OREANDA-NEWS. Fitch Ratings has downgraded RWE AG's Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'BBB' from 'BBB+', and the subordinated notes' rating to 'BB+' from 'BBB-' while maintaining them on Rating Watch Negative (RWN).

Fitch has also downgraded the rating of RWE Finance B.V.'s notes, which are guaranteed by RWE, to 'BBB' from 'BBB+' while maintaining it on RWN. The Short-term IDR is also downgraded to 'F3' from 'F2' and remains on RWN.

The downgrades reflects a further deterioration of RWE's operating environment not only from lower generation spreads, which we expected, but also from recurring system problems in UK supply leading to a loss of customers and tighter margins. Problems with delivering the bills and the lack of adequate operations controls led to a write down in expected revenues, higher bad debt provisions but also increased IT costs, which make the UK Supply division unprofitable in the medium term. Management's guidance for 2016 group EBITDA of EUR5.2-5.5bn is 24% down yoy, which is slightly worse than our expectations.

The RWN continues to reflect uncertainties around RWE's proposed group reorganisation. Although details remain unclear, debt layering within the group may lead to subordination of RWE's remaining creditors and thus a lower rating compared with its consolidated profile (currently reflected in the 'BBB' IDR). In particular, Fitch will review the equity-like features of the subordinated hybrid notes within the new structure once it is finalised. We currently assign the notes a 50% equity credit.

Rating upside may exist for RWE's senior unsecured notes if they are fully guaranteed by the proposed NewCo (housing the networks, renewable and retail divisions), assuming that the NewCo is otherwise ring-fenced from its parent, or if the issuer of the current bonds is substituted to NewCo. This could in turn be negative for RWE's IDR and any unguaranteed debt. Fitch will assess the credit quality of NewCo and its ring-fencing protection once the details become available.

An internal reorganisation with sale of a minority stake in NewCo without changes to external group structure would be neutral to ratings. The company has yet to make clear its plans for segregating debt within the group. We will resolve the RWN once the plans are clearer.

KEY RATING DRIVERS
Limited Headroom
For the RWE consolidated group, we forecast nuclear- and lease-adjusted funds from operations (FFO) net leverage of about 4.4x on average for 2016-2018 compared with our negative rating guidelines of 4.5x at the 'BBB' level and a fixed charge cover around 3.6x compared with the negative rating trigger of 3.5x. This reflects the expiration of the nuclear tax in 2017, which significantly improves leverage and growth in renewables capacity and efficiency measures. However, earnings from conventional generation will decline as hedges roll off, the difficulties in UK supply are likely to persist until 2019, in our view, and cost outperformance on the grids becomes more challenging.

Material Group Reorganisation
RWE plans to organise its networks, renewables and retail divisions under an independently listed subsidiary (NewCo), 10% of which will be sold to investors through an IPO in 2H16. If ring-fenced from RWE and depending on its debt level, it may be rated higher than its parent. RWE will remain the majority shareholder of NewCo with an initial stake of 90% but this could decrease over time.

Initially RWE's consolidated cash flow profile is not expected to change significantly since assets will be replaced with shares in NewCo and NewCo will return cash to RWE through dividends. Debt service may be routed to the parent through inter-company loans with NewCo.

Transaction Details Still Uncertain
The details of the transaction have yet to be announced. However, management guided that NewCo will aim to have a 3.0x-3.5x net debt/EBITDA. As a first step, some of RWE's debt is expected to be 'economically transferred' to NewCo through intercompany loans. Issues such as upstream guarantees and the exact ranking of any intercompany loans are still uncertain. Material changes require RWE AG and RWE Finance B.V. bondholders' consent on a case-by-case basis. The company has stated that there are no immediate plans to raise any direct external debt at NewCo.

Funding of Nuclear Provisions Uncertain
At end-2015 provisions for nuclear waste management were EUR10.4bn. Fitch currently calculates nuclear-adjusted net leverage by adding to net debt these provisions net of financial assets and by adding back the cash spent on nuclear utilisations (EUR179m for 2015) to FFO. In the event that the nuclear provisions are externalised, liability transfer with required cash or asset contribution higher than the existing provisions for this obligation would likely increase FFO-adjusted net leverage to over 4.5x and may trigger a negative rating action.

KEY ASSUMPTIONS
Assumptions within our rating case for the issuer include:
- RWE's average achieved power price in Germany of EUR33/MWh between 2016 and 2018. German forward prices of around EUR22/MWh and clean dark spreads of EUR3/MWh.
- Utilisation of provisions and negative cash-flow items not represented in EBITDA to increase to around EUR1bn (outflows) per annum over the medium term.
- Conservative low-triple-digit EUR million working capital outflows each year.
- Capital expenditure of EUR2.5bn in 2016, increasing to EUR3bn per year in 2017 and 2018.
- UK supply to return to profitability in 2019.

RATING SENSITIVITIES
Negative: Future developments that may lead to negative rating action include:
- Group reorganisation where current creditor's recourse to operating cash flows weakens, for example due to a lack of guarantees by NewCo. In addition, loss of equity credit for RWE's hybrid bonds, which may lead to higher leverage.
- Lease- and nuclear-adjusted FFO net leverage above 4.5x and corresponding fixed charge cover below 3.5x on a sustained basis.
- Energy market reform in Germany (or possibly in other countries) creating additional costs that cannot be passed on to consumers.
- The government establishing a public nuclear fund, depending on timing and scale of funding requirements.

Positive: Rating upside is limited; however, future developments that may lead to an affirmation of the ratings include:
- Group reorganisation where current creditor's recourse to operating cash flows does not weaken, for example due to guarantee from NewCo or no debt layering.

Assuming the current business profile and group structure remains unchanged, the following may lead to a positive rating action:
- A visible improvement in forecast financial metrics with lease- and nuclear-adjusted FFO net leverage below 4.0x and corresponding fixed charge cover above 4.0x. The metric may also improve if the German Constitutional Court judges the nuclear fuel tax as unconstitutional, leading to a return of funds to nuclear operators directly.

LIQUIDITY
RWE's liquidity remains strong. As of 31 December 2015, the group held EUR2.5bn of cash and cash equivalents, EUR6.7bn of short-term securities (after deducting EUR0.7m for restricted holdings) and EUR4bn of committed, undrawn revolving credit facilities with maturity in March 2021. The group has short-term maturities of EUR2.4bn. We forecast slightly negative free cash flow over the next three years.