OREANDA-NEWS. Fitch Ratings has assigned Georgian Water and Power LLC's (GWP) Long-term foreign and local currency Issuer Default Ratings (IDRs) of 'BB-'. The Outlook is Stable. Fitch also assigned GWP foreign and local currency senior unsecured ratings of 'BB-'.

The 'BB-' ratings reflect the company's natural monopoly position in Tblisi's water supply and sanitation sector. The ratings are supported by low sector risk, solid profitability, low leverage and good receivables collection rates. These positives are offset by regulatory uncertainty and lack of tariff increases, heavily worn-out water infrastructure causing around 50% water losses and a risk of related-party transactions.

KEY RATING DRIVERS
Natural Monopoly in Georgia's Capital City
The company's business profile benefits from its natural monopoly position in Georgia's growing capital city. GWP is the only supplier of water and waste water treatment services in Tbilisi. It owns and operates an about 2,700km water supply network and about 1,700km of waste water pipelines. The company has 45 pumping stations, 84 service reservoirs with total capacity of 320,000 cubic meters and two water treatment plants. We view outright ownership of the infrastructure, rather than a lease or a concession, as credit positive.

Profitability Aided by Hydro Power Generation
GWP's involvement in low-cost hydro power generation boosts the company's profitability. The company's EBITDA margin in the water supply and sanitation business is around 40%, below the European average. This is due to relatively low tariffs and high water losses. However, including electricity generation, GWP's profitability is 48%, which is closer to the European peer average. The involvement in hydro power also provides some revenue diversification.

The company operates hydro power plants with combined installed capacity of 145MW. Average annual production varies between 380GWh and 560GWh, depending on rainfall during the year. Average annual own electricity consumption varies between 270GWh and 300GWh, which means GWP is self-sufficient in power for water transportation and it benefits from additional revenue from third-party electricity sales. As hydro power has minimal input costs, profitability in this segment is particularly high.

Evolving Regulatory Framework
There is no clearly established regulatory framework or elaborate tariff methodology for water and sanitation service providers in Georgia. Privately owned GWP is subject to tariffs based on the principle of total expenditures, which was adopted in 2008 and implies a certain profit margin. The current tariff-setting methodology provides low visibility on potential tariff increases.

A new regulatory framework and new tariff-setting methodology are under consultation. The regulator, Georgian National Energy and Water Supply Regulatory Commission (GNERC), plans to implement a similar price-setting methodology to that of the electricity market, ie a combination of the regulated asset base and cost-plus approach. We expect GNERC to finalise the new methodology by end-2016.

The company's water and sanitation tariffs were last increased in 2010, in line with the tariff ceiling in the sale and purchase agreement (SPA) signed between the parent, Georgian Global Utility (GGU), and the state in 2008. Although the SPA assumes a possibility of further tariff increases in 2015, GNERC kept tariffs at the same level. Negotiations for a mutually acceptable agreement are being held between GWP, the Georgian government and GNERC. Medium-term regulatory uncertainty and lack of tariff increases are key limiting factors for GWP's rating.

Worn-Out Infrastructure
The Georgian water pipeline infrastructure is heavily depreciated due to legacy underinvestment. In some areas of the country, the network's technical conditions are unsatisfactory, which leads to leaks and frequent accidents. The poor condition of infrastructure is the main reason for leaks, causing on average 50% water loss. Worn-out infrastructure is not only costly to maintain, but is also causing accidents and grid disruptions. High water losses are negative for the company's financial profile. A failure to reduce the level of losses, combined with lack of tariff increases could lead to steady margin erosion in the medium term.

The company plans heavy capital expenditure and rehabilitation works to reduce losses in the medium term. GWP is developing a programme to prioritise infrastructure replacement in the areas where it would yield the highest economic benefit.

Good Receivables Collection Rates
The Georgian water utility sector has historically had low receivables collection rates because residential customers cannot be disconnected from water infrastructure for non-payment. GWP's collection rate improved significantly in 2011 because the authorities allowed disconnection of non-paying water customers from Tbilisi's electricity network. Electricity suppliers receive a monetary compensation from GWP for this service. Collection rates from residential water customers improved to 89% in 2011 from 61% in 2010. GWP's overall collection rate is currently around 96%, which the company believes could be further increased.

Low Leverage, Modest FX Exposure
We expect the company's FFO-adjusted net leverage (excluding connection fees) to be around 1.6x on average in 2015-2018. The leverage depends on the dividend payout and the scale of the investment programme, which could be opportunistically increased given the company's private ownership. Financial covenants in the bank loan agreements restrict net debt/EBITDA to 2.5x.

In 2015 GWP made significant progress in de-dollarising its debt. At end-September 2015 around GEL18.2m or 22% of debt was US dollar-denominated, which the company plans to reduce to zero by early 2016. In addition, around 10% of GWP's operating expenses and 30%-40% of capex (equivalent to GEL9m-GEL12m) is either US dollar denominated or pegged to the dollar, while all revenues are denominated in Georgian lari. The overall exposure is manageable and compares favourably with other CIS corporates. Relatively low leverage and modest exposure to foreign exchange risks are positive for the rating.

