OREANDA-NEWS. Fitch Ratings has affirmed Limited Liability Partnership Kazakhstan Utility Systems' (KUS) Long-Term Foreign and Local Currency Issuer Default Ratings (IDR) at 'BB-' with Stable Outlooks. The agency has also assigned a local currency senior unsecured rating of 'BB-' to the domestic bond programme of KZT12.3bn and the KZT100m bonds issued under it. A full list of rating actions is at the end of this commentary.

The affirmation reflects KUS's solid credit metrics and Fitch's expectations that the company will maintain a strong financial profile over 2016-2019, despite dividend payments starting from 2017 and high capex. The company's strong 1H16 financial and operational results, stable regional market share, vertical integration, benign regulatory regime in distribution segment at present and absence of FX exposure are also supportive. KUS's ratings are constrained by its limited size relative to larger peers and 'BB' rated CIS companies, unfavourable regulatory framework in generation segment and limitations in corporate governance.

KEY RATING DRIVERS

No FX Exposure

Unlike most Fitch-rated CIS peers especially in Kazakhstan, KUS is not exposed to foreign currency fluctuation risk as all of its debt at end-1H16 was denominated in local currency, and management expects all future borrowings to be raised in local currency. All revenues and nearly all costs are tenge-denominated. In end-July 2015, KUS successfully refinanced its only foreign currency-denominated liabilities to Falah Investment B. V. (private equity fund) of USD86.4m via a local currency-denominated loan from SB JSC Sberbank of Russia (BBB-/ Negative) for KZT16.3bn (USD86.4m). An interest payment of KZT6.2bn (USD36.4m) under this liability was also repaid in 2015 by an equity injection from KUS's ultimate beneficiaries.

Senior Unsecured Aligned with IDR

KUS's KZT12.3bn local currency bond programme and the KZT100m bonds issued under it are rated 'BB-', in line with its Long-term Local Currency IDR, as the bonds will benefit from sureties totalling KZT12.3bn provided on a several basis by Karaganda Zharyk LLP, Ontustik Zharyk Transit LLP, OntustikZharyk LLP, Energopotok LLP, Karagandy Zhylu Sbyt LLP and Raschetniy servisniy centr LLP, all wholly-owned subsidiaries of the group. The KZT100m bonds were purchased by two companies managed by Ordabasy Group PEF LLP.

The senior unsecured rating is equal to KUS's Long-Term Local Currency IDR, reflecting that the level of prior-ranking debt is below Fitch's threshold of 2.0x-2.5x EBITDA. In addition, the combined EBITDA of subsidiaries providing sureties for the bonds comprised 50% of the group's 2015 EBITDA. An increase in prior ranking debt to above 2.0x-2.5x EBITDA, lower level of sureties from group entities or a material drop in the share of operating entities providing sureties in the group EBITDA would indicate a material possibility of subordination and, as a result, the senior unsecured rating could be notched down from the IDR.

Strong 1H16 Results

KUS demonstrated strong operational and financial results in 2015 and 1H16. Electricity production rose by 2.2% yoy in 2015 compared with a 3.3% decline in Kazakhstan and continued to increase by 22.2% yoy in 1H16 vs. a 0.4% decline in Kazakhstan. This resulted in EBITDA increase by 7% yoy in 2015 and 24% yoy increase in 1H16. Fitch expects Kazakhstan GDP to decline by 1% and inflation to grow by 14% in 2016. We forecast the company's financial profile to remain strong, with an average EBITDA margin of about 28% over 2016-2019, which will support its ratings. This is based on our assumptions of approved tariff growth for distribution segment, and 0% tariff growth rate for the generation segment for 2016-2018.

Evolving Corporate Governance

Fitch views corporate governance at KUS as weaker than many larger state-owned Kazakh corporations rated in the 'BB' category. KUS's supervisory board is chaired by Dinmukhamet Idrissov (who owns Ordabasy Group PEF LLP - a private equity fund). The company's audited accounts list Magda Idrissova (Mr. Idrissov's wife) as 99% owner of KUS's equity. We view the non-transparent ownership structure and a potential non-disclosure of related-party transactions as a rating weakness. However, the company is taking steps to improve transparency by going public over the medium term.

Sound Business Profile, Vertical Integration

KUS's business profile benefits from the company's near-monopoly position in electricity generation, distribution and supply in the central part of Kazakhstan (Karaganda region) and South Region, which are highly populated (25% of country population). An energy deficit in South Region, where the company generates around 21% of FY2015 EBITDA supports demand for KUS's services there. However, the business profile is constrained by the company's small operations, for example, its market share of around 4% of the country's electricity generation volumes, 3% by installed capacity, and 8.5% by lengths of lines. The company is smaller than Ekibastuz GRES-1 (BB+/Stable, with 12% market share in electricity generation), but similar in size to CAEPCo (B+/Stable).

The company is integrated across the electricity value chain with the exception of fuel production and transmission, which gives it access to markets for its energy output and limits customer concentration. KUS derives its EBITDA equally from electricity distribution (49.4% of 2015 EBITDA) and electricity and heat generation (49.5%), with a minor contribution from supply (1.1%). The heat generation business is loss-making due to regulated end-user tariffs, which are kept low for social reasons. Fitch expects the generation and distribution segments to remain the main cash flow drivers for the group.

