery in case of contract cancellation by Madrid and the economic re-balancing in case of larger-than-expected investments or lack of tariff increases). However, we acknowledge that Madrid can change the contract unilaterally as long as Canal is 100% publicly owned.

Potential changes to either the framework agreement established between Canal and its shareholders, the gross debt cap policy established by Madrid, or the dividend policy are likely to have an impact on our assessment of the strength of the links between Canal and Madrid. The privatisation of Canal is not expected in the next four years. We consider it as an event risk. Privatisation is potentially both positive and negative for the company's credit profile.

Following the regional elections in May, a new coalition government was formed in Madrid, which does not change our view of political risk. In February 2015, Canal's Board of Directors increased the number of Directors to nine from six with Madrid gaining weight in the final Board composition (doubling to four representatives). This change does not affect our view on the parent and subsidiary linkage.

Dividends Viewed as Non-discretionary
Although Canal has a concession agreement with Madrid to provide water and sewage services, the company does not pay a concession fee as is customary for this type of agreement. Fitch treats the dividends paid as a fixed non-discretionary operating charge similar to a concession fee. This is despite that the dividend policy or the contract does not include an explicit commitment to pay dividends.

In this context, FFO is reduced by dividends paid (or expected to be paid), resulting in weaker FFO credit metrics. In Fitch's opinion this adjustment helps to present a more realistic financial position of Canal that is comparable to similar EU utilities but which are more leveraged, due to the need to pay for their concessions (upfront or in form of annual fees).

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for the issuer include:
- Current tariff structure is maintained and tariff growth rates are projected according to the estimated inflation for the previous year (2016: -0.5%; 2017: 0.8%; 2018 and 2019: 1.5%).
- Limited water volume decline in 2015 and 2016.
- Stable population and customer base.
- EBITDA of EUR460m on average for 2015-2019.
- Cost of new debt 200bps above the company's assumptions.
- Gross debt close to the EUR1.2bn cap for 2015-2019.
- Capex of EUR230m on average for 2015-2019.
- 70% consolidated dividend pay-out ratio.
- Reduced cost efficiencies versus company's business plan

RATING SENSITIVITIES
Positive: Future developments that could lead to positive rating action include:
-An upgrade of Madrid, together with stronger cash flow generation leading to FFO adjusted for dividends net leverage below 4.0x on a sustained basis, and also enhanced liquidity position. Stronger cash flow could be due to higher-than-expected tariff increase and water consumption.

Negative: Future developments that could lead to negative rating action include:
-Weaker cash flow generation leading to an FFO adjusted for dividends net leverage above 5.0x on a sustained basis. This could be due to a worse-than expected operating environment including regulatory changes or higher dividends.
-A negative rating action on Madrid, which would likely trigger the same negative rating action for Canal. This is provided that the strength of the links between the two allows for a maximum of one-notch differential.
-Failure to extend debt maturity profile or replenish liquidity

Fitch adjusts Canal's FFO calculations by deducting dividends to reflect our view of the non-discretionary nature of dividends outflow following the company's creation and restructuring in July 2012.

LIQUIDITY
As of end-September 2015, total liquidity was EUR267.8m, comprising EUR201.8m of unrestricted cash and EUR66m of available committed credit facilities maturing in December 2015 and expected to be renewed (and potentially increased) on a yearly basis. Cash position in 3Q15 was high due to a seasonal increase in water consumption in summer, boosted by an exceptionally hot July in Spain.

Canal's liquidity is sufficient to cover short-term debt of EUR124.3m; however, an extension of liquidity coverage is contingent on further refinancing in 2016-2017 and structurally constrained by legal limitations on long-term funding. Canal is subject to the Community of Madrid Budgetary Law that requires high-level authorisation to approve long-term committed credit lines.