OREANDA-NEWS. Fitch Ratings has assigned Russia-based electricity generator Public Joint-Stock Company The Second Generating Company of Wholesale Power Market (OGK-2), a Long-term foreign currency Issue Default Rating (IDR) of 'BB' with Stable Outlook. A full list of rating actions is at the end of this commentary.

OGK-2's 'BB' rating incorporates a one-notch uplift to its 'BB-' standalone rating for parental support from its ultimate majority shareholder, PAO Gazprom (BBB-/Negative).

OGK-2's standalone rating is underpinned by its position as one of the largest power generators in Russia and cash flow generation from capacity sales under the Capacity Supply Agreements (CSA). We currently expect the postponement of commissioning of certain new units under CSA and therefore leverage metrics are unlikely to improve to below 4x before end-2016. The standalone rating is constrained by high regulatory risk and the company's exposure to price and volume risk.

The Stable Outlook reflects our view of the company's ability to commission its new units and transfer the 420MW unit of Serovskaya GRES to PJSC Inter RAO (BBB-/Negative) in line with the updated schedule.

KEY RATING DRIVERS
One-Notch Uplift For Parental Support
OGK-2's 'BB' rating benefits from a one-notch uplift reflecting our view of likely support from PAO Gazprom, which indirectly owns 77.24% of OGK-2 through OOO Gazprom Energoholding (GEH). We assess the strategic, operational and to a lesser extent legal ties between OGK-2 and its parent company as moderately strong under Fitch's Parent and Subsidiary Rating Linkage methodology.

Moderately Strong Ties
The strength of the ties is supported by OGK-2's integral role in Gazprom's strategy of vertical integration and its substantial share in GEH's operations. OGK-2's installed capacity covered about 48% of GEH's total installed capacity at end-2014. Its gas-fired power plants are reliant on Gazprom's gas supplies, which accounted for about 76%-92% of the company's gas consumption over 2012-2014. We expect timely financial support to be available if the need arises, as has been the case in the past. In 2013, OGK-2 received capital injections of RUB22.3bn through additional share issues, mainly in order to fund a large-scale investment programme. Another means of support is the payment terms extension for OGK-2's gas purchases from Gazprom that has been done in the past, similarly to PJSC Mosenergo (BB+/Stable). Additionally, about 94% of OGK-2's total outstanding debt at end-1H15 was loans from Gazprom.

Strong Market Position
OGK-2's 'BB-' standalone rating is underpinned by the company's market position as one of the largest power generating companies in Russia. With 18.4GW of installed electric capacity and 68.7bn kWh of electricity generation, OGK-2 was responsible for about 7% of Russia's installed capacity and electricity generation in 2014. OGK-2 operates 11 power plants across Russia. The operation of multiple assets should moderate the risk of cash flow volatility (i.e driven by unexpected outage). The company is mainly involved in the production and sale of electricity on the wholesale market. In contrast to its large international peers that are involved in various power generation types, OGK-2 is focused on thermal power generation. Revenue from heat sales is immaterial (about 4% in 2014).

CSAs Support EBITDA
Similarly to rated Russian peers, stable earnings and a guaranteed return for capacity sales under the CSA are the key factors that mitigate the company's exposure to the market risk, support stability of its cash flow generation and enhance its business profile. The company estimates that the newly commissioned units under the CSAs contributed about 35%-40% to its EBITDA over 2012-2014. It expects their share to increase to about 50%-55% of EBITDA over 2016-2020 once all new capacity under the CSA framework is commissioned. We assume that the company will commission new capacities as per the revised schedule including new units of Ryazanskaya GRES from 1 January 2016 previously expected from 1 November 2015 and Serovskaya GRES from 1 April 2016 previously expected from 1 December 2015, Troitskaya GRES and Novocherkasskaya GRES from 1 April 2016 previously expected from 1 January 2016.

Deleveraging Unlikely Before 2017
In addition to high capex, we expect OGK-2's EBITDA margin to weaken to around 8% in 2015 due to the rise in fuel costs and decline in revenue from electricity sales. As a result, we expect funds from operations (FFO) net adjusted leverage to increase to about 6x in 2015 from 2.8x in 2014. However, we anticipate that the expected commissioning of new units at Serovskaya GRES, Troitskaya and Novocherkasskaya GRES with combined capacity of 1,410MW in April 2016, which will operate under the CSA framework, will boost 2016 EBITDA.

