Fitch Affirms Korea District Heating at 'A+'; Outlook Stable
KDHC's ratings and Stable Outlook reflect the company's moderately strong ties with the South Korean government, and its position as the largest provider of district heating in Korea.
KEY RATING DRIVERS
One Notch Below Sovereign: KDHC is rated one notch below Korea's rating (AA-/Stable). Fitch believes the strategic and operational ties with the sovereign, while strong, are weaker than other Fitch-rated Korean state-owned enterprises (SOEs), whose ratings are equalised with the state. This is because, in Fitch's view, KDHC's business is less critical to the state and it does not have a dominant position outside Greater Seoul.
Improvement in Margin: The company's revenue fell 13% yoy in 9M15 while EBIT surged 118.5% and Fitch expects the trend to continue for the full year. Contraction in electricity sales volume and the low system marginal price (SMP) were the main reasons for the decrease in revenue, while declining fuel costs supported higher profitability. For 2016, Fitch expects revenue to fall further as tariffs slide to reflect lower fuel costs, but profitability is likely to stay stable because margins are protected to a certain degree with the fuel cost adjustment mechanism in place.
Negative Free Cash Flow: We expect the company to post negative free cash flow over the next two to three years due to high capex. New major district heating projects, such as Hwasung Dongtan, are likely to raise KDHC's annual investment requirement to around KRW400bn-500bn in 2015-2016 (2014: KRW252bn). However, one-off cash inflow from the sale its subsidiary Incheon Total Energy for KRW67bn in 2015 will support the company's cash position in 2015.
Stable Standalone Credit Profile: The company's standalone credit profile remains weak for its state-supported rating, similar to other Fitch-rated SOEs in Korea. Its credit metrics will likely improve in 2015 due to improved profitability; however, we expect its credit metrics to weaken somewhat in the medium term from those expected for 2015. This is due to limited further benefits from low fuel prices, a decrease in electricity sales volume, and additional debt to fund the expected negative free cash flow generation. Overall, Fitch expects the company's FFO-adjusted net leverage to improve to around to 6x in 2015 (FY14: 8.1x) and to remain at around 6.75x in the next two to three years.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for KDHC include:
- Revenue to decline in 2015-2016 largely due to fall in electricity sales with lower volume and SMP
- EBIT margin to improve in 2015 as a result of lower oil prices and then slide due to tariff cuts
- Capex to increase with the construction of a major new town project in Dongtan and Hwasung.
- Leverage ratio to fall in 2015 to around 6.1x and then increase, reflecting heavy capex
RATING SENSITIVITIES
The issuer is rated at one notch below Korea's rating.
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
- A negative rating action on the sovereign.
- The government's inability to curtail the rate of increase in public-sector entities' debt, resulting in deterioration in the state's ability to provide timely and adequate support to key public-sector entities.
- Weakening of linkages with the state.
Positive: Future developments that may, individually or collectively, lead to a positive rating action include:
- A positive rating action on the sovereign, provided that the rating linkages between KDHC and the state remain intact and that the state's ability to support key state-owned entities remains strong.
-Strengthening of linkage with the state.
For the sovereign rating of Korea, the following sensitivities were outlined by Fitch in its Rating Action Commentary of 13 July 2015:
The main factors that, individually or collectively, could trigger positive rating action are:
- A convincing strategy to reduce the broader public debt burden, which would be reflected in lower debt to GDP ratios for the general government or state-linked enterprises
- Evidence that the economy can continue to grow over time, thereby narrowing the per-capita income gap with rating peers, without deterioration in the combined household balance sheet
The main factors that, individually or collectively, could trigger negative rating action are:
- An unexpected large rise in the public-sector debt burden caused by a deviation from the current prudent fiscal policy framework or crystallisation of financial sector or other contingent liabilities
- Evidence that GDP growth will be structurally lower than expected, potentially reflecting medium- to long-term challenges for Korea's economic model.
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