Fitch Upgrades E. ONs Senior Unsecured Rating to 'A-'; Affirms IDR at 'BBB+'
The upgrade of the senior unsecured rating reflects a one-notch uplift relative to the IDR representing expected above-average recoveries upon default. This is in line with our approach to ratings of debt instruments of utilities that derive at least 50% of their earnings from regulated network activities with a robust and established tariff-setting process. The upgrade follows our review of the full terms of the demerger after the initial listing of Uniper shares on 12 September 2016.
The ratings reflect our view of E. ON's more focused business profile - post the company's de-merger of subsidiary Uniper - which will be characterised by a majority of earnings being driven by regulated networks and also a large proportion of quasi-regulated earnings from renewables and heat. Fitch has also factored in E. ON management's commitment to maintain a strong balance sheet backed by tangible actions such as the announcement of a potential equity issue following the German government's decision to transfer long-term nuclear provisions into a state fund.
KEY RATING DRIVERS
Stronger Business Profile Post Demerger
E. ON's post-demerger cash flow will be generated by regulated networks (over 50% of EBITDA), a well-diversified renewables portfolio with feed-in-tariffs and other support mechanisms, customer solutions that include district heating and contracts with municipalities as well as earnings from nuclear generation in Germany. E. ON's business profile will be strengthened by a more predictable earnings stream post-demerger. The major uncertainty surrounding the company's business profile is risks associated with German nuclear provisions.
Our updated rating sensitivities reflect E. ON's high percentage of regulated earnings and business diversification particularly in western European countries with established and robust regulatory regimes such as Germany and Sweden. Furthermore, our guidelines continue to reflect nuclear adjusted leverage ratios, which add long-term nuclear provisions to financial debt, to reflect the imminent costs associated with the nuclear shut down. Our negative rating sensitivity for E. ON's 'BBB+' Long-Term IDR is 4.5x funds from operations (FFO) nuclear-adjusted net leverage.
Negative Free Cash Flow (FCF)
In 2016 E. ON will invest EUR3.4bn, comprising EUR2.8bn on networks and renewables and
EUR0.6bn on customer solutions mainly related to projects in heat, onsite generation and energy efficiency. For renewables some large offshore projects are being planned, such as Rampion in the UK and Arkona in Germany. Similar projects in E. ON's portfolio earn over EUR170 per megawatt hour (MWh); however, capex costs are also high. E. ON has a dividend policy of 40%-60% pay-out on adjusted net income basis. Based on these assumptions we expect negative FCF over the next three years.
Limited Impact from Nuclear Provisions
KFK, a specially appointed government commission, has concluded that E. ON should pay about EUR10bn into a state fund, which is about EUR2bn more than provisioned for intermediate and long-term nuclear waste storage costs estimate. In return, the state will assume these liabilities and all related risks, while E. ON will still be responsible for decommissioning costs of its nuclear power plants.
Details of the asset and liability transfer (such as timing) are needed before the KFK recommendations are implemented into law. We expect the total negative impact on E. ON's debt (and consequently on leverage ratios) to amount up to EUR2.5bn. We assume that E. ON's cash outflow related to the decommissioning of the company's nuclear plants will not change over the rating horizon, but expect the nuclear-adjusted and - unadjusted leverage to converge at just under 4.5x by end-2019.
German Regulatory Review Neutral
The new German price control for electricity networks will start in 2019. In September the regulator will announce a new allowed return on equity (current proposal is for 6.91% to be applied to 40% of the regulatory asset base (RAB)) and elimination of the time lag between assets entering operations and when they start being remunerated, among other changes. A lower allowed return on equity will be negative for E. ON, although the change has been expected. We believe that the overall impact of a lower return will be mitigated by other factors such as efficiency bonuses, which may be positive for large networks such E. ON.
Committed to Strengthening Balance-Sheet
E. ON's management has stated their commitment to a strong balance sheet and have identified various measures available for maintaining a financial profile that is consistent with a strong investment grade rating. The company is currently faced with a series of uncertainties, such as the expected resolution on the nuclear provisions transfer. The decision on any further capital measures, such as an equity issue, depends on the terms of the nuclear provisions transfer and on the outcome of the ongoing nuclear fuel tax law suit (albeit management flagged that it may proceed with capital measures ahead of a final decision on the law suit).
Fitch's key assumptions within the rating case for E. ON include:
- Moderate growth in earnings (1%-3%), mainly following investments in grid and renewables projects. We do not factor in any asset rotation in our forecasts.
- Already announced renewables projects to go ahead as planned (Arkona, Rampion, US projects).
- Capex of EUR3.2bn-EUR3.4bn annually, broadly in line with E. ON's guidance and announced projects.
- Dividends of EUR480m annually, in line with the company's pay-out policy of 40%-60% of adjusted net income.
- Transfer of EUR8bn of nuclear provisions into the state-run fund, and an additional premium of EUR2bn, to be paid in 2017. We assume this will be paid from liquid funds. Further to this we assume that E. ON will successfully issue equity at an amount discussed during the 1H16 results presentation. We do not assume any return of nuclear tax already paid by E. ON or other capital measures such as hybrid issuance.
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- FFO-nuclear adjusted net leverage materially below 4.0x or corresponding fixed charge cover materially above 4.0x on a sustained basis.
- A ruling by the German Constitutional Court on the nuclear fuel tax as unconstitutional, with funds being returned to nuclear operators (higher rating impact, if in addition to equity issue).
- Additional upside from the implementation and terms of the state-run nuclear fund.
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- FFO-adjusted net leverage materially above 4.5x or corresponding fixed charge cover materially below 3.0x on a sustained basis.
- Overinvestment or an ambitious dividend policy.
- Failure to implement the equity issue as proposed, also in the absence of nuclear tax return or other balance sheet-enhancing measures.
- Additional downside from the implementation of the state run nuclear fund.
E. ON's liquidity remains strong. As of 30 June 2016, the group held EUR4.2bn of unrestricted cash and cash equivalents, around EUR1.9bn of short-term securities and fixed income deposits and EUR5bn of committed, undrawn credit facilities with maturity in November 2019, which is expected to reduce after the spin-off of Uniper. Short-term financial liabilities stood at EUR1.8bn. Fitch forecasts negative FCF of EUR1.6bn in 2016.