Fitch affirms long-term rating of Mangistau Distribution Power Grid at level "BB+"; outlook "Negative"

/Fitch Ratings, Moscow, August 6, 15, heading by KASE/ – Fitch Ratings has affirmed the Kazakhstan-based Mangistau Electricity Distribution Company JSC's (MEDNC) Long-term Issuer Default Rating (IDR) at 'BB+' with a Negative Outlook. Fitch has also assigned MEDNC's proposed KZT2.5bn senior unsecured notes due 2025 a 'BBB-(EXP)' expected local currency senior unsecured rating. A full list of ratings actions is available at the end of this commentary. The expected senior unsecured rating is in line with MEDNC's Long-term local currency IDR of 'BBB-'. The bonds will constitute a direct and unsecured obligation of the company. MEDNC will use the proceeds of the bond to finance its investment programme. The final bond's rating is contingent upon the receipt of final documentation conforming materially to information already received. The Negative Outlook reflects our assessment of weakening ties between MEDNC and its ultimate parent, Kazakhstan (BBB+/Stable). This is due to the planned sale of the full 75% stake owned by 100% state-owned JSC Samruk- Energy (BBB-/Stable) in MEDNC over the medium term as well as expected material deterioration of the company's credit metrics over 2015-2018 due to debt-funded large capex imposed by the state. Consistent evidence of weakening links between the company and ultimate parent would result in Fitch shifting to a bottom-up rating approach from the currently applied top-down assessment. MEDNC's ratings are currently notched down three levels from the sovereign's. KEY RATING DRIVERS Ambitious Debt-Funded Capex MEDNC plans to embark on a substantial capex programme approved by the government of KZT28.5bn for 2015-2018. As a result, we expect the company's free cash flow (FCF) to remain significantly negative for 2015-2018. The company plans to finance the investment programme mostly with borrowed funds. MEDNC expects to issue KZT2.5bn, KZT11.6bn and KZT2.3bn of domestic bonds in 2015, 2016 and 2017, respectively. Capex will be spent on the construction of two new electricity distribution grids Aktau-Karazhanbas and Aktau-Uzen for KZT13bn and the reconstruction of existing distribution lines and substations. These two new grids aim to service the expected higher capacity needs of Aktau's existing oil refining companies, and a fourth refinery, which is scheduled to be constructed in Aktau Region over the medium term. We consider MEDNC's planned large-scale investments to be opportunistic as the refinery projects, which are expected to drive electricity demand, have not been implemented yet and may be postponed due to lower oil prices and the slowdown of the Kazakh economy. As a result, we believe MEDNC's new grids construction project could face high execution risk, which may be exacerbated by reliance on external funding from domestic markets or domestic banks, as well as by volume risk, which may or may not be fully reflected in tariffs. Deteriorating Standalone Profile We expect that the implementation of the aggressive investment programme, which will be funded by significant debt, is likely to lead to a material deterioration of MEDNC's credit metrics and, as a result, its standalone profile. We now assess the company's standalone profile as commensurate with the mid-'B' rating category. Fitch expects funds flow from operations (FFO) gross adjusted leverage to increase to around 3x by end-2015 and remain well above 5x over 2016-2017 under the agency's conservative assumptions. At end-2014 MEDNC reported FFO gross adjusted leverage of 2.0x, up from 1.3x at end-2013. Weakening Ties May Change Rating Approach The Negative Outlook is driven by weakening links between MEDNC and its majority shareholder Samruk-Energy and ultimately the state. This is due to the planned sale of Samruk-Energy's stake in MEDNC and lack of commitment by the state to provide financial support to the company, whose credit metrics are likely to substantially deteriorate due to high capex imposed by the state. Consistent evidence of weakening links with the ultimate parent leading to deterioration of MEDNC's credit metrics such that FFO gross adjusted leverage remains above 5x over 2015-2019 would result in Fitch adopting a bottom-up rating approach from the current top-down approach. MEDNC's ratings are currently notched down from Kazakhstan's by three notches, reflecting moderately strong links between the company and its ultimate parent. Samruk-Energy does not view MEDNC as strategic and is likely to sell its stake in