Fitch assigned long-term default rating to SevKazEnergo at level "BВ-"; outlook "Stable"

/Fitch Ratings, Moscow, June 2, 15, heading by KASE/ – Fitch Ratings has assigned Kazakhstan-based electricity and heat generator and distributor Joint Stock Company Sevkazenergo (Sevkazenergo), a Long-term foreign currency IDR of 'BB-' with Stable Outlook. A full list of ratings actions is at the end of this comment. Sevkazenergo's ratings are aligned with those of its sole shareholder, Joint Stock Company Central-Asian Electric-Power Corporation (CAEPCo, BB-/Stable), reflecting its position as one of two key operating subsidiaries within the CAEPCo group, contributing 37% of group EBITDA. The rating reflects Sevkazenergo's vertical integration, stable regional market share and access to cheap regulated coal supplies. KEY RATING DRIVERS Generation Dominates Despite Integration Sevkazenergo is one of the CAEPCo's key operating subsidiaries. The company is integrated across the electricity value chain with the exception of fuel production and transmission, which gives the company access to markets for its energy output and limits customer concentration. Sevkazenergo covers electricity and heat generation, distribution and supply in Petropavlovsk regions, which is responsible for about 3% of electricity generation in Kazakhstan. Despite integration, Sevkazenergo's EBITDA is dominated by generation services, which accounted for about 94% of company's EBITDA in 2014. Cheap Fuel Supports EBITDA Kazakh coal prices are significantly below international market rates, reflecting their regulated nature and low transport costs. An unexpected and significant increase in the price of coal above Fitch's current inflationary driven estimates of 7%-9% annually would have a negative impact on EBITDA, although we consider this unlikely. Fuel costs are reflected in power tariff caps to protect energy affordability and the coal price charged to utilities is regulated annually, limiting price exposure. Solid CFO, Negative FCF Expected Fitch anticipates Sevkazenergo to continue generating healthy cash flows from operations of around KZT8bn on average for 2015-2018 but its ambitious capex along with dividends payments is likely to result in negative FCF of around KZT1.7bn p.a. over the same period. Fitch expects Sevkazenergo to rely on new borrowings to finance cash shortfalls. Sevkazenergo estimates capex of about KZT46bn over 2015-2019 to modernise aging infrastructure, and will likely require additional funding. High Leverage Expected We expect Sevkazenergo's ambitious investment programme of KZT37bn over 2015-2018 to be partially debt funded, therefore we forecast its average FFO adjusted leverage to remain elevated at about 2.6x over the same period. However, we note that Sevkazenergo's investment programme has some flexibility until 2016 (committed capex amounted to KZT7bn to be spent in 2015) and afterwards will depend on the approved tariffs. The company expects maintenance capex of around KZT3bn on average over 2015-2019. The capex programme is aimed at modernising about 50% of Sevkazenergo's ageing 1960s generation capacity by 2017, as well as upgrading its distribution network. Capacity expansion will be moderate at around 15% in total to 2017 but additional benefits will be reduced losses in production and distribution of heat and electricity. Loss Making Heat Business The heat distribution business is loss-making due to high heat losses and regulated end user tariffs, which Fitch assumes are kept low for social reasons (heat generation is reported within overall generation and cash flow accretive), a situation that we assume will persist but gradually improve. Regulatory Uncertainty The Kazakh authorities are currently considering draft legislation on the implementation of an electricity capacity market. When fully implemented, the capacity market should ensure an economically sound return on investment and should provide incentives for construction of new generation assets or for expanding current capacity. An effective launch of the capacity market should provide a stable revenue stream to fund utilities' capital investment programmes. A successfully functioning capacity market is likely to support credit profiles of power generators. However, no final decision regarding a capacity market has been made. Fitch expects that tariffs for generators will continue to reflect fuel and other costs inflation while capacity payments will cover capex needs. State approval of maximum tariff caps for a seven-year period with possible annual revisions are under discussion. Electricity transmission tariffs could switch from the 'benchmarking' methodology introduced in 2013, to long-term tariffs (five years) approval based on 'cost plus allowable profit margin' methodology. Long-term (five years) heat generation, distribution and sales tariffs based on 'cost plus allowable profit margin' methodology are also under consideration, to replace