S&P: U. K.-Based Water Company Portsmouth Water 'BBB' Ratings Affirmed; Outlook Stable
At the same time, we affirmed our 'BBB' issue rating on the senior secured debt and revolving credit facility issued by Portsmouth Water.
Our affirmation reflects Portsmouth Water's consistent and predictable revenue and cash flow streams from the low-risk, regulated water business, as well as its natural monopoly position and a generally supportive and transparent regulatory framework.
Our assessment of Portsmouth Water's excellent business risk is based on a generally supportive and transparent regulatory framework, as well as a small but largely residential customer base and adequate cost control. The strength of the U. K. water utility regulator (Ofwat) and its framework is reflected in our assessment of Portsmouth Water having a strong regulatory advantage (see "Why U. K. Utilities' Regulatory Frameworks Merit A "Strong" Regulatory Advantage Assessment," published on Dec. 11, 2013 on RatingsDirect).
In our view, Ofwat and its framework provide Portsmouth Water with a strong regulatory advantage, with a long track record of over 20 years of transparent guidelines, good and timely recovery of costs (albeit on an ex-ante basis), high predictability and consistency, and regulatory independence. Like all U. K. water companies, Portsmouth Water is exposed to regulatory reset risk every five years, as well as occasional policy updates proposed by the regulator or the government. Reset risk is low at the moment as the current regulatory period ends in 2020.
During 2015-2016, Portsmouth Water failed two of Ofwat's regulatory outcome delivery incentives--water quality and water quality contacts. Any penalties which Portsmouth Water receives during the current regulatory period will be reflected in the form of reduced customer bills in the upcoming regulatory period. As a result, we do not see these penalties as having an immediate impact on the company and, as the cost will be evenly distributed throughout the five-year period, they should not significantly affect the company as a whole. Portsmouth Water is also hoping to achieve some rewards during the remaining part of the period in order to help reduce the impact of the penalties already incurred.
Our assessment of Portsmouth Water's aggressive financial risk profile reflects our view of the group's relatively weak cash flow and leverage measures. However, we have good visibility until the end of the current regulatory period in 2020. We expect DCF to be neutral or better, based on current capital expenditure (capex) plans. We forecast S&P Global Ratings-adjusted FFO to debt to remain solidly above 7%. This year, Portsmouth Water switched to International Financial Reporting Standards from UK-GAAP, resulting in the removal of the volatility created in the FFO-to-debt ratio by the different intrayear treatment of infrastructure renewable expenditure. We also expect the company to maintain leverage under 80% of adjusted debt to regulatory capital value to comply with Portsmouth Water's covenants. We use our low-volatility financial benchmarks as the company derives all of its earnings under a strong regulatory framework.
A change in inflation--retail price index (RPI) to consumer price index (CPI) or CPIH (which includes owner occupiers' housing costs)--could affect small companies with a high proportion of long-dated, RPI-linked debt, such as Portsmouth Water. This could leave the company exposed to a mismatch in revenues and actual financing costs (see "Ofwat Water 2020: Rising Volatility And Decreasing Earnings Could Pressure Ratings On U. K. Water Utilities," published on June 23, 2016).
Our base case assumes: RPI of 1.8% in 2016 and 3.0% in 2017. Thereafter, we use a 2.5% long-term rate, although the actual rate depends on market conditions. Low-single-digit percentage revenue growth from 2017. Stable EBITDA margins of about 30%-35%.Large front-ended capex plan, ranging from an annual high of about ?10 million in the early part of the regulatory period to a low of about ?6 million at the end of the regulatory period. Dividends remaining at ?0.4 million throughout the regulatory period. We adjust the dividend to a total level of ?1.6 million due to ?1.2 million that Portsmouth Water pays to its employees in relation to the Employee Ownership Trust annually. Nonhousehold retail business to be sold in April 2017 when the market opens. Based on these assumptions, we arrive at the following credit measures: FFO to debt of about 7.0%-9.0% over the next three years. DCF to debt of about 1.0% on average over the next three years.
The stable outlook reflects our expectation that Portsmouth Water will post neutral to slightly positive DCF on average and maintain FFO to debt above 7% for the next two-to-three years. It also reflects our expectation that there will be no deterioration in the company's operating and regulatory performance.
We could consider lowering the ratings if Portsmouth Water is unable to maintain adjusted FFO to debt of at least 7%. This could be caused by, among other factors, operating cost overruns or an inability to recover unexpected costs through the regulatory framework. We could also consider a downgrade if the company's operating performance with regards to regulatory measures deteriorates, incurring further financial penalties by breaching regulatory key performance indicators (KPIs).
Conversely, we could raise the ratings if Portsmouth Water's cash flow protection metrics and financial risk profile improve significantly on a sustainable basis. Specifically, we could consider an upgrade if we believe the company can achieve adjusted FFO to debt above 9% and positive DCF on a sustainable basis. We would also need to see that Portsmouth Water is meeting all of its regulatory KPI metrics on a sustainable basis before considering any positive rating action.