OREANDA-NEWS. December 15, 2015. Fitch Ratings has downgraded South Africa-based Transnet SOC Ltd's (Transnet) Long-term foreign currency Issuer Default Rating (IDR) to 'BBB-' from 'BBB'. The Outlook is Stable. Fitch has also affirmed the Long-term local currency IDR at 'BBB' with a Stable Outlook. A full list of rating actions is available at the end of this commentary.

The downgrade reflects reflect a similar rating action on South Africa, see 'Fitch Downgrades South Africa to 'BBB-'; Outlook Stable', dated 4 December 2015, at www.fitchratings.com.

Transnet is rated in a bottom-up approach under Fitch's parent and subsidiary rating linkage criteria from its standalone profile of 'BBB-'. The single-notch uplift to 'BBB' for the local currency IDR reflects strong strategic and operational links between Transnet and the South African state (BBB-/BBB/Stable).

KEY RATING DRIVERS
Strong Business Profile
Transnet's credit profile benefits from the company's monopolistic position in the country's rail, port and pipeline services, with a long-term contract base and business diversification underpinning its strong operating cash flows. The ratings are constrained by structural weaknesses in the operating environment (including wage pressures and an evolving regulatory framework), together with expected negative free cash flow (FCF) and substantial funding needs due to large capex.

Rail Underpinned by Long-term Contracts
The Transnet Freight Rail (TFR) division is supported by a long-term contractual framework with top 20 diversified counterparties, including miners, industrial companies and trade. Export coal, manganese and iron ore (58% of the rail business) are supported by long-term take-or-pay agreements, and in some cases, for 20 years and with five-year review periods. The remaining rail business - general freight - is normally contracted within five-year take-or-pay frameworks. Price calculations are generally derived from an agreed model that allows Transnet to recover the cost and a fair return on capital (generally at inflation plus a percentage). Transnet also has the ability to adjust tariffs for infrastructure spending.

Government Support
Transnet has strong operational and strategic links with the South African government. These include government-approved business and funding plans, budgets and strategy, tangible support (in the form of a zero dividend policy) and Transnet's importance to the country's extractive industries and overall economy. We view the likelihood of an increase in government guarantees of Transnet's debt (currently at 3%) as low and therefore the legal links are unlikely to strengthen.

Market Demand Strategy
Market demand strategy (MDS) drives the company's capex plan and outlines future spending for each segment to support infrastructure ramp-up in freight volumes and operational efficiencies. Transnet will continue its high investment with over ZAR300bn by 2022, mostly in TFR, despite some near-term revisions due to slower economic growth.

Credit Metrics Likely to Weaken
Although we expect growth in revenues and zero dividend policy to be maintained, pressures on opex (wages, energy) and high capex will result in continued negative FCF and funds from operations (FFO) adjusted net leverage of around 4x for FY15-17 while FFO interest coverage may drop below 4x over the same period. Despite a likely weakening of Transnet's financial profile, its credit metrics are commensurate with its ratings.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Transnet include:
- Revenue growth driven by increase in freight volumes and tariff adjustments.
- EBITDA margin to remain fairly stable over the next 4 years as tariffs are adjusted for increasing operational costs.
- Capex of ZAR337bn for the next seven years.
- No dividend payments.

RATING SENSITIVITIES
Negative: Future developments that may individually or collectively result in negative rating action include:
- Weaker world commodity markets leading to a decrease in South African exports, a weak domestic economy or delay in new tariff-setting implementation for ports and concurrent maintenance of high capex plans leading to expected FFO adjusted net leverage of well above 4.0x on a sustained basis.
- Weakening of government links, for example, through reduced support for a zero dividend policy.
- A downgrade of South Africa's sovereign rating.

Positive: Future developments that may individually or collectively result in positive rating action include:
- More robust demand or pricing supporting stronger FCF and reducing expected FFO adjusted net leverage of below 3.5x on a sustained basis.
- Stronger links with the government (direct government guarantees for a substantial part of Transnet's debt) provided the sovereign rating remains above that of Transnet.

LIQUIDITY
At 31 March 2015, Transnet had liquidity of ZAR11.1bn, comprising ZAR6.1bn of unrestricted cash and ZAR5bn committed facilities available from local banks. This compares with short-term debt maturities of ZAR17.3bn. Given the expected negative FCF, liquidity may be stretched over the next three years, but Transnet has a proven record of access to external funding.

FULL LIST OF RATING ACTIONS
Long-term foreign currency IDR: downgraded to 'BBB-' from 'BBB'; Outlook Stable
Short-term foreign currency IDR: affirmed at 'F3'
Foreign currency senior unsecured rating: downgraded to 'BBB-' from 'BBB'
Long-term local currency IDR: affirmed at 'BBB'; Outlook Stable
Short-term local currency IDR: affirmed at 'F3'
Local currency senior unsecured rating: affirmed at 'BBB'
National Long-term rating affirmed at 'AA(zaf)'; Outlook Stable
National Short-term rating affirmed at 'F1+(zaf)'
National senior unsecured rating affirmed at 'AA(zaf)'
National senior unsecured rating for notes guaranteed by South African government affirmed at 'AAA(zaf)'