OREANDA-NEWS. Fitch Ratings has affirmed South African state-owned Rand Water's National Long-term rating and senior unsecured rating at 'AA+(zaf)' and National Short-term rating at 'F1+(zaf)'. The Outlook on the Long-term rating is Stable.

The ratings, which are notched down once from the sovereign's rating (Long-term local currency Issuer Default Rating: BBB/Stable), continue to reflect strong links between the company and the state, including the strategic importance of South Africa's water sector, and reflect a high level of implied support from the national government. Rand Water continues to maintain its strong regional position as the main bulk water distributor in the greater Gauteng province.

Fitch views Rand Water's standalone profile as 'AA(zaf)', reflecting a favourable cost-reflective regulatory tariff structure over the medium term that is balanced by large capex plans (excluding government-funded growth capex), which according to our projections will likely lead to a deterioration of credit ratios by 2018. The lack of an independent regulator exposes the tariff determination to political risks and the company faces counterparty concentration.

KEY RATING DRIVERS
Strong Shareholder Links
The strong links between Rand Water and the government are evidenced by its full ownership by the South African state. This is further supported by Rand Water's status as a non-commercial entity, a zero dividend policy, non-payment of taxes, its customer structure largely consisting of public entities and municipalities, procurement of raw water from the Department of Water and Sanitation (DWS) and direct grants from the government to certain Rand Water infrastructure projects. Fitch assumes that further tangible support would be provided, if needed.

Furthermore, Rand Water's Board of Directors is appointed by the Minister of Water and Sanitation. The government's ownership of Rand Water is further entrenched through the approval of the company's capex programme and the setting of its borrowing limit, which is revised annually.

Borrowing limits approved by the Minister of Finance in June 2013 are ZAR5.8bn for core water infrastructure projects, which expire on 30 June 2018. The borrowing limit allows the utility to raise an additional ZAR5.8bn during this five-year period. In the financial year to June 2015 the utility raised an additional ZAR1.1bn of debt, bringing total debt to ZAR3.7bn. Consequently, Rand Water has ZAR3.6bn headroom remaining under the current borrowing limit and we do not envisage a breach of this borrowing limit in the next two years.

Peak Demand Close to Capacity
The peak demand profile for 2015 reached 4,962 megalitres per day (Ml/d), just less than the utility's capacity of 5,000 Ml/d (average 4,757 Ml/d). Rand Water's plans to address the supply side capacity will increase capex to about ZAR14bn for 2016 to 2019 (ZAR7.8bn 2012-2015). For FY16, peak demand is expected to reach approximately 5,000 Ml/d compared with capacity of 5,250 Ml/d. The increase in capex will lead to negative free cash flow, which will be funded by bond issuances under the ZAR10bn Domestic Medium Term Note (DMTN) programme (ZAR6.3bn available at FYE15). We do not expect the leverage and coverage ratios to breach the negative rating guidelines with sufficient headroom under coverage and some pressure on net leverage at 3x in 2018.

Natural Monopoly Position
Rand Water's credit profile is supported by its regional monopoly position in the greater Gauteng region. Local municipalities and local authorities owned by the state make up almost 90% of Rand Water's water sales, with its largest customer being the City of Johannesburg (Long-term local currency Issuer Default Rating: BBB/Stable).

Supportive Tariff Structure
Funds from operations (FFO), which is a key driver of the ratios, is supported by increased cash generation due to the double-digit tariff increases. Tariffs are approved by DWS (both a regulator and supplier of raw water) and more recently, DWS established an economic water regulator. This step would be positive if multi-year tariff increases were to be established. If the tariff increases reduce below our expectation, we expect Rand Water to reduce the capex programme and/or DWS to increase grant support.

Expansion of Service Area
Fitch expects Rand Water's service area to expand in the next 18 to 36 months. The first stage, now concluded, saw the consolidation of the Bushbuckridge Water Board into Rand Water, by DWS.

Fitch believes the concept of 'implementing agent', whereby DWS channels infrastructure grants through 'Rand Water', will become increasingly prevalent. Rand Water controls the underlying projects but the associated capex and cash flows will remain with the municipality (funding is usually provided by DWS). Rand Water could benefit from economies of scale as the procurement for infrastructure-related items increases.

Fitch does not believe the South African Government and/or Ministry of DWS will force Rand Water to take on projects that are not financially viable. This is evidenced in the Water Services Act, No. 108 of 1997. More recently, in the state of the nation address, President Zuma mentioned "For the state owned companies to contribute to the successful implementation of the National Development Plan, they must be financially sound". Fitch expects it is likely that infrastructure expansion costs, which cannot be recovered through the tariff, will be fully or partially funded by the DWS.

The CEO of Rand Water, Mr Percy Sechemane, has been appointed to the President's National Planning committee, which Fitch views as positive as this could help ensure the expansion of the service area is implemented with the financial sustainability of Rand Water as the key theme.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- No impact from the expansion of the Rand Water service area.
- Fitch expects a 0% volume increase in water sales per year for 2016, there after approximately 1% for 2017 to 2019 per year primarily driven by population growth in Gauteng province.
- We expect an increase of 11% in Rand Water's cost of raw water in FY16, to be passed through to end users through a low double-digit bulk water tariff increase effective 1 July 2016.
- The cost of energy will increase by approximately 18% in 2016, which is a combination of volume increase and weighted tariff increase, which varies from Eskom Holdings SOC Ltd (Long-term local currency Issuer Default Rating: BBB/Stable) to individual municipalities.
- We expect a yoy improvement in EBITDA margin in FY16 and FY17.
- ZAR14bn of capex for the next four years will lead to significant negative free cash flow, which will be primarily funded from internally generated funds and debt of approximately ZAR6bn.

RATING SENSITIVITIES
Future developments that may individually or collectively lead to negative rating action include:
- Weakening linkage with the sovereign in conjunction with deterioration in FFO adjusted net leverage to over 3.0x and FFO interest cover to less than 3.0x on a sustained basis.

Future developments that may individually or collectively lead to positive rating action include:
- Strengthening of the standalone profile, particularly a significant improvement in free cash flow.
- Explicit government guarantee for a majority of Rand Water's debt.

LIQUIDITY
Liquidity is supported by a cash balance of ZAR1,508m and a committed facility of ZAR1,000m as of 31 December 2015. There are no major debt maturities in the medium term. Although Fitch expects negative FCF of ZAR1,214m at financial year end 2016 due to capex, spending will be contingent on obtaining funding.