OREANDA-NEWS. Fitch Ratings has downgraded Azerbaijan-based utilities company JSC Azerenerji's (Azerenerji) Long-term Issuer Default Rating (IDR) to 'BB+' from 'BBB-' and Short-term IDR to 'B' from 'F3'. The Outlook is Negative.

The downgrade of Azerenerji's rating reflects the downgrade of the Republic of Azerbaijan's Long-term foreign currency IDR to 'BB+' from 'BBB-' (see 'Fitch Downgrades Azerbaijan to 'BB+'; Outlook Negative' at www.fitchratings.com).

Azerenerji's ratings are aligned with the Republic of Azerbaijan, reflecting the company's strong legal, strategic and operational ties with the state. All of the company's outstanding debt at end-2015 was guaranteed by the state.

KEY RATING DRIVERS
State Guarantees Key
The rating alignment reflects state guarantees for all of Azerenerji's outstanding debt at end-2015, the company's strategic importance to the Azerbaijani economy, strong operational links, including tariff and capex approval by the government, as well as a track record of direct tangible state support.

State Support to Continue
Fitch assumes that the share of state-guaranteed debt will remain fairly stable over 2016-2018 and we do not expect any significant changes to the legal links with the state in the foreseeable future as there are no plans at present to privatise Azerenerji. The state has also continued to provide equity injections, totalling AZN930m over 2009-2015, to partially fund its investment programme (35% of total capex over this period). The company expects to receive another AZN3.7bn over 2016-2019, covering almost all of its investment needs.

Devaluation Drives Leverage Increase
The 50% Azerbaijan manat devaluation in December 2015 has further weakened Azerenerji's standalone credit profile due to the currency mismatch between the company's debt and revenues and limited use of hedging to reduce exchange-rate risk exposure. At end-2015, almost all of the company's outstanding debt was denominated in foreign currencies, mainly in dollars, euros, and Japanese yen while almost all of its revenue was based in local currency. We expect the devaluation will increase Azerenerji's gross leverage to around 20x over 2016-2018, other things being equal, from 7.5x in 2014.

Given the already high leverage, Fitch expects Azerenerji to receive state guarantees for any new debt in addition to equity injections for specific investment projects.

Potential Covenant Breach
Fitch expects the forecasted deterioration of Azerenerji's financials will lead to a continued breach of debt service coverage ratio covenant set forth in the loan agreement with Asian Development Bank (ADB). The covenant is currently set at cash flow from operating activities/(repayments plus interest) above 1.5x. Azerenerji is currently negotiating with ADB to waive the covenant breach.

Near Monopoly Position
The strength of strategic ties is underpinned by Azerenerji's virtual monopoly in Azerbaijan's electricity generation market and transmission segment. This demonstrates the company's importance to Azerbaijan's economy, despite a fairly low contribution to the country's GDP.

Weakening Standalone Profile
Azerenerji's standalone profile has weakened, due to its worsening financial performance and weak liquidity. Deteriorating financial performance was mainly driven by an imbalanced tariff-setting mechanism where substantial gas tariff increases have not been matched by electricity tariff change, that pressured EBITDA margin, and by manat devaluation, that resulted in debt increase. However, we do not expect the worsening standalone profile to affect the ratings unless the company faces unremedied liquidity squeeze.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Electricity volumes growth in line with Fitch's GDP forecasts of -3.3% to 1.5% over 2015-2018
- Flat electricity and gas tariff growth over 2016-2018, ie continued tariff mismatch
- Inflation-driven cost increase, which Fitch expects at about 4%-14% over 2015-2018
- No dividend payments
- Capex of about AZN530m on average over 2015-2018, largely funded though new equity
- Refinancing supported by the government
- USD/AZN exchange rate of 1.6 over 2016-2018

RATING SENSITIVITIES
Positive: Future developments that could, individually or collectively, lead to positive rating actions include:
- A positive sovereign rating action provided that the linkages between Azerenerji and the state remain strong.

Negative: Future developments that could, individually or collectively, lead to a downgrade include:
- A sovereign downgrade
- Evidence of weakening state support, for example, in an unremedied liquidity squeeze.

RATING SENSITIVITIES FOR THE SOVEREIGN
The main factors that could, individually or collectively, trigger negative rating action are:
- A failure to adjust expenditure or revenue to the lower oil price environment, resulting in a more rapid draw-down of external assets.
- A further fall in hydrocarbon prices, or a prolongation of the current price weakness.

The main factors that could, individually or collectively, trigger positive rating action are:
- An improvement in the budgetary position, beyond the measures currently envisaged, sufficient to increase Fitch's confidence in the longer-term sustainability of Azerbaijan's sovereign balance sheet strengths.
- A sustained rise in hydrocarbon prices that restores fiscal and external buffers.
- Improvements in governance and the business environment, and progress towards diversifying the economy away from hydrocarbons.

LIQUIDITY AND DEBT STRUCTURE
Fitch views Azerenerji's liquidity as weak and conditional on continued tangible support from the government. At end-2015 cash of AZN1.3m was insufficient to cover short-term debt of AZN326m. Liquidity risk is somewhat mitigated by the state guarantees on the company's outstanding debt.

We expect Azerenerji's ambitious investment programme, which will result in negative free cash flow, to be largely funded by new equity. This should partially free up operating cash flow for the repayment of existing debt maturities.