S&P: Subordinated Class B Debt Guaranteed By Anglian Water On Negative Outlook; Ratings Affirmed
Four of the senior secured class A bonds issued by AWSF retain an unconditional and irrevocable guarantee provided by MBIA U. K. Insurance Ltd. We rate monoline-insured debt issues at the higher of the rating on the monoline and the Standard & Poor's underlying rating (SPUR). The long-term debt ratings on the four insured bonds reflects the SPUR, which is 'A-'.
The rating on the senior class A debt reflects our assessment of the Anglian Water financing group's stand-alone credit profile (SACP)--based on credit metrics excluding subordinated debt--at 'bbb+'. The rating incorporates one notch of uplift for structural enhancements. The rating on the subordinated class B debt reflects the group's subordinated SACP--based on credit metrics including both senior and subordinated debt--which we assess at 'bbb'.
The SACPs reflect our view of the company's financial risk profile as aggressive and its business risk profile as excellent. The higher SACP for senior debt also incorporates our view of the relatively strong cash flow coverage ratios for senior debt only, compared with the consolidated metrics, due to the cushion of subordinated debt and the better positioning of senior creditors in terms of security enforcement and decision-making power. We apply our low volatility financial benchmarks because we assess the U. K. regulatory framework as offering a strong regulatory advantage.
The negative outlook on the subordinated class B debt reflects our concern that Anglian Water Services Ltd.'s (AWS) financial headroom has weakened in the current regulatory period, as illustrated by the S&P Global Ratings-adjusted funds from operations (FFO)-to-debt ratio falling below the 6% we expect for the year ending March 2017. The decline is expected to be triggered by higher inflation causing an increase in indexation on debt; the group's planned capital expenditure (capex); and an aggressive dividend policy in an already-highly-leveraged balance sheet. AWS has committed to reducing leverage over the current regulatory period from about 83% debt to regulatory capital (RCV) to under 80% by reducing dividends and delivering outperformance on its total expenditures. This should alleviate the pressure on its financial profile from 2018. However, we consider that the headroom in its ratios is very limited; if AWS proves unable to deliver this improvement, it could delay its financial recovery.
Our outlook on the class A senior secured debt is stable because we expect the adjusted FFO to debt, based on senior debt only, to remain comfortably above our guideline of 7% during the current regulatory period. The ratios for the senior secured debt benefit from lower cost of debt compared with the subordinated debt, which helps to boost ratios.
Our assessment of AWS' business risk as excellent reflects the stable and predictable revenue and cash flow streams from the low-risk regulated water and waste water businesses, its natural monopoly position in its service area, and a generally supportive and transparent regulatory framework. We consider that the U. K. water regulatory framework, which is designed and monitored by Ofwat, supports the industry, given its transparency and our assessment of a strong regulatory advantage.
In our opinion, AWS' operational performance remains at the top of its local peer group, based on its historical performance against the operational measures assessed by Ofwat, such as the Service Incentive Mechanism score, and stable asset serviceability. We expect that AWS will continue to manage its operational performance to a high standard, which should help it repair its financial profile.
Furthermore, we apply one notch of rating uplift to the senior debt, which benefits from structural features designed to increase cash flow certainty for debtholders (see "Rating Structurally Enhanced Debt Issued By Regulated Utilities And Transportation Infrastructure Businesses," published on Feb. 24, 2016 on RatingsDirect).
In our base case, we assume: AWS will maintain a high operating standard. Debt will increase and total leverage by debt to RCV will remain around 80%.Dividend payments will be approximately ?430 million over the current regulatory period. Based on these assumptions, we arrive at the following credit measures for the senior and subordinated debt: EBITDA margin of 54%-55% in the financial year (FY) to March 2017, and 55%-56% in FY2018.FFO to debt of 5%-6% in FY2017 and 5.5%-6.0% in FY2018.Free operating cash flow to debt of minus 1% to flat in FY2017 and 1%-2% in FY2018.For the senior debt only:FFO to debt is projected to be 7%-8% in FY2017 and 7.5%-8.5% in FY2018.
The negative outlook on AWSF's class B debt reflects our expectation that average FFO, based on senior and subordinated debt, will fall below 6% in 2017. Although we expect the ratios to recover by 2018, we consider that there is no headroom over the current regulatory period because of high leverage and aggressive dividend payouts. If the company cannot reduce leverage or fails to achieve expected operating efficiencies, the pressure on cash flow coverage ratios could continue to 2018 and beyond.
The outlook for the class A debt remains stable. We expect that AWSF will maintain average FFO to debt metrics above 7%, based on senior debt only. We consider that AWS operates with a low degree of covenant headroom, but the secured class A debt benefits from several structural features and stronger cash flow coverage metrics than the subordinated class B debt.
We could lower the rating on AWSF's class B debt if we do not see FFO to debt revert to above 6% in the current regulatory period or if operating performance weakens.
We could lower the rating on the class A debt if the class A debt credit metrics fell below 7%.
We could revise the outlook on AWSF's class B debt back to stable if overall total leverage reduces and adjusted FFO to debt improves to above 6%. That said, we see limited scope for a higher rating on the class A or B debt because the financial covenants allow the group to operate with high leverage.