Nevertheless, the expected acquisition of a 90.5046% stake in OGK-Investproekt from PJSC Mosenergo for about RUB5.6bn in 1H16 may result in OGK-2's leverage remaining elevated at above 3.5x at end-2016, as OGK-Investproekt's outstanding debt was about RUB12bn including RUB1bn owed to OGK-2. OGK-2 expects to fund the acquisition with own and external funds. According to management, 420MW of Cherepovetskaya GRES is the main asset of OGK-Investproekt that was commissioned in March 2015 and operates under CSA.

Not All Rent Expenses Capitalised
We do not capitalise the rent expenses that are represented by rent payments made by OGK-2 in relation to Adlerskaya TPP and 420MW unit of Cherepovetskaya GRES. These rent expenses were RUB2.2bn in 1H15 or about 86% of total rent expenses. According to the company, these expenses are largely pass-through payments made by OGK-2 to OOO Gazprom Investproekt, a 100% subsidiary of Gazprom, and OOO OGK-Investproekt, a JV between OGK-2 (9.49%) and Mosenergo (90.51%) which are both part of GEH. OOO Gazprom Investproekt and OOO OGK-Investproekt funded the construction of the Adlerskaya TPP and the new unit at Cherepovetskaya GRES, respectively. These rent payments are calculated as the difference between the revenue generated by these power plants and corresponding costs incurred by OGK-2, which serves as the operator of these power generating units and is a party to the respective CSA agreements. The rent agreements are renewed annually, which should limit OGK-2's financial exposure in case of operational disruptions at the plants. However, Fitch may revise its treatment of these rent payments if the payments under the rental agreements substantially exceed the cash flows generated by the respective power plants. We expect rent payments in relation to 420MW unit at Chereprovetskaya GRES to discontinue in 2H16 if the acquisition of OGK-Investproekt by OGK-2 is carried out.

Negative Free Cash Flow in 2015
Fitch expects OGK-2 to generate cash flow from operations of around RUB11.4bn on average over 2015-2018 following commissioning of new capacity under CSA, which stipulated tariffs are 3.0x-3.5x higher on average than those for existing facilities. However, we expect negative free cash flow (FCF) in 2015 due to ambitious investment plans of RUB23bn. Fitch expects OGK-2 to rely on new borrowings to finance cash shortfalls.

FCF may turn positive in 2016 if new 420MW unit at Serovskaya GRES is transferred to Inter RAO and therefore will not require any capex outflow in 2016 and beyond that will result in lower capex expectations in addition to expected increase in EBITDA.

Less Efficient Than Rated Russian Peers
Fitch believes OGK-2 is less efficient in terms of fuel utilisation than Inter RAO and Mosenergo. The latter is considered the top quartile performer in the thermal generation among Russian generating companies. OGK-2's electricity fuel rate slightly improved to 345 gfe/kWh in 2014 from 354 gfe/kWh in 2011. The company's strategy envisages an improvement in operational efficiency through the introduction of more efficient new capacity and decommissioning of old and less efficient assets as well as modernisation of existing facilities.

Gas Dominates Fuel Costs
OGK-2's operating costs are dominated by fuel expenses, which made up over two-thirds of the company's operating costs on average over 2011-2014. The company's profitability is consequently highly sensitive to changes in fuel prices. Its fuel mix is dominated by natural gas (65% in 2014) followed by coal (35%). Although Gazprom group companies covered about 76%-92% of OGK-2's gas needs over 2012-2014, we do not view the supplier concentration as a credit risk, as OGK-2 is majority indirectly owned by Gazprom, which makes it an integral part of Gazprom Group, supports stability of gas supplies and provides certain elements of vertical integration. Gazprom may extend the payment terms for gas supplies if the need arise, as was the case in the past.

Volume and Price Risk Exposure
OGK-2 generates most of its revenue from electricity and capacity sale (about 70%) on the free market exposing the company to volume and price risks with the remaining sales made on the regulated market. Price risk may be exacerbated by the regulatory changes affecting tariffs. We believe volumes and price risks are moderated by cash flow generation from new capacity sales under the CSA with favourable economics.

