Fitch Ratings-Moscow-20 December 2016: Fitch Ratings has downgraded Kazakhstan Electricity Grid Operating Company's (KEGOC) Long-Term Foreign Currency Issuer Default Rating to 'BBB-' from 'BBB'. The Outlook is Stable. A full list of ratings actions is available at the end of this commentary.
The downgrade reflects weakened legal ties between KEGOC and its sole, indirect shareholder - the Republic of Kazakhstan (BBB/Stable), following a decline in the share of state-guaranteed debt below our 40% threshold. The share of state-guaranteed debt had been the key driver of the alignment of their ratings. Following the downgrade, the company's Long-Term IDRs are one notch lower than the sovereign's.
KEGOC's ratings continue to reflect overall strong links with the government and we expect timely support in case of need, including should financial covenants need to be waived or renegotiated.
KEY RATING DRIVERS
Weakened Legal Ties
We have introduced a one-notch difference from the sovereign rating for KEGOC due to weakened legal links with the government. Our rating case does not assume any new guarantees to be provided from the government for KEGOC's debt. We expect KEGOC to attract new borrowings at market rates without any preference. KEGOC's share of guaranteed debt fell to 34% at end-3Q16, below our threshold of 40%. The share of guaranteed debt is expected to fall further as the company substitutes debt from EBRD and IBRD with unsecured local bonds.
State Support Underpins Top-Down Approach
We continue to view the operational and strategic links between KEGOC and the state as strong, which supports the application of our top-down rating approach. The strength of the ties is underpinned by the company's strategic importance to the Kazakh economy as it is 90%+1 controlled by the state. Other factors supporting the links are the status of KEGOC as the national electricity transmission grid operator, strong operational ties, including tariff and capex approval, and track record of state support in the form of equity injections, contributions of assets, subordinated loans and subsidies.
Local Bonds Substitution
In June-September 2016 KEGOC placed KZT47.5bn of local unsecured bonds, which were subscribed by National Pension Fund. The interest rate was set at CPI+2.9%. The first coupon rate was set based on CPI in March 2016 at 18.6%, which is high given the modest economic growth in Kazakhstan. The company may issue additional KZT36bn of local bonds in 2017 in case of business needs. We expect interest rate to decrease to 10%-13% in 2017-2019 following the slowdown of inflation in Kazakhstan.
KEGOC continues to benefit from favourable long-term tariffs set by the Committee on Regulation of Natural Monopolies and Protection of Competition until 2020. The tariffs for transmission, dispatching and balancing increased by an average 12% in 2016 and are expected to grow on average 8% in 2017-2020.
In our view long-term tariffs provide earnings visibility, although they remain subject to revision in case of macroeconomic shock or tenge devaluation. In our rating case, we forecast tariffs to grow on average 2% below approved levels over 2017-2020.
CAPEX Remains High
KEGOC's capex programme of KZT236bn for 2016-2020 remains high, although it was scaled down in September 2016 from KZT268bn previously with the postponement of some development projects. The share of maintenance capex is low at an average 14% for 2016-2020, providing the scope for cuts to total capex. However, we do not expect substantial reductions to capex since approved high tariff growth is contingent on certain investments being realised. We also expect KEGOC to rely on new unguaranteed borrowings to finance its large capex programme.
Strengthening Standalone Profile
We assess KEGOC's standalone profile as commensurate with a high 'BB' rating category given the company's monopoly position in electricity transmission in the country and sound financial profile. However, the company's standalone profile is constrained by large capex, which is likely to result in continued negative free cash flow (FCF), and by a high exposure to FX.
Nevertheless, the company's financial profile significantly improved in 2015, and we expect its funds from operations (FFO) adjusted leverage and FFO fixed charge cover to average 2.5x and 6.9x in 2016-2020, respectively. In Kazakhstan we usually look at gross metrics due to a weak local banking system. If the company repays some of its FX-denominated loans, its leverage metric will improve further.
KEGOC is an electricity transmission company in Kazakhstan. Its closest peers are FedGrid (BBB-/Stable), Russian electricity transmission operator, and MOESK (BB+/Stable), the principal electricity distribution company in Moscow and the wider Moscow region. KEGOC and its peers are subject to the regulatory uncertainties stemming from macroeconomic shocks and to possible political interference. Their investment programmes are usually sizeable.
