OREANDA-NEWS. Fitch Ratings has affirmed Portugal-based Redes Energeticas Nacionais, SGPS, S.A.'s (REN) Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB'. The Outlook on the IDR is Stable. The Short-term IDR has been affirmed at 'F3'. REN Finance B.V.'s senior unsecured rating is also affirmed at 'BBB'.

The Stable Outlook reflects our view that the company will manage to generate neutral-to-positive free cash flow (FCF) for the period 2016-2018, due to lower capex needs and a stable dividend policy. This is notwithstanding our expectations of low 10-year Portuguese government bond yields (to which REN's regulated revenues are linked), a stricter regulatory update for gas from 2016 and the continuation of the energy sector levy introduced in 2014.

The 'BBB' rating reflects the low business risk profile of REN's electricity and gas transmission, gas storage and regasification activities in Portugal with more than 95% of 2015 EBITDA generated under a transparent, fairly stable and supportive regulatory framework. It also reflects REN's higher leverage and a more generous dividend policy than other European peers.

KEY RATING DRIVERS
Recent Performance within Expectations
REN's EBITDA fell 3% yoy in 2015 (including EUR20m of ENAGAS's stake capital gain). Lower 10-year Portuguese government bond yields, directly translating into lower rate of returns (RoR), and a strict regulatory update for electricity since January 2015, are partially compensated by decreasing cost of debt. Net debt increased slightly, due to the payment of the 2014 energy sector levy in 2015. Overall, performance was in line with REN's 2015 - 2018 business plan and Fitch's own assumptions.

Earnings Decline Limited
We expect that low Portuguese yields and regulatory reviews will continue to translate into falling regulated revenues and EBITDA during the period 2016-2018. However, the regulator ERSE has set a limit to the fall in RoR for gas at 7.33% (only up to June 2016) and for electricity at 5.65% (up to December 2017). Fitch's RoR forecast is close to the floor for electricity at 6% for 2016.

Continued optimisation of cost of debt boosted by large-scale maturities of more expensive debt in 2016 and effective control of operating costs will further help compensate expected lower revenues.

Structurally Neutral to Positive FCF
Following an expansion phase, REN's grid has reached maturity and mainly requires maintenance capex and limited investments for the next three years. Average yearly capex has decreased to EUR175m for 2016-2018, from EUR300m in the previous period until 2014. In addition, REN plans to maintain nominal dividend per share at EUR0.171 per year for 2016-2018, contributing to slightly positive FCF over the next three years. We do not assume any international equity investment in 2016-2018 although this was contemplated in REN's strategic update last May.

Stricter Review for Gas
A new regulatory period for gas will start from June 2016 to June 2019. In our rating case, we assume that the current regulatory scheme will be applied in the new regulatory period with the exception of gas RoR, which will be aligned lower with that of electricity even though gas is considered a higher-risk business than electricity.

In our view, the upcoming review will be in line with other parts of Europe and would largely reflect the evolution of the cost of debt. The impact on revenues is limited to around EUR11m per year in our rating case as gas is around 30% of REN's EBITDA. We expect ERSE to finalise a draft of its regulatory review in mid-April.

Rising Leverage; Improved Coverage
We estimate funds from operations (FFO) adjusted net leverage would be slightly over our negative rating trigger of 6.5x in 2016-2018 at 6.7x, while the other metrics would remain comfortably placed within current guidelines with a significant improvement of interest coverage. Fitch also acknowledges REN's additional financial flexibility on balance sheet (i.e. EUR104m Red Electrica Corporacion's stake and EUR220m of regulatory receivables) and management's policy to maintain credit metrics commensurate with the current rating.

However, the group currently has no rating headroom and we expect unforeseen financial needs (or additional investment appetite) to be met by the use of retained financial flexibility on balance sheet (as was the case in 2015 with the sale of Enagas' stake to fund the purchase of Galp's gas storage facilities) as opposed to raising new debt.

Energy Sector Levy Maintained
Fitch expects the energy sector levy to continue and has assumed a EUR26m additional tax over each forecast year under the rating case. Unlike the previous government, the recently appointed government seems to be less in favour of a cancellation of the energy levy.

Nevertheless, we expect ERSE to continue to demonstrate independence from political interference in its regulatory review. In December 2015, ERSE approved a substantial increase in access tariffs of 6% for 2016.

Sovereign Rating Implications
REN's Long-term IDR and Stable Outlook are not constrained by the sovereign's credit profile. However, according to Fitch's approach to eurozone countries, a downgrade of the Portuguese sovereign rating could lead to a downgrade of REN's IDR, as our criteria allow domestically focused corporates to be rated up to three notches above their country's sovereign rating in the 'BB' category. Notching would depend on the factors affecting the sovereign rating trajectory and Fitch's view of its impact on corporate creditworthiness in the country. Fitch in March changed the Outlook on the Portuguese sovereign to Stable from Positive.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
-10-year Portuguese government bond yield at 3.1% in 2016 before recovering slightly
-Stricter regulatory updates for gas (RoR aligned to that of electricity from June 2016) and for electricity (from January 2018).
-No regulatory efficiency gains.
-Continued cost of debt optimisation reflected in lower average cost of debt (decreasing to 3.1% in 2018 from 4.1% in 2015).
-Energy sector levy of around EUR26m per year in the 2016-2018 period.
-Average capex at around EUR175m in the 2016-2018 period.
-Nominal dividend per share maintained at EUR0.171 per year for 2016-2018
-Regulatory receivables on balance sheet (tariff deviations) of EUR220m for 2016-2018.
-No M&A or greenfield international investments.

RATING SENSITIVITIES
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- An improved economic environment, and reduced structural pressure and political risk in the electricity sector
- Expected net debt-to-regulatory asset base (RAB) below 65%, FFO adjusted net leverage below 5.5x, and FFO interest coverage above 3.5x on a sustained basis

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- A downgrade of the sovereign rating, depending on the factors affecting the sovereign rating trajectory and Fitch's view of its impact on corporate creditworthiness in the country.
- An increase in debt, potentially for international expansion, or weaker cash flows leading to expected net debt-to-RAB above 75%, FFO adjusted net leverage above 6.5x, and FFO interest coverage below 3.0x on a sustained basis
- Further negative changes to the regulatory framework, such as downward RAB revision or significant delays in the recovery of tariff deviations, or adverse fiscal measures.

LIQUIDITY
As of 31 December 2015, REN had around EUR63.7m of readily available cash and around EUR906m of undrawn committed facilities, including commercial paper under subscription guarantee, an undrawn EIB loan and credit lines. We view REN's liquidity as adequate for operating and funding needs up to end-2017.
Debt maturities total around EUR704m until 2017 and we forecast neutral-to- positive FCF of around EUR31m for the same period, depending on tariff deviations which will impact working capital and cash tax.