OREANDA-NEWS. Fitch Ratings has assigned Russia-based electricity generator Public Joint-Stock Company Territorial Generating Company No. 1 (TGC-1) a Long-Term Foreign Currency Issuer Default Rating (IDR) of 'BB+' with Stable Outlook. A full list of rating actions is at the end of this commentary.

TGC-1's 'BB+' rating is supported by the company's solid credit metrics. Fitch expects that the company will maintain a sound financial profile over 2016-2019, despite expected dividend payments, high capex and expected high rent payments. The rating also incorporates the company's solid business profile, with favourable geography of operations, a strong market position in electricity and heat sales in St. Petersburg and border regions, supportive regulation for operations under capacity supply agreements (CSA) that envision long-term guaranteed payments.

At the same time, Fitch expects weak growth for the Russian economy in 2016-2017 and the government's social responsibilities could continue to exacerbate the regulatory and political risks.

TGC-1's rating also benefits from a single-notch uplift reflecting the company's links with its majority indirect shareholder, PJSC Gazprom (BBB-/Negative), which indirectly owns 51.79% through its 100% subsidiary Gazpromenergoholding LLC (GEH).

KEY RATING DRIVERS

Hydro Generation Enhances Profitability

TGC-1's business profile benefits from its diversity with 54 hydro and thermal power plants, and almost half of its total electricity production generated at low-cost hydro generating facilities. The company is smaller than PJSC Mosenergo (BB+/Stable), Enel Russia (BB+/Stable), OGK-2 (BB/Stable), with installed power capacity of 7GW and heat capacity of 14,142Gcal/h in 2015. However, TGC-1 is the most profitable of GEH's four subsidiaries in the utility sector with the highest EBITDA margin of 25% as of end-2015 compared with 17% for Mosenergo and 9% for OGK-2, mostly due to the exposure to hydro capacities and fairly efficient assets.

The exposure to hydro power generation enhances TGC-1's profitability (thanks to no fuel cost and priority of dispatch). It also provides revenue diversification from the less supportive heat sales by the thermal plants that require subsidy and represent the weaker part of the company's operations, in our view.

Fuel Price Volatility Exposure

The company's profitability is highly sensitive to the changes in fuel prices, with fuel expenses accounting for almost half of TGC-1's 2015 operating costs. Its fuel mix is dominated by natural gas, which comprises 90% of total fuel consumption with coal and fuel oil making up the remaining 10%. The company is fully reliant on Gazprom's gas supplies. However, we do not view the supplier concentration as a constraining risk as TGC-1 is majority owned by Gazprom, which implies elements of vertical integration for the wider group.

The domestic gas market is regulated and TGC-1 purchases gas from Gazprom at the tariffs set by the Federal Antimonopoly Services. We assumed gas prices growth at half the pace of inflation over 2016-2019, with electricity prices increasing below gas prices. This is likely to result in some margin squeeze.

Favourable Geography, Scandinavian Exports

The company has a dominant position in the St. Petersburg, Karelia, Leningrad and Murmansk regions, which benefit from higher collection rates from customers and tend to have the most dynamic growth in terms of electricity and heat consumption. This does not fully offset the company's exposure to electricity demand volatility, but it could ease the impact if electricity sales decline. TGC-1 also benefits from the export to Scandinavian countries, which fully offsets its minor FX debt exposure.

Supportive CSAs, Challenging Environment

The tariff-setting methodology for capacities operating under CSAs have not been revised since its implementation in 2009. The most recent tariff hike was in 2015, resulting in a 14% yoy increase due to increased yields from government bonds, which was one of the factors highlighted in the tariff-setting methodology for these units. CSAs provide a guarantee for capacity payment for 10 years from the date of the plant commissioning and thus support healthy profitability and greater cash flow visibility.

The track record of the CSA framework in Russia is positive, but in our view remains exposed to risks within the operating and regulatory environment. The newly commissioned units operating under the CSAs contributed around 41% of TGC-1's 2015 EBITDA. They will contribute around 45% of company's EBITDA by 2017 once the last units under the CSA framework at Centralnaya combined heating power plant (CHP) are commissioned.

Capex, Dividends Drive Negative FCF

We expect continued material capex to drive negative free cash flow (FCF) over the medium term, despite strong earnings and cash flow from operations (CFO) of around RUB10bn on average over 2016-2019. In line with management's guidance, Fitch forecasts dividends at 35% of net income under IFRS and capex of RUB42bn for 2016-2019. According to management, there is some capex flexibility as it is mostly related to the modernisation of existing facilities, including inefficient CHPs and highly amortised heating grids in St. Petersburg.

Rent Drives Leverage Increase

According to TGC-1's management, a substantial part of the company's rent expenses from 2017 will be represented by payments for two units at Centralnaya CHP. These rent payments are expected to reach around RUB2bn per year or about 80% of total rent expenses over 2017-2019. Centralnaya CHP's new units are included in CSAs, and expected to be commissioned by the end-2016. The funding scheme was used by the shareholder to ease the TGC-1's leverage in 2013-2014, avoid potential covenant breaches and launch the CHP on time under CSAs.