MEDNC in 2016-2017. Favourable Tariffs MEDNC's tariffs are approved by Kazakhstan's Agency on Regulating Natural Monopolies and Competition Protection in conjunction with the company's capex programme. At present, MEDNC's tariffs are approved for five years 2015-2019 based on an assumed tariff growth of 0.3%-15.3% per annum, which Fitch views positively. The tariff system for transmission and distribution segments, which is predominantly based on benchmarking efficiency, results in favourable tariffs for MEDNC. Near-Monopoly Position 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 its cash flow generation capacity, its high exposure to a single industry (oil and gas) and, within that, high customer concentration (the top four customers represented over 64% of 2014 revenue). The latter is somewhat mitigated by the state ownership of some customers, and by prepayment terms under transmission and distribution agreements. RATING SENSITIVITIES Negative: Future developments that could lead to negative rating action include: – 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. Positive: Future developments that could lead to positive rating action include: – 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. For the sovereign rating of Kazakhstan, MEDNC's ultimate parent, Fitch outlined the following sensitivities in its rating action commentary of 1 May 2015: The Outlook is Stable, meaning that the downside and upside risks are evenly balanced. However, the following risk factors individually, or collectively, could trigger negative rating action: – Policy mismanagement and/or a prolonged fall in oil prices leading to a decline in sovereign net foreign assets accompanied by reduced economic and financial stability – Renewed weakness in the banking sector, which leads to contingent liabilities for the sovereign – A political risk event. Conversely, the following factors, individually or collectively, could result in positive rating action: – Moves to strengthen monetary and exchange rate policy – An effective restructuring of banks' balance sheets – Steps to reduce the vulnerability of the public finances to future oil price shocks, for example, by reducing the non-oil deficit, currently estimated at more than 9% of GDP – Substantial improvements in governance and institutional strength. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: – Domestic GDP growth of 1.8% in 2015 and 2.5%-4% in 2016-2018 and inflation of 6.2% in 2015 and 5.5% over 2016-2018 – Electricity distribution tariff growth in line with government-approved level – Cost inflation in line with expected CPI – Capital expenditure in line with government-approved level – Dividend payments of 15% of IFRS net income over 2016-2018. LIQUIDITY AND DEBT STRUCTURE Fitch views MEDNC's liquidity as manageable, comprising solely cash as the company does not have any available credit lines. At end-2014, MEDNC's cash balance of KZT1.1bn was sufficient to cover short-term maturities of KZT314m. Cash balances are mostly held in local currency with domestic banks including Halyk Bank of Kazakhstan (BB/Stable) and Nurbank. At end-2014, most of MEDNC's debt was represented by two unsecured fixed-rate bonds of KZT1.7bn and KZT2.4bn maturing in 2023 and in 2024, respectively. The rest of the debt is represented by interest-free loans with maturity up to 2036 from MEDNC's customers to co-finance new network connections. MEDNC benefits from limited foreign-exchange risks and from the absence of interest-rate risks. MENDC's ambitious capex programme will be funded by additional debt over the medium term. MEDNC has some track record in accessing the domestic bond market. During 2014 MEDNC issued KZT2.4bn of bonds to partly finance its substantial capex needs (KZT3bn) for the year. FULL LIST OF RATING ACTIONS Long-term foreign currency IDR: affirmed at 'BB+', Outlook Negative Long-term local currency IDR: affirmed at 'BBB-', Outlook Negative National Long-term rating: affirmed at 'AA(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 and KZT2.4bn bonds, affirmed at BBB-' Expected local currency senior unsecured rating on the proposed KZT2.5bn notes assigned at 'BBB-(EXP)' Contact: Principal Analyst Alexey Evstratenkov Analyst +7 495 956 9984 Supervisory Analyst Elina Kulieva Associate Director +7 495 956 9975 Fitch Ratings CIS Ltd 26 Valovaya Street Moscow 115054 Committee Chairperson Angelina Valavina Senior Director +44 20 3530 1314 Contact for media in Moscow: yulia Belskaya von Tell, Moscow, tel. + 7 495 956 9908/9901, julia.belskayavontell@fitchratings.com [2015-08-07]