Fitch downgrades SevKazEnergo ratings; outlook Stable

/Fitch Ratings, Moscow, July 28, 2016, heading by KASE/ – Fitch Ratings has downgraded Kazakhstan-based Joint Stock Company Sevkazenergo's Long-Term Foreign Currency Issuer Default Rating (IDR) to 'B+' from 'BB-'. The Outlook is Stable. A full list of ratings actions is at the end of this commentary. The downgrade follows the downgrade of Sevkazenergo's sole shareholder, Joint Stock Company Central-Asian Electric-Power Corporation (CAEPCo, B+/Stable; see 'Fitch Downgrades CAEPCo to 'B+'; Outlook Stable'). Sevkazenergo's ratings are aligned with CAEPCo's, reflecting its position as one of two key operating subsidiaries within the CAEPCo group, contributing 43% of group EBITDA. The downgrade reflects the expected deterioration of CAEPCO's credit metrics over 2016-2019 as a result of the Kazakh tenge's devaluation in 2015 and the company's high exposure to foreign currency fluctuation risks. The rating also reflects Sevkazenergo's vertical integration, a stable regional market share and a benign regulatory regime in the distribution segment. However, the rating is constrained by the company's weak liquidity profile, unfavourable regulatory environment in the generation segment and significant capex needs, which are expected to be partially debt funded. We assess CAEPCo, Sevkazenergo and another 100% subsidiary, Pavlodarenergo, on a consolidated basis, since there is no ring-fencing, treasury is centrally managed and debt is located at both holdco and opco levels. KEY RATING DRIVERS High FX Exposure Pressures Credit Metrics The devaluation of the Kazakhstan tenge by more than 90% in 2015 has weakened Sevkazenergo's credit profiles due to a currency mismatch between the company's debt and revenues and the absence of hedging to reduce foreign exchange risk exposure. At end-2015, 40% of company's outstanding debt was US dollar-denominated, while all revenue was local currency-denominated. We expect this pressure to continue, even with no further tenge devaluation. The amount ofcash denominated in US dollars was negligible at end-2015. Covenants Breach As a result of the tenge devaluation, Sevkazenergo breached its current ratio covenant per loan agreements with EBRD in 2015. The company received a waiver for 2015. We expect Sevkazenergo to breach this covenant in 2016-2019 even with no further tenge depreciation. Failure to obtain a waiver or revise the covenant may lead to a further downgrade. EBRD indirectly owns 22.6% of Sevkazenergo. Significant Capex, Negative FCF Expected We expect capex to remain high, despite the completion of the mandatory investment programme, which CAEPCo agreed with the government in 2009-2015 when tariff caps were in place. Fitch expects Sevkazenergo to continue generating solid cash flow from operations (CFO) of KZT9bn on average over 2016-2019, although free cash flow (FCF) is likely to remain negative at an average KZT1bn per year over the same period. This will be mainly driven by the company's significant investment programme of an average KZT9bn annually for 2016-2019 as well as dividend payments of about 50% of net profit over the medium term. We have adjusted Sevkazenergo's investment programme on capex/revenue ratio to reflect that most of it has is discretionary. Fitch expects Sevkazenergo to rely on new borrowings to finance cash shortfalls. Dividends to Delay Deleveraging Sevkazenergo's financial policy to pay dividends could delay de-leveraging in the long term. However, we believe that should the tenge devaluation undermine the company's credit metrics, To the extent CAEPCo has sufficient funds to service its debt, Sevkazenergo retains the flexibility to lower dividends to preserve cash, as demonstrated in 2011 when it cut dividends to offset higher capex. According to CAEPCo, Sevkazenergo will not pay dividends in 2016, while in our rating case we assume a 50% payout from 2017. Nevertheless, we expect FCF to remain negative since funds from operations (FFO) will not be sufficient to cover still high capex and dividends. 