OREANDA-NEWS. Fitch Ratings has affirmed Italian utility Terna S.p.A.'s Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB+'. The Outlook is Stable. The Short-term IDR has been affirmed at 'F2'.

The affirmation reflects a satisfactory outcome for the fifth regulatory period, structurally lower capex needs and an improved fiscal environment in Italy, but also the recent debt-funded acquisition of the high-voltage grid of Ferrovie dello Stato (FS, BBB+/Stable) for EUR757m.

According to our conservative forecasts, Terna's funds from operations (FFO) adjusted net leverage will average 6.6x until 2019, with limited headroom within our rating guideline of 6.75x. However, we expect FFO interest coverage and net debt/regulatory asset base (RAB) ratios to remain comfortably within our rating guidelines across 2016-2019, averaging 7.5x and 59% respectively.

KEY RATING DRIVERS
High Revenue Visibility
The group's regulated revenues for the business plan horizon (2016-19) are predictable, since 2016 coincides with the application of the updated methodology for weighted average cost of capital (WACC) calculation and the beginning of the fifth regulatory period for electricity transmission. Fitch judges that the price review published in December 2015 by the Italian regulator Autorita per l'Energia Elettrica, il Gas ed il Sistema Idrico (AEEGSI) is overall well-balanced.

AEEGSI has introduced an eight-year regulatory period 2016-2023, divided into two sub-periods: the first one spanning 2016-2019 based on the same methodology for tariff determination as the previous one, while in 2020-2023 a total expenditure (totex) mechanism will be introduced. A more selective approach to investments is underlined in the reduction of the extra return on new investments (1% over base WACC versus previous 1.5% or 2%), which is subject to certain conditions, including projects completion by 2019.

The time lag for recognition of investments in the RAB has been reduced to one year, but the previous extra 1% on top of the base WACC to compensate for time lag has been eliminated for new investments. The X factor, assumed at 1% (down from 3% in the fourth period), reflects the already realised efficiencies to be passed on to end customers, without additional targets for the current period.

Updated WACC Methodology
The real pre-tax WACC defined for electricity transmission at 5.3% from 2016 compares negatively with the 6.3% applied in 2014-2015, but is higher than the assumption included in the previous rating case (below 5%) and consistent with the current interest rate environment.

The AEEGSI has undertaken a comprehensive revision of the WACC calculation methodology and the new formula is based on real values inferred from historical evidence. This eliminates the discrepancy previously caused by the presence of nominal values (sourced both from historical short-term, as risk-free rate, and long-term, as equity risk premium) and inflation (estimated on a forward-looking basis by the regulator). AEEGSI has also introduced a regulatory period of the WACC of six years (2016-2021), with an interim revision after three years (2019), which applies to all regulated gas and electricity activities.

Overall we view the new framework for WACC definition as providing more stability and visibility to the level of remuneration, while retaining some flexibility through the update of some key drivers after three years.

Acquisition of FS Grid
The acquisition of FS high-voltage grid was concluded in December 2015 for EUR757m in cash, aligned with the amount already factored in our previous rating case. No headcount and debt were transferred with the business. The acquired business is mostly regulated (around 95% of the EBITDA) and adds a RAB of around EUR700m to the group's invested capital.

In 2016 Terna will only benefit from EUR42m of allowed opex recognition and some contribution from unregulated activities, while full remuneration of the regulated business will start in 2017. Around 20% of the RAB will benefit from an extra remuneration of 1.5% for 12 years. The acquired assets' residual life is equal to 29 years. The efficiency factor is set at 1.6% for 2017-2019 and at a challenging 4.8% for the following nine years. However, we see significant scope for cost synergies from the acquisition.

We expect the acquired business to contribute almost equally to EBITDA and capex in 2017-2019 at around EUR90m per year on average.

Structurally Improving Free Cash Flows
As the bulk of Terna's upgrade capex programme has been completed the company expects to gradually reduce annual investments in the regulated business to an average of around EUR800m in 2016-2017 and EUR500m in 2018-2019. In the period 2011-2015 Terna invested on average EUR1.2bn per year, which resulted in a fairly young asset base (calendar RAB at end-2015 amounted to EUR13.8bn).

The fiscal environment in Italy is improving, as proven by the abolition of the Robin Hood Tax (6.5% additional tax rate) in 2015, while the 2016 Stability Law foresees a reduction of the corporate tax rate by 3.5pp from 2017. On the other hand, management has indicated a dividend annual increase of 3% across the business plan, reaching EUR444m in 2019. As a result, Fitch expects Terna to achieve structurally neutral free cash flows (FCF) after 2018 (a negative average EUR600m in 2011-2015).

Balanced Approach to Non-Traditional Activities
Terna's objective in relation to the non-traditional business is to achieve some upside in results without putting capital at risk, particularly through service-based non-capital intensive activities. Fitch expects these businesses to contribute around EUR50m annual EBITDA, or 3%-4% of consolidated EBITDA.

The new business plan also includes cumulative investments dedicated to international growth of EUR150m-EUR200m. The growth should come from regulated businesses where the regulatory framework is deemed adequately reliable (likely in some Latam countries), while the non-regulated business will gradually expand mainly through EPC activity. Management has indicated a preference for greenfield initiatives, possibly through partnerships.

Low-Cost Debt Funding
Terna expects cost of debt at around 2% across the business plan horizon. The company benefits from its hedging strategy, which includes long-term fair value hedging of some expensive bonds and cash flow hedging with a shorter timeframe. Although we conservatively assume increases in cost of new debt from 2017, our rating case expects a solid FFO interest coverage of around 7.5x.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Terna include:
- EBITDA gradually rising to EUR1.6bn in 2018-2019, factoring in inflation of 0.5% on average, broadly flat contribution from non-traditional activities at EUR50m and annual cost savings on regulated activities of EUR40m in 2019
- cost of new debt issued from 2017 at 3%-3.5%
- No Robin Hood tax and decrease of the corporate tax rate by 3.5pp from 2017
- Cash absorption from working capital across the current regulatory period as a conservative buffer
- Cumulative capex of EUR2.9bn in 2016-2019 (including capex related to FS and international growth), but on a decreasing trend during the period
- Dividends increasing 3% every year

RATING SENSITIVITIES
Positive: An upgrade is unlikely over the next 24 months due to the increase of FFO adjusted net leverage stemming from the FS grid acquisition. However, future developments that could lead to a positive rating action include:
- FFO net adjusted leverage declining below 6.0x on a sustained basis

Negative: Future developments that could lead to a negative rating action include:
- Deterioration of FFO adjusted net leverage above 6.75x, FFO interest coverage below 4.0x, Net Debt/RAB approaching 65% over a sustained period, for instance as a result of worse-than- expected FCF or debt-funded acquisitions
- Growing exposure to unregulated activities or regulated activities with less predictable regulatory frameworks

LIQUIDITY
Terna's liquidity is healthy. Fitch estimates readily available cash at year end 2015 slightly above EUR400m with undrawn committed credit lines of EUR750m and EUR800m due in 2019 and 2020, respectively. This compares comfortably with our estimate of debt maturities of around EUR500m in 2016 and a negative post-dividend FCF of around EUR380m. The group has a favourable track record in accessing capital markets.