S&P: Swedish Electricity Distributor Ellevio AB's €10 Billion Debt Program Assigned 'BBB' Rating; Outlook Stable
The above rating is in line with the preliminary rating that we assigned on Aug. 9, 2016.
Our rating on Ellevio AB's senior secured debt program reflects its stand-alone credit profile (SACP) of 'bbb-' and a one-notch uplift for structural enhancements.
In our view, Ellevio has an excellent business risk profile, which benefits from fully regulated electricity distribution operations, with natural monopoly market positions in its service areas. We view the Swedish regulatory framework for electricity distribution as stable, transparent, and predictable, with a long track record. This is despite some modifications in methodology between regulatory periods, and some minor weaknesses relating to customer compensation in the case of longer unplanned outages.
We view positively the pre-set regulatory allowed rate of return on capital (i. e. the WACC rate) for the full four-year regulatory period, the ability for the operator to adjust tariffs at any time, and the ability to carry over regulatory surplus or deficits from the current regulatory period to the next, which adds to stability in cash flows. We also believe that the allowed return adequately covers operating and capital costs. We recognize that the negative effect on capital compensation, due to the transition to an age-adjusted model for regulatory asset value for the regulatory period from 2016-2019, will be partially mitigated by the introduction of an age-floor for old assets. We also expect Ellevio to be able to increase prices in this regulatory period to recover regulatory deficits in the previous period.
We see the potentially high customer compensation required in case of outages above 12 hours as a minor regulatory weakness, although noting that the impact on Ellevio is limited, partly owing to high cabling and weatherproofing rates. We also recognize that the regulatory framework does not cover capital expenditures (capex) during construction, only once the assets are in operation. We note, however, that the asset base is updated on a six-month basis, reducing the time lag. We also view the ongoing legal dispute between the regulator and the distribution system operators (DSOs) about the WACC level for the current regulatory period of 2016-2019 as creating some uncertainty. We note, however, that previous court proceedings regarding the WACC for the previous regulatory period of 2012-2015 ruled in favor of the DSOs.
Although Ellevio is one of the largest DSOs in Sweden, its size is relatively limited compared with larger international peers. However, Ellevio has good diversity in terms of customers and geographical service areas, which reduces risks related to unplanned outages due to, for example, weather conditions. We further believe that Ellevio's operating efficiency and profitability are broadly in line with major peers.
We assess Ellevio's financial risk profile as aggressive, reflecting our forecast weighted-average FFO to debt of about 7.5%-8.5%, based on senior secured debt. Although we view debt levels as high, we take into account the low volatility in cash flows--reflecting the strong regulatory framework--which lead us to benchmark credit measures against our low volatility table. We acknowledge likely negative discretionary cash flows related to high capex levels and shareholder returns. We also note that covenant levels, both for lock-up event as default event, would allow a higher leverage than we currently have in our base-case forecasts. At the same time, we note that capex spent should be added to the regulatory assets base and thus increase allowed regulatory return. We also understand that the company's shareholder returns are flexible and can be reduced if needed to preserve credit ratios (also before reaching dividend lock-up levels).
In our comparable ratings analysis, we view negatively the significant portion of, and payments on, the shareholder funds in the capital structure which are in the form of shareholder loans. However, we exclude the loans from debt in our ratio calculations reflecting their equity-like features such as deep subordination, maturities beyond all other debt, and the possibility of accruing interest. We also acknowledge the ongoing disputes between the regulator and the DSOs, which creates some uncertainties about the WACC-level and when it will finally be determined.
In our base case, we assume: Price increases during the current regulatory period through the reduction of its regulatory deficit in 2012-2015. This should also provide a cushion for cash flow deterioration in case the court rules in favor of the regulator's determined WACC of 4.53% for the existing regulatory period, instead of the operator's request of 6.3%.Capex of about Swedish krona (SEK) 2.0 billion-SEK2.5 billion annually for the next few years. Shareholder returns of between SEK0.8 billion–SEK 1.2 billion in the next few years, which we assume will be flexible if needed to sustain credit measures. Based on these assumptions, we arrive at the following credit measures based on senior secured debt: FFO to debt of 7.5%-8.5%.Debt to EBITDA of 8.0x-9.0x.
The credit facility contains debt to EBITDA covenants for lock up and default of 10.75x and 12.0x, respectively. The interest cover covenants for lock up and default are 1.7x and 1.2x, respectively. We estimate that the group has headroom under both its trigger and events of default covenants for leverage and interest costs.
Ellevio AB is the operating company in the Ellevio group, which also includes four holding companies above Ellevio AB. The ultimate owners are international investor Borelais, two Swedish national pension funds (AP3 and AP1), and Swedish mutual insurance company Folksam. Following the refinancing of existing debt, Ellevio AB and its immediate holding company Ellevio Holding 4 AB will form a ring-fenced financing structure, with Ellevio AB as the borrower. We apply one notch of uplift from Ellevio AB's SACP to the senior secured debt, as the senior secured debt will benefit from structural features designed to increase cash flow certainty for senior secured debtholders. These features include:Restrictions on mergers, acquisitions, and asset disposals, and a share pledge in the operating and holding company's assets (to the extent allowed by legislation) and shares. Dividend - and debt-restricted payment conditions and a covenanted liquidity structure that should, in our opinion, allow the Ellevio financing group to manage temporary cash flow shocks. An automatic 12-month standstill period after an event of default, during which time creditors can take control of Ellevio and either aim for operational recovery or sell the shares in the operating and immediate holding company. Prudent management of foreign exchange, refinancing, and counterparty risks.
The stable outlook on Ellevio's underlying credit quality reflects its stable and predictable earnings, which are supported by a favorable regulatory framework. We anticipate that Ellevio will maintain credit measures in line with the current ratings, including FFO to debt of at least 6% based on senior secured debt. We further assume that there will be no change to Ellevio group's structure or the financing structure.
We currently see the potential for a positive rating action as limited, reflecting our view of Ellevio's financial policy and covenant structures. However, we could raise the rating if credit measures permanently strengthened, for example, if lower dividend payments resulted in reduced debt. We could also consider a positive rating action if the financial risk profile improved, supported by the group's financial policy, resulting in a ratio of FFO to debt of sustainably above 8%.
A negative rating action would primarily relate to any unexpected negative changes to the regulatory framework for Ellevio, which could cause earnings volatility or deterioration, and weigh on credit measures. Material acquisition activity or excessive shareholder returns could also cause lead us to lower the rating. If FFO to debt decreased sustainably below 6%, we could take a negative rating action.