Fitch Affirms Mangistau Electricity Distribution Company at ‘BB’; Outlook Negative
Fitch Ratings-Moscow-20 December 2016: Fitch Ratings has affirmed Kazakhstan-based Mangistau Electricity Distribution Network Company JSC’s (MEDNC) Long-Term Issuer Default Rating (IDR) at ‘BB’ with a Negative Outlook. A full list of ratings actions is available at the end of this commentary.
The Negative Outlook reflects our expectation of weakening ties between MEDNC and its ultimate parent, Kazakhstan (BBB/Stable) as a result of the planned sale of the full 75% stake owned by state-controlled JSC Samruk-Energy (BB+/Stable) in MEDNC over the medium term. Weakening links with the state and the absence of explicit parental support would result in Fitch adopting a bottom-up rating approach, compared with the current top-down application.
KEY RATING DRIVERS
Samruk-Energy does not view MEDNC as strategic and is likely to sell its stake in MEDNC over the medium-term. The likely bidder is LLP Kazakhstan Utility Systems (BB-/Stable), which acquired 6.2% of MEDNC in January 2016 and announced its intention to increase its share to a controlling interest. Once privatisation takes place we may change our rating approach to reflect MEDNC’s standalone profile if no explicit support is forthcoming from the new owner.
MEDNC’s ratings are currently notched down from Kazakhstan’s by three notches, reflecting the moderate strength of the links and lack of commitment by the state to provide financial support to the company.
Capex to Drive Negative FCF
We expect the company’s free cash flow (FCF) to remain significantly negative over the rating horizon of 2016-2020, due to a substantial capex programme approved by the government of KZT27.5bn for 2016-2020. However, the company will shift the KZT6.3bn capex scheduled for 2016-2017 to later years. Thus the company’s leveraging is expected to be slower and more gradual than we had previously expected.
Fitch expects funds flow from operations (FFO) gross adjusted leverage to increase to 4x by end-2016 and on average 4.7x in 2017-2020, from 2.8x in 2015.
Capex will be spent on the construction of two new electricity distribution grids Aktau-Karazhanbas and Aktau-Uzen for KZT12.1bn and the reconstruction of existing distribution lines and substations. We believe MEDNC’s new grids construction project could face high execution risk as well as volume risk, which may or may not be fully reflected in tariffs. The company plans to finance the investment programme mostly with borrowed funds and expects to issue KZT19.6bn of domestic bonds in 2017-2020.
Weak Standalone Profile
We continue to assess the company’s standalone profile as commensurate with the mid-‘B’ rating category, which reflects its small size, industry and customer concentration, negative FCF expectation and weakening credit metrics. However, it also positively reflects the current supportive tariff regime and sound-quality counterparties, and capex flexibility.
Long-term Favourable Tariffs
In November 2015 tariffs were approved for 2016-2020 for MEDNC and its legal entities. Tariff growth is assumed at a healthy 15% in 2016 and substantially slower at 1.9%-4.9% over 2017-2020. Long-term tariffs add visibility to the company’s cash flows, but below-inflation tariff growth is a drag on the company’s credit profile.
MEDNC’s tariffs are approved by Kazakhstan’s Agency on Regulating Natural Monopolies and Competition Protection in conjunction with the company’s capex programme. Tariffs are differentiated by type of client – legal entities, households and public institutions. Legal entities accounted for 86% of MEDNC’s transmission volumes in 2015.
MEDNC’s credit profile is supported by the company’s near-monopoly position in electricity transmission and distribution in the Region of Mangistau, one of Kazakhstan’s strategic oil- and gas-producing regions. It is also underpinned by prospects for economic development and expansion in the region, in relation to both oil and gas and transportation, and by favourable long-term tariffs.
Small Scale, Concentrated Customer Base
The business profile is constrained by MEDNC’s small scale of operations limiting the company’s cash flow generation capacity, a high exposure to a single industry (oil and gas) and, within that, high customer concentration (the top four customers represented 62% of revenue in 1H16). The latter is somewhat mitigated by the state ownership of some customers, and by prepayment terms under transmission and distribution agreements.
