OREANDA-NEWS. Fitch Ratings has affirmed Spanish utility group Madrilena Red de Gas, S.A.U.'s (MRG) Long term Issuer Default Rating (IDR) at 'BBB-' with a Stable Outlook and senior unsecured rating at 'BBB'. Fitch has also affirmed Madrilena Red de Gas Finance BV's senior unsecured rating at 'BBB'.

The ratings reflect greater stability and sustainability of new gas distribution regulation in Spain. Although there is a risk of higher dividends under new ownership, MRG continues to have flexibility over capex and dividends to preserve the credit metrics. The Stable Outlook reflects a more stable regulatory framework following recent reforms while the liquidity profile is sufficient to cover operational and financial requirements up to the maturity of MRG's EUR500m bond in September 2018.

KEY RATING DRIVERS
Greater Stability and Sustainability
Regulation of gas transmission and distribution is now more stable and sustainable following recent reforms. Established by law, the regulation can only be changed at end-2020 by parliamentary approval and requires a report from the Spanish regulator National Commission for Markets and Competition (CNMC).

Limited Volume Risk
Long-term regulatory weaknesses remain in the form of volume risk and lack of indexation to inflation. MRG has higher sensitivity to residential gas demand and potential cash flow volatility, than its immediate peer Redexis Gas, S.A. (BBB-/Stable). Nevertheless, the impact of a 10% fall in residential gas volumes would affect just 4% of 2015 regulated revenues. Also, inflation is currently not a risk. Fitch Sovereigns team has recently lowered its estimates of Spanish inflation to 0.8% from 1% in 2016 and to 1.5% from 2% in 2017.

Gas Tariff Deficit Resolved
As a result of Reform Law 8/2014, the gas system has generated a surplus for the first time since 2007-08. This implies more sustainable regulation with reduced risk of further reform and allows MRG to start recovering regulatory receivables of EUR27m from 2015. Fitch recently revised the sector Outlook in Spain to Stable for 2016 from Negative.

New Shareholders & Dividends
MRG was sold to a consortium comprising Chinese sovereign fund Gingko Tree, Dutch pension fund PGGM and investment arm of Electricite de France (A/Stable), EDF Invest, in May 2015. The ownership structure is not known, though no single owner has majority control, nor is the duration of the agreement between the shareholders. Fitch viewed the sale as credit-neutral as it had no impact on the financial or business profile and there was no debt increase at MRG. A share buyback with a cash outflow of EUR63m was made in October 2014 in lieu of dividends. Higher dividends are forecasted for the future.

Fitch sees a risk of higher dividends under the new ownership, due to higher visibility of cash flow under the new regulation. Nonetheless, we expect dividend policy to remain supportive as the new investors have publicly stated their intention to maintain MRG's investment-grade ratings. Dividend policy remains based on the distribution of 100% of free cash flow (FCF) plus any other cash in (or out) flows, leaving cash of around EUR10m for operational needs.

Flexibility Protects Credit Metrics
MRG has considerable discretion over capex, with maintenance capex averaging around EUR1m a year. The company has also indicated that dividend policy is flexible to preserve its investment grade rating. The dividend payout for the financial year to June 2015 of EUR63m was consistent with maintaining funds from operations (FFO) adjusted net leverage within 6.5x and Fitch expects this to continue. We also expect a fall in cash tax in FY16, due to Spanish tax reform, further supporting MRG's credit metrics.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for MRG include:
- Growth in gas distribution supply points of 0.5% per year.
- Opex growth of 2.0% pa, slightly above Fitch Sovereigns' forecast of 1.5% inflation per year from 2017.
- Capex in line with management expectations at an average of EUR15m for 2015-2020.
- 100% FCF net of both debt drawdowns and acquisitions is distributed to shareholders.

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, result in positive rating action include:
-Stronger cash flow generation due to lower cash dividends leading to FFO adjusted net leverage below 5.5x and FFO interest cover above 3.5x on a sustained basis.

Negative: Future developments that may, individually or collectively, result in negative rating action include:
-Weaker cash flow generation due to any further regulatory change, major debt funded acquisitions or higher dividends leading to FFO adjusted net leverage above 6.5x and FFO interest cover below 2.5x on a sustained basis.

LIQUIDITY
As of 30 June 2015, MRG had cash and cash equivalents of EUR56.1m plus available capex and revolving credit facilities of EUR150m, expiring in 2020. However, MRG paid a dividend of EUR63m, leaving around EUR10m of operational cash in July. Fitch expects negative FCF post dividends of EUR15m in FY16. Fitch believes MRG's liquidity profile is sufficient to meet financial needs until September 2018, when the EUR500m bond matures.