Unpredictable Regulatory Regime
Like other Russian utilities, OGK-2 is exposed to regulatory risk, reflected in frequent modifications of the regulatory regime and political interventions. This undermines the predictability of the regulatory framework, which is necessary for utilities to make long-term investment decisions.

In 2014 the government cancelled index-linked price increases in the competitive capacity market for 2015, indexation of regulated tariffs for electricity and capacity sales in 2014 as well as capacity price indexation for newly commissioned nuclear and hydro power plants for 2014-2015. While abolishing capacity price indexation was related to new capacity of nuclear and hydro power, it remains to be seen whether this change of the CSAs' terms will also be extended to thermal power plants.

Guaranteed payments under the CSAs are currently considerably higher than capacity payments for the old capacity, but have not been significantly altered so far. Any significant revision of the CSAs will weigh heavily on utilities' financial profiles and increase cash flow risk as the CSA framework was developed to ensure long-term investments in ageing power assets. However, our financial projections for OGK-2 are based on the assumption that the fundamentals of the CSA framework will remain unchanged.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Domestic GDP decline of 4% and inflation of 15.5% in 2015, in 2016 GDP growth of 0.5% and CPI of 9%
- Electricity consumption to decline slower than GDP contraction in 2015
- Electricity tariffs to increase below inflation
- Inflation-driven gas price increase
- Capital expenditure in line with management's expectations
- Dividend payments of 15%-20% of IFRS net income over 2016-2018

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
-Improvement in financial profile due to, among other things, higher than expected growth in tariffs and/or volumes supporting FFO net adjusted leverage below 3x and FFO interest coverage above 6.5x on a sustained basis.
-Stronger parental support.
-Increased predictability of the regulatory and operational framework in Russia.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Inability to improve credit metrics so that FFO net adjusted leverage remains above 4x and FFO interest coverage stays below 3x on a sustained basis due to, among other factors, failure to commence operations at the new units in line with schedule, lower volumes of electricity and capacity sales, lower tariffs or margin squeeze driven by the rise of fuel prices not fully compensated by the electric prices growth, weak working capital management, M&A transaction resulting in higher debt levels and/or intensive capex programme.
- Weakening of parental support may result in a removal of the one-notch uplift to OGK-2's standalone rating.
- Deterioration of the regulatory and operational environment in Russia.

LIQUIDITY
Manageable Liquidity
Fitch assesses OGK-2's liquidity as manageable within Gazprom group context. At end-1H15 OGK-2's cash and cash equivalents were RUB6.7bn and sufficient to cover upcoming short-term debt maturities of RUB6.6bn. The majority of debt at end-1H15 (about 94%) was capex-related loans from Gazprom, OGK-2's ultimate parent. The company has access to uncommitted credit lines of about RUB24bn mainly from major Russian banks due over 2015-2020. However, OGK-2 does not pay commitment fees under unused credit facilities, which is common practice in Russia. OGK-2 is also considering placing a local bond in 4Q15 of about RUB15bn under the bond programme that envisages bonds issuance of up to RUB30bn or its equivalent in foreign currency. Fitch notes that OGK-2's investment programme has little or no flexibility, which increases short term funding needs.

Limited FX Exposure
OGK-2's FX exposure is limited to capex projects that encompass a foreign currency component. The company estimates that about RUB5.8bn of capex over 2015-2016 relating to purchases of equipment is denominated in foreign currencies or about 14% of total capex spending over the same period. According to management, FX-denominated capex expenses were translated assuming RUB80 per EUR1. Fitch notes that at end-1H15 OGK-2 had a portion of cash in US dollars (about RUB2bn). At end-2015 all of OGK-2's debt was local currency denominated. FX exposure may increase if the company issues foreign currency debt.

FULL LIST OF RATING ACTIONS

Long-term foreign currency IDR assigned at 'BB', Outlook Stable
Long-term local currency IDR assigned at 'BB', Outlook Stable
Short-term foreign currency IDR assigned at 'B'
Short-term local currency IDR assigned at 'B'
National Long-term Rating assigned at 'AA-(rus)', Outlook Stable
Expected local currency senior unsecured rating assigned at 'BB(EXP)'.