KEGOC and MOESK are also subject to volume risk, while FedGrid's exposure to volume risk is limited since the company's tariffs are set based on, among other factors, customers' declared electricity capacity needs and not on actual electricity consumption. KEGOC is rated based on a top-down approach while FedGrid and MOESK are rated on a standalone basis plus uplift for state support. KEGOC's standalone profile is almost the same as that of FedGrid and MOESK.
Fitch's key assumptions within the rating case for KEGOC include:
- Tariff growth of 2% below the approved long-term tariffs
- Transmission volumes to grow in line with GDP over 2016-2020
- KZT236bn of total capex in 2016-2020
- 80% dividend pay-out ratio in 2017-2020, which is higher than the company's forecast of 40%
- Interest rate for local bonds at 13.4% in 2017, 12.4% in 2018 and 10.4% in 2019-2020.
Future Developments That May, Individually or Collectively, Lead to Positive Rating Action
- Positive sovereign rating action;
- Strengthening of legal ties (e.g. the share of guaranteed debt rises steadily above 40%);
- Enhancement of the business or financial profile, possibly as a result of stronger regulation and higher equity funding, which would be positive for the unguaranteed debt profile of KEGOC and its standalone rating.
Future Developments That May, Individually or Collectively, Lead to Negative Rating Action
- Negative sovereign rating action;
-If the state tolerates deterioration of the company's credit profile e.g. through increased capex programme without sufficient funding or downward revision of tariffs, leading to FFO adjusted gross leverage persistently higher than 4x and FFO fixed charge coverage below 4x, we may consider widening the notching or changing the rating approach to bottom-up.
For the sovereign rating of Kazakhstan, KEGOC's ultimate parent, Fitch outlined the following sensitivities in its rating action commentary of 28 October 2016:
The following risk factors individually, or collectively, could trigger negative rating action:
- Policy mismanagement or prolonged low oil prices leading to a further weakening in the sovereign external balance sheet.
- Materialisation of significant contingent liabilities from the banking sector on the sovereign balance sheet.
The following factors, individually or collectively, could result in positive rating action:
- A sustained recovery in external and fiscal buffers.
- Steps to reduce the vulnerability of the public finances to future oil price shocks, for example, by shrinking the non-oil deficit.
- A sustained recovery in the economy supported by substantial improvements in the business climate and governance and greater diversification.
At 30 September 2016 KEGOC's readily available cash position stood at KZT140bn, which was sufficient to cover short-term maturities of KZT26bn. The company has a fairly balanced debt maturity profile with a KZT22bn annual repayment. However, Fitch expects negative FCF of average KZT6bn annually over 2016-2020, driven by a substantial investment programme.
Almost all of the group's cash position is held at domestic banks. While we believe that the company's access to liquidity for daily operations is likely to be adequate, its full access to all the cash held at Kazakh banks may be limited. As a result, we focus on gross leverage ratios in our analysis rather than on net figures.
High FX exposure
KEGOC is exposed to currency risk as about 76% of the company's KZT205bn debt at 30 September 2016 was in foreign currencies (51% in USD and 25% in EUR) with only a marginal portion of revenue denominated in USD (related to transnational electricity flow). KEGOC does not have any hedging arrangements, although the currency mismatch risk is partly mitigated by its holding of KZT74bn of USD-denominated cash and bank deposits.
Vulnerability to FX risk will be reduced as KEGOC issues further local bonds or decides to repay some of its loans early. Nevertheless, we expect the FX exposure to remain significant.
FULL LIST OF RATING ACTIONS
Long-Term Foreign and Local Currency IDRs downgraded to 'BBB-' from 'BBB', Outlook Stable
Short-Term Foreign Currency IDR downgraded to 'F3' from 'F2'.
Dmitry Doronin, CFA
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Fitch Ratings CIS Ltd
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Arkadiusz Wicik, CFA
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Summary of Financial Statement Adjustments
Operating leases: We applied a 6x multiple (relevant to Kazakhstan) to operating lease expenses to create a debt-like obligation.
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