According to the rent payment agreement, these expenses represent the funding costs incurred by MRES LLC (100% subsidiary of Gazprom) for the construction of these units for TGC-1. We view TGC-1's obligation as debt-like and capitalise the annual rent payments into off-balance sheet debt using 6x multiple typical for Russia.

Weaker Metrics Expected

We anticipate a contraction in Russia's GDP of 0.7% in 2016 and 8.2% inflation, which we do not expect to be fully reflected in electricity price increases. However, we forecast TGC-1's financial profile will remain solid with an average EBITDA margin of about 21%. We expect TGC-1's FFO net adjusted leverage to weaken to an average 2.5x over 2016-2019 from an average 2.0x over 2012-2015 and FFO fixed charge cover to decline to below 3.0x on average over 2017-2019 from above 5.0x over 2012-2015.

This will be mostly due to high capex in 2016-2019, 35% dividend payout ratio from net income under IFRS, rent payment increases over 2017-2019, modest electricity prices growth largely below inflation and high interest rates of 12.5% for all new debt to be raised over the rating horizon. We view leverage as commensurate with the standalone rating, but FFO fixed charge coverage is weaker compared with some similarly rated peers.

Uplift for Parental Support

Fitch considers the strategic, operational and to a lesser extent legal ties between TGC-1 and its parent company as moderately strong under Fitch's Parent and Subsidiary Rating Linkage methodology. The strength of the ties is supported by TGC-1's integral role in Gazprom's strategy of vertical integration, its substantial share in GEH's operations. Additionally, TGC-1's gas-fired power plants are fully reliant on Gazprom's gas supplies.

We also note that about 40% of TGC-1's total outstanding debt at end-1H16 comprised loans from Gazprom, at a relatively low interest rate. Given TGC-1's solid credit metrics, significant financial support from its majority shareholder has not been needed. However, Fitch would expect financial support to be available if the need arises. We view the dividends at maximum 35% of net income as modest, but do not expect a further increase.

KEY ASSUMPTIONS

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

- Domestic GDP decline of 0.7% and inflation of 9% in 2016, in 2017 GDP growth of 1.3% and CPI of 6.3%

- Net power output marginal growth at CAGR of below 1% over 2016-2019

- Gas tariffs indexation by 2% from July 2016, and slightly below 3% over 2017-2019

- Non-regulated electricity prices growth slightly below gas prices increase over 2016-2019

- Electricity tariffs to increase below inflation

- Dividends at 35% of net income under IFRS starting from 2017

- Capex in line with management expectations

- Additional rent payments of average RUB2bn over 2017-2019 related to Centralnaya CHP construction are capitalised at 6x

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

- Capex and dividends moderation and/or higher than expected growth rate for electricity and heat tariffs in comparison with domestic gas prices increase resulting in improvement of the financial profile (e. g. FFO net adjusted leverage below 1.5x and FFO fixed charge cover above 4x on a sustained basis).

- Stronger parental support.

- Increased predictability of the regulatory framework for utilities in Russia.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

- Weaker than expected power prices, significant rise in fuel prices and/or more ambitious capex programme resulting in deterioration of the financial profile (eg FFO net adjusted leverage above 3x and FFO fixed charge cover well below 3x on a sustained basis).

- Weakening of parental support (eg significantly higher dividends payout while shareholder loan is fully refinanced with debt) may result in a removal of the one-notch uplift to TGC-1's standalone rating.

- Deterioration of the regulatory and operational environment in Russia.

LIQUIDITY AND DEBT STRUCTURE

Fitch assess TGC-1's liquidity as weak but manageable. At end-1H16 TGC-1's cash and equivalents stood at RUB1.7bn, which was not sufficient to cover upcoming short-term maturities of RUB14.6bn. However, as of end-1H16, TGC-1 had access to uncommitted credit lines of about RUB32bn mostly from major Russian banks due over 2016-2021. The company does not pay commitment fees under unused credit facilities, which is a common practice in Russia. The short-term debt is mostly related to the loan from Gazprom (RUB10bn, about 68% of short-term debt) maturing in end-October 2016.

Fitch also expects negative FCF over 2016-2017 driven by the anticipated investment programme of about RUB20bn over the same period, which will require additional funding to finance cash shortfalls, if not curtailed as some flexibility remains.

Limited FX Exposure

Euro-denominated debt was around 5% (RUB1.5bn) of total debt as of end-2015. This exposure is naturally hedged by the revenue stream from electricity export operations to Scandinavian countries around RUB1.1bn. Consequently, we do not consider TGC-1 is exposed to FX risk.

FULL LIST OF RATING ACTIONS

Long-Term Foreign Currency IDR assigned at 'BB+', Stable Outlook

Long-Term Local Currency IDR assigned at 'BB+', Stable Outlook

Short-Term Foreign Currency IDR assigned at 'B'

Short-Term Local Currency IDR assigned at 'B'

Local currency senior unsecured ratings assigned at 'BB+'