OREANDA-NEWS. December 15, 2015. Fitch Ratings has downgraded South African utility Eskom Holdings SOC Ltd's (Eskom) Long-term local currency Issuer Default Rating (IDR) to 'BBB' from 'BBB+'. The Outlook is Stable. A full list of rating actions is at the end of this commentary.

The rating action reflects the downgrade of South Africa's Long-term local currency IDR to 'BBB' from 'BBB+' and Long-term foreign currency IDR to 'BBB-' from 'BBB' (see 'Fitch Downgrades South Africa to 'BBB-'; Outlook Stable' dated 4 December 2015 on www.fitchratings.com)

Fitch continues to assess the links between Eskom and the government of South Africa (BBB-/BBB/Stable) as strong, evidenced by the Guarantee Framework Agreement (GFA) and most recently by the equity conversion of the government's subordinated loan to Eskom. Fitch's expectation of additional equity contributions in FY16 also supports the alignment of Eskom's IDR with that of the sovereign.

Fitch views Eskom's standalone creditworthiness as 'B-', reflecting its high leverage, negative free cash flow and weak liquidity position. While operating profitability has improved (EBITDA FY15: ZAR27.1bn; FY14: ZAR25.3bn), increased debt has resulted in slight deterioration in both the leverage and coverage metrics for FY15. Fitch expects Eskom's standalone credit metrics to worsen for FY16. However, Fitch forecasts the combination of the announced sovereign support and improved trading expectations (largely driven by tariff increases) to result in relatively stable leverage for FY16.

KEY RATING DRIVERS
Sovereign Support
In FY15 the government provided tangible evidence of its support for Eskom through the decision to convert its subordinated shareholder loan (ZAR26.6bn carrying value) to equity, as well as providing a further undertaking to provide an additional ZAR23bn equity contribution (ZAR10bn received in July 2015, ZAR10bn expected to be provided in December 2015 and the final ZAR3bn in March 2016). We continue to view both the new equity, and debt to equity conversion, as an indication of strong sovereign support for Eskom, despite pressure on the sovereign's creditworthiness. Along with the GFA, they are the most important elements supporting the continued rating alignment with the sovereign.

Government Guaranteed Debt
At FYE15 the group had ZAR147bn of government guaranteed debt representing 49% of outstanding debt for the year. The government guaranteed facilities are set out under the GFA under which Eskom has available undrawn facilities of ZAR191bn (ZAR50bn is under the specific domestic multi-term note programme).

Importantly, Eskom's debt issued outside the GFA benefits from a priority of payment clause where the company would first apply its available resources towards repayment of non-guaranteed debt given that guaranteed debt is ultimately serviced by the government. We expect Eskom to continue to issue both guaranteed and unguaranteed debt according to market demand but do not expect the share of the state-guaranteed debt to reduce significantly below 50% in the short to medium term.

Management Changes
Fitch views positively the permanent appointment of Brian Molefe as CEO and Anoj Singh as CFO, delivering clarity to the group's executive management and addressing near-term uncertainty over governance and strategic direction. A new executive committee was announced on 22 October 2015, which is expected to stabilise and strengthen the utility's leadership.

Weaker Cash Position Impacts Liquidity
While the group has shown some improvement in EBITDA profitability (core EBITDA remains relatively stable but there are improvements in other revenues and expenses), it still has extensive capital expenditure and the increase in primary energy costs resulted in a decrease in cash held at FYE15 (ZAR8.8bn). The additional equity contributions following FY15 are aimed at addressing short-term liquidity requirements. The group will continue to rely on its ability to raise sufficient funding to meet capex requirements.

Management has indicated that the ZAR20bn cash liquidity buffer remains a liquidity target. Sufficient liquidity will be maintained for short-term requirements while capex requirements will be met through additional long-term debt.

Standalone 'B-' Credit Profile
Eskom's standalone credit profile is commensurate with a 'B-' rating, reflecting the expectation of significant and increasing leverage required to fund the capacity expansion programme. The execution risks associated with the capex programme are highlighted by the timing delays experienced on all of the current major projects (Medupi, Kusile and Ingula).

Negative Cost Control Impacts
Primary energy costs increased by 19% (higher than tariff increases or inflation) for FY15 to ZAR83.4bn (FY14: ZAR69.8bn) with adverse impacts from coal and Independent Power Producers. We expect primary energy costs to remain significant in FY16 and FY17 before moving closer to inflation in the medium term.

Due to delays with Medupi, Eskom was forced to pay penalties under its take-or-pay coal agreement resulting in a negative impact of ZAR6.8bn. Increased payments to IPPs also significantly increased primary energy costs by ZAR6.2bn. The continuing use of open cycle gas turbine (OCGT) fuels, although lower than in FY14, was still a significant ZAR9.5bn cost to the group (the highest primary energy cost after coal).

Tariff Determination
Nersa, South Africa's energy regulator, allowed Eskom to recoup costs of ZAR7.8bn incurred during its previous price control (1 April 2012 - 31 March 2013), translating into a 12.7% tariff increase from 1 April 2015. Eskom has also submitted a further application within this regulatory clearing account to Nersa for compensation for amounts under-recovered from 1 April 2013 to 31 March 2014. If approved, this may improve pricing from 1 April 2016.

We expect tariff increases of around 13% for FY16 and FY17 to allow for some improvement in Eskom's credit metrics from FY16. Failing that, further equity support from the government may be needed. Nersa disallowed Eskom's application for an additional increase of 9.5% in FY16 under its selective reopener to cover costs for OCGT and the Short-term Power Purchase Programme, which we expect will lead to further leverage requirements for FY16.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Eskom include:
- The debt/equity swap of the ZAR60bn (ZAR26.6bn carrying value) subordinated shareholder loan reflected in FY16.
- The additional ZAR23bn equity contribution from the shareholder reflected in FY16.
- Growth in volumes sold limited in FY16 due to load shedding and operational limitations thereafter assumed to follow GDP growth.
- Tariffs charged reflect the 12.7% increase for FY16 with similar expectations for FY17, thereafter with high single digit increases.
- Primary energy cost expectations are for low double digit increases in FY16 and FY17 followed by high single digit increases thereafter.
- Employee expenses assumed to grow at CPI in the short term with higher growth in the medium term as financial position improves.
- Capex intensity remains high in short-term with some moderation in the medium term.

RATING SENSITIVITIES
Negative: Future developments that could lead to a downgrade include:
- A decline in government support or a downgrade of South Africa's sovereign rating.
- Failure to achieve more cost-reflective tariffs, in the absence of increased government support, resulting in an unsustainable financial profile and a reduction in Eskom's debt service capability.

Positive: Future developments that could lead to the Outlook being revised to Positive include:
- The revision of the Outlook on South Africa's sovereign rating to Positive, providing that the strength of parent-subsidiary linkage does not weaken.

LIQUIDITY
At end-FY15 the group had cash reserves of ZAR8.8bn and a ZAR500m revolving credit facility against short-term maturities of ZAR19.9bn. Eskom continues to maintain a further ZAR6.0bn of short-term investments in securities, which could be accessed at short notice to support its liquidity position. The additional ZAR10bn equity contribution from the sovereign is expected to be received in December 2015 and a further ZAR3bn in March 2016 supporting the liquidity position.

FULL LIST OF RATING ACTIONS
Long-term local currency IDR downgraded to 'BBB' from 'BBB+'; Outlook Stable
Local currency senior unsecured rating downgraded to 'BBB' from 'BBB+'
National Long-term rating affirmed at 'AAA(zaf)'; Outlook Stable
National Short-term rating affirmed at 'F1+(zaf)'