OREANDA-NEWS. Fitch Ratings has affirmed Linea Group Holding Spa's (LGH) Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB-'. The Outlook on the IDR is Stable.

The affirmation mainly reflects the fairly predictable business activities, the negative current trading and our expectations of deleveraging in the medium term. We project that leverage returns to the level commensurate with the rating in 2017 and 2018 after being above the negative leverage guideline in 2015 and 2016.

Fitch sees the imminent acquisition of 51% of LGH by A2A as credit positive, in light of the A2A's solid credit profile and potential joint development opportunities. In our view, the acquisition by A2A could reduce the risk of large acquisitions by LGH, supporting deleveraging.

KEY RATING DRIVERS
Development in Waste
LGH is targeting development of its waste activities, from organic and external growth. In particular, the company plans to increase landfill capacity in Sicily (+660,000 tons) and build a new treatment plant in Lombardy by 2016. Moreover, the planned acquisition in the short term of a waste company active in the same reference area with an EBITDA of EUR6m (expected to rise to EUR17m mainly for the commissioning of a landfill) should complement LGH's waste activities.

Although Fitch understands the rationale (Italy lacks waste treatment plants), the organic investments are subject to delays and the acquisition could deliver lower than expected EBITDA growth. Fitch views negatively the increase of unregulated landfill activities, which have lower visibility than the group's other businesses.

Tenders Awaited in Gas Distribution
The tender process for gas distribution concessions in Italy aims to consolidate the sector from 7,000 municipalities acting as grantors to 177 pools of municipalities (Ambiti Territoriali Minimi, ATEM). The process is slowly starting to take pace, following severe delays due to a lack of administrative details and reactivity from local authorities. LGH will concentrate its bids on five strategic ATEMs where the company holds an incumbent position, exiting the remaining nine areas where it has a marginal presence.

Contract renewal risk is mitigated by the group's leadership position in the target ATEMs and by regulation recognising an indemnity payment on the loss of a concession based on RAB/concession residual value at expiry. We see potential upside from the tenders for LGH, since its concessions portfolio is characterised by high concession fees of more than 20% of revenues on average, while the auctions set a cap at 10%. Fitch does not include any impact from the tenders in its forecasts, while factoring in the recent WACC reduction to 6.1% from 6.9% for gas distribution from 2016.

Negative Current Trading
LGH managed to maintain broadly flat EBITDA in 2012-2014 at around EUR90m (defined by Fitch) despite the challenging market and climate context, with funds from operations (FFO) net adjusted leverage reducing from 5.2x in 2012 to 4.8x in 2014. In 2014, regulated activities contributed around 30% of the EBITDA, with quasi-regulated (waste-to-energy, district heating, renewables) adding around 25%. The unregulated part of the business mostly relates to waste activities and gas supply.

However, the company had a negative start to 2015 with reported EBITDA decreasing from EUR45m to EUR36m in the first half of the year, due to the combination of low hydro production, high average temperature and the expiry of some of the incentives on the Lomellina WTE plant.

In 2015 the group completed three small acquisitions in supply, district heating and renewables, with a combined pro-forma impact of around EUR5m on the EBITDA and EUR35m on net debt. Management expects to finalise a larger acquisition in waste, with EBITDA contribution of EUR6m, potentially rising to more than EUR17m in 2018 due to landfill development activities. Pro-forma for these transactions, Fitch estimates an FFO adjusted net leverage of 5.6x and FFO interest coverage of 3.9x in 2015.

Deleverage From 2017
Fitch has made some conservative assumptions, mainly related to the slower pace of development in waste, the exclusion of any benefit coming from the tenders in gas distribution, declining margins for supply, while considering the acquisitions (the three already realised and the one expected to be closed shortly) pro-forma from 2015. As a result FFO net adjusted leverage for 2015-2019 is expected to average 4.8x, reflecting a decrease from the 5.6x pro-forma level estimated for 2015 to 3.8x in 2019. Fitch expects FFO interest coverage to average 4.2x for the same period.