Part of a Larger Group
GWP is a 100%-owned subsidiary of the GGU group, ultimately controlled by a Russian individual, Mr Andrey Rappoport. Around 90% of GGU's revenue and 100% of EBITDA is generated at GWP, with 84% of borrowings raised at GWP level. Other material subsidiaries of GGU include Rustavi Water Company and Mtskheta Water Company, which have historically benefited from GWP's intercompany loans. GNERC and tax authorities monitor transactions with affiliates to ensure they are conducted at arm's length.

Although we understand that GGU plans to fund each of its subsidiaries on a standalone basis, there is no ring-fencing in the group restricting the provision of intercompany lending. It would be negative for the ratings if GWP continued to deploy a significant part of its cash in lending to weaker sister companies.

There is limited visibility on intercompany transactions within GGU due to lack of audited accounts. However, we expect visibility to improve in 2016, when the first set of group audited accounts is planned to be issued.

Private Ownership Exposes to Political Risks
GGU is the only privately owned water utility in Georgia. It serves around 32% of the country's urban population, with GWP serving around 26%. All other water supply and sewerage assets in Georgia are state owned and subsidised. The long-term sector development plan is being developed by the state to encourage affordable infrastructure investment. If a universal solution is established, a privately-run company may be disadvantaged, as indicated by the disagreement about 2015 tariff increases. Being the only private player in the sector controlled by the government increases exposure to political risks, especially at a time when the industry is expecting significant changes.

Private Equity Involvement Credit Positive
In December 2014 Bank of Georgia Holdings PLC acquired a 25% stake in GGU via a leveraged buyout. As a result, GWP's leverage rose to 1.4x net debt/EBITDA at end-2014 from 0.1x net debt/EBITDA at end-2013. Bank of Georgia acts as a private equity investor, aiming to increase GGU's value and exit via an IPO in the medium term.

We expect private equity involvement to have a positive impact on the company's revenue, profitability and investment profile in the medium term. The shareholders changed the whole GWP senior management team after the acquisition. The new management team is working on initiatives to increase efficiencies, including reduction of non-revenue water and water losses, collection rate improvement, maximisation of third-party electricity sales and prioritising investment projects with the highest return rates. Although the acquisition has led to an increase in debt, the company's leverage is still modest relative to its European peers.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- 2.7% average growth in the annual water consumption of commercial customers in 2015-2018, in line with GDP growth
- Stable population in Tbilisi over the forecast period
- Zero water tariff increases for commercial and residential customers in 2015-2018
- Water losses dropping from 51.5% in 2014 to 44.0% in 2018
- Modest pace of further water metering roll-out, to 30% metered residential customers by end-2018 from 21% at end-2014
- Annual cost of water and electricity production growing at 10% and 14% CAGRs, respectively
- Average annual capital expenditures (net of customer connection fees) of GEL31m over 2015-2018
- Average weighted cost of debt at 10%-12%
- 30% dividend pay-out

RATING SENSITIVITIES
Positive: Positive rating action is not anticipated in the near future. However, these developments may, individually or collectively, lead to positive rating action:
- Approval of a long-term tariff-setting methodology, with tariff increases sufficient to cover operating costs and incentivise infrastructure investment.
- Significant improvement in asset quality and the amount of network losses.

Negative: Developments that may, individually or collectively, lead to negative rating action include:
- An increase in FFO net adjusted leverage (excluding connection fees) towards 3.0x (under existing tariff-setting mechanism) as a result of high capital expenditures or dividend distributions.
- A sustained reduction in profitability and cash generation through a worsening operating performance, long-term lack of tariff increases, failure to reduce water losses or deterioration in cash collection rates.
- The senior unsecured rating could be notched down if the amount of priority debt, ranking ahead of the senior unsecured debt, increases towards 2.0x EBITDA.

LIQUIDITY
At 30 September 2015, GWP had short-term debt of GEL11.7m against cash and cash equivalents of GEL6.7m and Fitch's projected operating cash flow of GEL35.4m. We expect capital expenditure for the next 12 months to be around GEL24.5m. The company does not have any available committed credit facilities, and its liquidity profile is reliant on internal cash generation. The significant flexibility GWP has in relation to its investment programme means we assess the company's liquidity profile as adequate.

Most of GWP's debt is secured on the shares of its parent, GGU, which affords creditors some control in a potential insolvency. The recently placed local currency bonds are unsecured, and therefore, have less creditor protection than the rest of the debt. We do not notch unsecured debt ratings down from the IDR as the amount of priority debt does not exceed Fitch's threshold of 2.0x EBITDA. Should the amount of prior ranking debt exceed 2.0x EBITDA, we could apply downward notching to senior unsecured ratings.