the present annual approval practice. Fitch views positively the potential switch to long-term tariff approval. However, we note that there are still uncertainties in the regulatory regime post 2015. Dividends to Delay Debt Reduction Sevkazenergo's financial policy is to pay dividends and this could delay de- leveraging in the long term. However, we believe that should tariffs and volumes underperform, Sevkazenergo retains the flexibility to lower dividends to preserve cash, as demonstrated in 2011 when the dividend payout ratio decreased to about 12% upon 2011 results due to the decision of shareholders to accelerate the implementation of investment programme. Sevkazenergo's sole shareholder, CAEPCo, is currently considering a more flexible dividend policy, widening to 15%-50% of net profit from 30%-50%, although we expect it to be adequate to cover debt service requirements at CAEPCo. The company is expecting to pay about 25%-30% of net profit in the medium term. RATING SENSITIVITIES Positive: Future developments that could lead to positive rating action include: - A stronger financial profile than forecast by Fitch due to, among other things, higher than expected growth in electric and heat tariffs and/or generation electricity supporting FFO gross adjusted leverage below 2x and FFO interest coverage above 7x on a sustained basis would be positive for the ratings. - Increased certainty regarding the post-2015 regulatory framework could also be supportive of the ratings. Negative: Future developments that could lead to negative rating action include:: - A substantially above inflation increase in coal price and/or tariffs materially lower than our forecasts, leading to FFO gross adjusted leverage persistently higher than 3x and FFO interest coverage below 4.5x would be negative for the ratings. - Committing to capex without sufficient available funding, worsening overall liquidity position may also be rating negative. LIQUIDITY AND DEBT STRUCTURE Imminent Refinancing Needs Fitch views Sevkazenergo's liquidity as weak. At end-2015 short-term debt amounted to KZT7bn against cash and cash equivalents of KZT0.5bn along with unused credit facilities of KZT1.5bn. The majority of short-term debt is working capital facilities maturing in September-October 2015 that are secured by an assets pledge. The company is currently negotiating maturity extension of these loans. Additionally CAEPCo plans to issue up to KZT6.8bn of local bonds in June 2015 (KZT2.5bn is planned to be issued by Sevkazenergo, the remainder by CAEPCO). Sevkazenergo's and CAEPCo's bond proceeds could be used for refinancing Sevkazenergo's maturing loans. According to management the unused credit facilities limits could be redeployed between companies within the CAEPCo group. However, the CAEPCo group's treasury is co-ordinated centrally for the parent company and the subsidiaries. Fitch notes that at end-2014, CAEPCo group's unused credit facilities amounted to KZT7.6bn. At FY-2014 most of Sevkazenergo's debt was made up of secured bank loans (KZT13.6bn or about 62%) and unsecured local bonds maturing in 2020 (KZT6bn in total or 28%). Senior Unsecured Debt Aligned Issuer Rating Sevkazenergo's KZT6bn local senior unsecured bond is rated 'BB-' in line with its IDR as the bonds are issued at the operating company level, its overall leverage is not excessive and the level of encumbered assets compared to senior unsecured debt is low. At end-2014, pledged assets amounted to KZT57bn (out of KZT85bn). Foreign Currency Exposure Sevkazenergo is subject to foreign currency fluctuation risks as about 27% of its debt at FY2014 was denominated in US dollars. Fitch notes that the company does not have hedging policies in place. The amount of cash denominated in US dollars was negligible at end-2014. Sevkazenergo is also exposed to interest rate risk since it about half of its outstanding loans are drawn under floating interest rates. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - Electricity volume growth in line with Fitch forecasted GDP of 2.5%-3.5% over 2015-2019. - Tariffs growth as approved by the government for 2015 and in line with inflation, which Fitch forecasts at about 6%-8% in 2016-2019. - Capex as expected by the company. - Inflation-driven cost increase. FULL LIST OF RATING ACTIONS Long-term foreign currency IDR assigned at 'BB-', Outlook Stable Long-term local currency IDR assigned at 'BB-', Outlook Stable National Long-term Rating assigned at 'BBB+(kaz)', Outlook Stable Local currency senior unsecured rating assigned at 'BB-', Recovery Rating 'RR4'. Contact: Principal Analyst Elina Kulieva Associate Director +7 495 956 99 01 Supervisory Analyst Oxana Zguralskaya Director +7 495 956 70 99 Fitch Ratings CIS Ltd 26 Valovaya Street Moscow 115054 Committee Chairperson Josef Pospisil Senior Director +44 20 35301287 Media Relations: Julia Belskaya von Tell, Moscow, tel. + 7 495 956 9908/9901, julia.belskayavontell@fitchratings.com [2015-06-03]