We expect free cash flow to be positive throughout the rating horizon (although very thin in 2015-2016), consistently with historical results, benefiting from lower tax charges.

Capital Structure
Debt raised by operating companies is gradually reducing, but still accounted for 22% of the total at June 2015. This is mitigated for bondholders by the upstream guarantees from opcos representing at least 80% of group EBITDA. Despite a substantial contribution from regulated and quasi-regulated activities, the portions do not meet Fitch's minimum guideline for a senior unsecured notching uplift. In addition, the priority debt within the capital structure suggests that the notching of senior unsecured debt is not appropriate.

Acquisition by A2A is Credit Positive
LGH has been involved in rumours of potential M&A deals with domestic players for several years. The group's shareholders have now accepted the offer made by A2A for the acquisition of a 51% stake in LGH for around EUR125m (paid through cash and A2A's shares). A2A is the largest Italian multi-utility mainly active in the Lombardy region (like LGH), with an EBITDA of around EUR1.0bn, more than half of which comes from regulated and quasi-regulated activities. We understand that the final agreement could include some provisions to allow the increase of A2A's stake in LGH in the midterm.

Fitch believes that overall the deal is credit positive for LGH, considering potential joint development opportunities (waste, district heating, gas distribution and supply) and A2A's solid credit profile. We estimate pro-forma FFO net adjusted leverage in the range of 4x for the combined group. Moreover, the transaction could reduce the risk of significant acquisitions by LGH, which we view as the main threat for deleveraging. Potential cost synergies are less clear as historically Italian utilities have tried to preserve strong operational autonomy in business combinations, hindering full integration at the operating level.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for LGH include:
- Inclusion from 2015 pro-forma of the acquisitions realised and the one expected in waste, for a total pro-forma EBITDA contribution of around EUR10m and impact on net debt of around EUR50m in 2015.
- Constant perimeter and WACC reduction by 80 basis points from 2016 for the gas distribution.
- Some delays in the commissioning of the landfills and a lower contribution expected from the acquisitions from 2016. Recovery of the EBITDA to EUR90m (including acquisitions) in 2017.
- Cost of the new debt refinancing the outstanding bond at 5% (the current bond, issued in 2013, has a 3.875% coupon).
- Tax rate still high at more than 40% (notwithstanding the cancellation of the Robin Hood Tax.
- Cumulative capex slightly higher than EUR200m for 2015-2019.
- Average dividend pay-out of around 60%.

RATING SENSITIVITIES
Positive: An upgrade is not likely in the next 24 months, as we expect leverage to be above the negative guideline in 2015 and 2016. However, future developments that could lead, individually or collectively, to positive rating action include:
- Successful retendering of expiring strategic gas distribution concessions.
- FFO adjusted net leverage and FFO interest cover ratios below 4.0x and above 5.0x, respectively, on a sustained basis.
- Once the acquisition by A2A is closed, strong links and a supportive attitude from the buyer.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- FFO adjusted net leverage above 5.0x and FFO interest coverage below 4.0x on a sustained basis.
- A large acquisition funded by debt and/ or a change in dividend policy.
- Unsuccessful renegotiation of strategic gas distribution concessions and/ or a shift in the business mix towards unregulated activities (including landfills).

LIQUIDITY
At end-June 2015, LGH had available cash of EUR129m and committed undrawn lines of EUR65m, including RCF for EUR50m (maturing in 2017) and EUR15m medium to long term credit lines, which are sufficient to cover short-term debt maturities of EUR28m and negative Fitch-forecasted free cash flow of EUR50m until end of June 2016 (including cash-out for acquisitions). The company also had uncommitted undrawn lines of EUR25m at end-June 2015. Debt is mainly raised at the level of the parent LGH S.p.A. (78%), with an average maturity of around 4.4 years and almost completely fixed or swapped. The Eurobonds due in 2018 represent around 60% of gross debt.