Further Expansion Plans

KUS's strategy envisages further expansion into West and East regions in Kazakhstan. It plans to participate in privatisation of 51% stake in Mangistau Electricity Distribution Network Company (BB/Negative) and 100% stake in East-Kazakhstan Regional Grid Company, although the company intends to remain focused on profitability, according to management. We view this as an aggressive target, given a potential acquisition price totalling around KZT13bn. However, according to KUS's management, the final time and terms of privatisation remain unclear and the placement of the remaining portion of the bonds programme is dependent on them.

Credit metrics may weaken towards Fitch's guidelines for negative rating action if the company increases capex on expansion plans or potential M&A activity with no respective contribution to the earnings. However, these will depend on market conditions and the tariffs set for new assets.

Moderate Capex, Solid Credit Metrics

KUS's ratings are underpinned by the company's solid credit metrics and stable financial profile, which is likely to remain strong over 2016-2020. Its funds from operations (FFO) gross adjusted leverage decreased to 1.6x in 2015 from 2.2x in 2014, and FFO interest coverage was 7.1x in 2015 (10.0x in 2014). Fitch expects KUS to remain well placed relative to CIS and international peers based on these metrics, with FFO gross adjusted leverage of below 2.0x and FFO interest coverage above 4.0x over 2016-2019.

KUS's capex programme is aimed at modernising the company's ageing generation capacity, as well as upgrading its distribution network. Capacity expansion is expected by the company to be moderate and will depend on approved tariffs. The company estimates the investment programme of KZT57bn over 2016-2019, including maintenance capex on average of around KZT8bn. In our rating case, we assume capex in line with management guidance.

Regulatory Environment

Following the postponement of the capacity market launch in Kazakhstan until 2019, the regulator decided to freeze generation tariffs and set them at 2015 levels for 2016-2018. However, in electricity distribution five-year tariffs were approved using the "cost plus allowable margin" methodology instead of previously used "benchmarking".

Tariffs at Karaganda Zharyk LLP and Ontustik Zharyk Transit LLP in 2020 compared with 2015 were approved with 4% and 6% increases, respectively, in CAGR terms. The heat generation 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).

Potential Dividends

Fitch expects KUS to continue generating solid cash flow from operations (CFO) of KZT20bn on average over 2016-2019, with likely positive free cash flow (FCF; before dividends) of average KZT7bn (KZT2.8bn in 2015) over same period. KUS's financial policy does not imply any dividends before the company reached sustainable positive FCF. However, KUS is considering undertaking an IPO and taking into account the forecasted positive FCF (before dividends) in our rating case we assume dividend payout of 100% from company's net profit for 2017-2019, which will result in FFO adjusted gross leverage keeping still below 2.0x other things being equal.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

- Electricity generation growth of 3.5% in 2016 and in line with Fitch forecasted GDP of 2% over 2017-2019

- Zero tariff growth in 2016-2018 in electricity generation and as approved by the regulator for electricity distribution and heat sales

- Capex in line with management guidance

- Inflation-driven cost increase

- 100% dividend pay-out starting from 2017.

RATING SENSITIVITIES

Positive: Rating upside is limited in the foreseeable future, although future developments that could lead to positive rating action include:

- Long-term predictability of the regulatory framework, with less political interference and a cost-reflective heat segment in a stronger operating environment.

- Increased transparency of the ownership structure and generally stronger corporate governance.

- Increased scale of business.

Negative: Future developments that could lead to negative rating action, include:

-Weaker-than-expected financial performance or financial guarantees for parent debt or aggressive M&A, leading to FFO gross adjusted leverage persistently higher than 3x (2015: 1.6x) and FFO interest coverage below 4.5x (2015: 7.1x).

- Committing to capex without sufficient available funding, worsening overall liquidity position.

LIQUIDITY AND DEBT STRUCTURE

Adequate Liquidity

Fitch views KUS's liquidity as adequate, assuming access to available credit facilities, deposits and estimated positive FCF for 2016F. At end-1H16 short-term debt amounted to KZT5.8bn against cash and cash equivalents of KZT1.2bn, supplemented by deposits from SB JSC Sberbank of Russia of KZT4.1bn and unused committed credit facilities of KZT6.7bn from Development Bank of Kazakhstan. The company is centrally managed, including its treasury functions, across operating subsidiaries by a single management board; we therefore focus on the consolidated group in our credit analysis.

As of end-1H16, the major part of KUS's debt comprised of secured loans from local banks raised at opcos' level. The largest creditors are Development Bank of Kazakhstan (KZT17.8bn), Sberbank (KZT13.9bn) and Tsesnabank (KZT0.6bn). All bank loans are nominated in tenge and have fixed interest rates.

FULL LIST OF RATING ACTIONS

Long-Term Foreign and Local Currency IDRs affirmed at 'BB-'; Outlook Stable

National Long-Term Rating affirmed at 'BBB+(kaz)'; Outlook Stable

Local currency senior unsecured rating assigned at 'BB-'

National senior unsecured rating assigned at 'BBB+(kaz)'