MEDNC is a small electricity distribution company in western Kazakhstan. Its closest peers are MOESK (BB+/Stable), the principal electricity distribution company in Moscow and the wider Moscow region. Other peers are KEGOC (BBB-/Stable) and FedGrid (BBB-/Stable), electricity transmission companies with operations across Kazakhstan and Russia, respectively.
MEDNC has a much smaller scale of operations than its peers and has the weakest standalone credit profile. MEDNC and its peers are subject to regulatory uncertainties stemming from macroeconomic shocks and to possible political interference. Their investment programmes are usually sizeable. MEDNC, KEGOC and MOESK are also subject to volume risk, while FedGrid’s exposure to volume risk is limited since its tariffs are based on, among other factors, customers’ declared electricity capacity needs and not on actual electricity consumption.
MEDNC and KEGOC are rated top-down, while FedGrid and MOESK are rated based on a standalone basis plus uplift for state support.
Fitch’s key assumptions within the rating case for MEDNC include:
– Domestic GDP growth of 0.6% in 2016 and 2%-3% in 2017-2020 and inflation of 15.2% in 2016 and 5-8% over 2017-2020
– Electricity distribution volumes increase in line with GDP
– Electricity distribution tariff growth as approved by the regulator
– Cost inflation slightly below expected CPI to reflect the company’s cost control efforts
– Capex in line with government-approved level
– Dividend payments of 15% of IFRS net income over 2016-2020.
Future Developments That May, Individually or Collectively, Lead to Positive Rating Action
– Stronger links with the ultimate parent.
-Enhancement of the business profile, such as diversification and scale with only modest increase in leverage, which would be positive for the standalone profile.
Future Developments That May, Individually or Collectively, Lead to Negative Rating Action
– Negative rating action on Kazakhstan’s ratings.
-Weakening links with the ultimate parent – the state, including but not limited to a reduction of Samruk-Energy’s stake in MEDNC to less than 50%, or an elevated dividend payout, insufficient tariffs and increased capex contributing to weaker credit metrics such that FFO gross adjusted leverage remains above 5.0x on a sustained basis.
For the sovereign rating of Kazakhstan 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.
LIQUIDITY AND DEBT STRUCTURE
At end-9M16, MEDNC’s cash balance of KZT601m was sufficient to cover short-term maturities of KZT259m. Cash balances are mostly held in local currency with domestic banks.
At end-9M16, most of MEDNC’s debt was represented by three unsecured fixed-rate bonds of KZT1.7bn, KZT2.4bn and KZT3.3bn maturing in 2023-2025. The rest of the debt is represented by bank loans, including the recently drawn seven-year KZT2.9bn, out of a KZT6.4bn uncommitted credit line from Bank Centercredit (B/Stable), at 17%. The company plans to finance cash shortfalls with additional borrowing from local bond issues and bank loans. In 2017 MEDNC also plans to refinance the KZT2.9bn loan with local bonds at a lower rate.
MEDNC is exposed to FX risk as about 40% of the company’s KZT8.4bn debt represents local bonds which were linked to the KZT/USD exchange rate and placed in September 2015. The base rate is 250 KZT/USD and if tenge devalues, the principal increases proportionately. Thus as of 30 September 2016 when the exchange rate was 335KZT/USD, the principal value of this bond issue increased to KZT3.3bn from KZT2.5bn.
FULL LIST OF RATING ACTIONS
Long-Term Foreign and Local Currency IDRs affirmed at ‘BB’, Outlook Negative
National Long-Term Rating affirmed at ‘A+(kaz)’, Outlook Negative
Short-Term Foreign Currency IDR affirmed at ‘B’
Foreign currency senior unsecured rating affirmed at ‘BB’.
Local currency senior unsecured rating, including that on KZT1.7bn, KZT2.4bn and KZT3.3bn bonds, affirmed at ‘BB’.
Dmitry Doronin, CFA
+7 495 956 9984
+7 495 956 2402
Fitch Ratings CIS Ltd
26 Valovaya Street
Arkadiusz Wicik, CFA
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Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: email@example.com.
Additional information is available on www.fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary.
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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