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 region, which is responsible for 3.1% of electricity generation in Kazakhstan as of end-2015. Despite integration, Sevkazenergo's EBITDA is dominated by generation services. Strong 1H16 Results Sevkazenergo demonstrated strong operational and financial results in 2015 and 1H16. Electricity production rose by 2.8% yoy in 2015 compared with a 3.3% decline in Kazakhstan and continued to increase by 17.4% yoy in 1H16 vs. 0.4% decline in Kazakhstan. Despite this, we expect Kazakhstan GDP to decline by 1% and inflation to grow by 14% in 2016. We forecast the company's financial profiles to remain strong, with an average EBITDA margin of about 37% over 2016-2019, which will support its ratings. This is based on our assumptions of approved tariff growth for distribution segment, 0% tariff growth rate for generation segment for 2016-2018. Regulatory Environment Following the postponement of the capacity market launch in Kazakhstan until 2019, the regulator decided to freeze generation tariffs and fix them at the 2015 level for 2016-2018. However, in electricity distribution five-year tariffs were approved on the basis of "cost plus allowable margin" methodology instead of the previously used "benchmarking". In the heat segment "cost plus allowable margin" methodology remained unchanged, but tariffs were also approved for five years. The heat distribution business continues to be loss-making due to large heat losses and regulated end-user tariffs, which Fitch assumes are kept low for social reasons (heat generation is reported within overall generation and is cash flow- accretive). KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - Electricity volume growth in line with Fitch GDP forecasts of 2.0% over 2017- 2019 - Tariffs growth as approved by the government for distribution segment with 3% CAGR over 2016-2020 and 0% for generation segment for 2016-2018 - Capex in line with the company's adjusted on capex/revenue ratio - Inflation-driven cost increase - No further tenge depreciation - Dividend payments of 50% of IFRS net income over 2017-2019. RATING SENSITIVITIES Negative: Future developments that could lead to negative rating action include: - Negative rating action on CAEPCo as Sevkazenergo's ratings are aligned with the parent IDR.. Positive: Future developments that could lead to an upgrade include: - Positive rating action on CAEPCo. The sensitivities may change if the links with CAEPCo weaken. For the rating of CAEPCo, Sevkazenergo's ultimate parent, Fitch outlined the following sensitivities in its rating action commentary of 27 July 2016: The sensitivities may change if the links with CAEPCo weaken. For the rating of CAEPCo, Sevkazenergo's ultimate parent, Fitch outlined the following sensitivities in its rating action commentary of 27 July 2016: - Sustained slowdown of the Kazakh economy, further tenge devaluation, increase in coal prices that is substantially above inflation or tariffs materially lower than our forecasts, leading to FFO-adjusted gross leverage persistently higher than 4x and FFO interest coverage below 3.5x. - Committing to capex without sufficient available funding and worsening overall liquidity. Positive: Future developments that could lead to an upgrade include: - A stronger financial profile than forecast by Fitch supporting FFO adjusted gross leverage below 3x and FFO interest coverage above 4.5x on a sustained basis. LIQUIDITY AND DEBT STRUCTURE Satisfactory Liquidity Fitch views Sevkazenergo's liquidity as satisfactory assuming availability of external funding for the forecast negative FCF over 2016-2019. According to the management, the CAEPCo group's treasury is co-ordinated centrally for the parent company and the subsidiaries. At end-1H16, Sevkazenergo's cash and cash equivalents stood at KZT571m, which together with short-term bank deposits with a maturity up to one year of KZT160m and unused credit facilities of KZT4.2bn are sufficient to cover short-term debt maturities of KZT4.1bn. However, any potential further tenge devaluation and negative FCF over 2016-2019 means Sevkazenergo will need to raise further debt to finance cash shortfalls. At end-2015 most of Sevkazenergo's debt was made up of secured bank loans (KZT18.6bn or about 68%) and unsecured local bonds maturing in 2020 (KZT8.9bn in total or 32%). Senior Unsecured Debt Aligned Issuer Rating Sevkazenergo's KZT9bn local senior unsecured bond is rated 'B+', 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 with senior unsecured debt is low. At end-2015, pledged assets amounted to KZT67bn (out of KZT92bn). FULL LIST OF RATING ACTIONS Long-Term Foreign and Local Currency IDRs downgraded to 'B+' from 'BB-', Outlook Stable National Long-term Rating downgraded to 'BBB (kaz)' from 'BBB+(kaz)', Outlook Stable Local currency senior unsecured rating downgraded to 'B+' from 'BB-'; Recovery Rating 'RR4'. [2016-07-29]