OREANDA-NEWS. Fitch Ratings has affirmed Italian utility Terna Spa's Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB+'. The Outlook is Stable. The Short-term IDR has been affirmed at 'F2'.

The affirmation reflects our expectation of the negative impact of the next regulatory review (starting in 2016) to be partially compensated by substantially reduced future capex needs and lower tax following the recent abolition of the Robin Hood Tax in Italy. However, the potential acquisition of the high-voltage grid of Ferrovie dello Stato (FS) is likely to have a negative impact on the company's credit ratios and would reduce current rating headroom.

Fitch's revised forecasts include a reduction of the weighted average cost of capital (WACC) to below 5% (from the current 6.3%) in the next regulatory period. According to our conservative estimates the acquisition of FS assets would increase funds from operations (FFO) adjusted net leverage above our rating guideline of 6.75x in 2016-2017, before returning to 6.75x in 2018. However, we expect FFO interest coverage and net debt/regulatory asset base (RAB) ratios to remain within the rating guidance across the period, averaging 7.1x and 60%, respectively for 2016-2018.

KEY RATING DRIVERS

Limited Revenue Visibility
The Autorita' per l'Energia Elettrica, il Gas ed il Sistema Idrico (AEEGSI, or the regulator), which is independent since its constitution in 1995, will define towards the end of 2015 the tariff framework for the fifth regulatory period starting in 2016. We note that utilities are actively involved in discussion with the regulator in this respect. Fitch does not expect a change in the main pillars of the regulatory framework, with revenues covering the remuneration of the RAB (with fixed extra-premium for strategic investments), depreciation and operating costs (with an efficiency factor), although a gradual shift is expected towards output-based incentives, at least for growth investments.

The downward revision of the risk-free rate included in the (real pre-tax) WACC considered for remunerating the RAB will hit the revenues and margins of Terna. Fitch considers that other factors of the WACC formula will be updated (in particular inflation) and help smooth the impact of the new regulatory period on regulated utilities. We are factoring a high single-digit drop of regulated revenues for Terna in 2016.

Fitch notes that a low inflation rate included in the formula at the start of the regulatory period is positive for the real pre-tax WACC, while a prolonged low-inflation scenario during the regulatory period would negatively affect revenues, even if partially counterbalanced by the evolution of operating costs and financial charges.

Lower Capex Needs
Improving the Italian transmission network has been a primary objective of the regulator, as testified by the extra returns guaranteed for 12 years on strategic investments. After 10 years of heavy investments, including realising the most important projects, we assume that the group will reduce annual investments to around EUR600m from 2016 (vs. an annual average of EUR1.2bn realised in 2012-2014).

Future cash flows will also benefit from the abolition of the Robin Hood Tax in Italy, declared unconstitutional in February 2015. The companies will not be able to claw back the amounts already paid, but starting from 2015 the 6.5% surcharge on the tax rate will not apply anymore, yielding for Terna savings of around EUR50m per year. On the other hand, Fitch acknowledges that management is committed to avoiding a significant reduction of the dividends distribution from the current level of around EUR400m.

Potential Acquisition of FS Grid
The so-called 'Stability Law' for 2015 foresaw the full inclusion of FS assets in the regulated electricity transmission perimeter if the transaction materialises. Currently the negotiation of the deal is in a preliminary stage. We believe that the transaction would allow efficiencies and economies of scale in the context of the same regulatory environment.

However, we assume that the potential FS acquisition would be debt-funded (or using cash on balance sheet) and the capex needs of FS grid would be higher than the incremental EBITDA. As a result the transaction would be incrementally credit- negative and, according to our conservative estimates, would increase FFO adjusted net leverage above our rating guideline of 6.75x in 2016-2017, before returning to 6.75x in 2018. Additional relevant acquisitions are not on the agenda at the moment, which we believe would have a negative impact on the ratings, if debt-funded.

Rising Leverage but Solid Coverage
The likely increase in leverage, which depends on the regulatory outcome and the FS grid transaction, is negative for the ratings. This is mitigated by an improvement in free cash flow (FCF) generation as we expect structurally positive (pre-dividend) FCF for 2016-2018 compared with significantly negative (pre-dividend) FCF in 2010-2013. However, we project FCF after dividends to be negative until 2017.

Solid FFO interest coverage ratios (average of 7.1x for 2016-2018 including the FS acquisition), albeit helped by the low interest rate environment and management's expressed long-term commitment to maintain the net debt/RAB ratio at a conservative level (currently at around 54%, trending towards 60% from 2016) also help to offset the weak FFO net adjusted leverage.

Low-Cost Debt Funding
Terna benefits from a low cost of debt. In 2014 the company reported an average borrowing cost of around 2.5%. In February 2015 Terna issued a EUR1bn seven-year bond with a coupon of 0.875%. Fitch expects Terna to apply a pre-funding strategy to take advantage of the low interest rate environment. The company also benefits from its hedging strategy, which includes long term fair value hedging and cash flow hedging with a more limited timeframe. We assume increases in cost for new debt in the next few years.

Limited Weight of Non-Traditional Activities
Fitch expects Terna's non-regulated activities revenues to increase to EUR330m in 2019 from around EUR200m expected in 2015. Management's objective in relation to non-traditional business is to achieve some upside in results without putting capital at risk, particularly through service-based non-capital intensive activities. However, Fitch expects the unregulated business incremental annual EBITDA contribution to be fairly limited (EUR10m-EUR15m per year), with regulated activities still accounting for the majority of the group's EBITDA generation at the end of the current regulatory period (96% in 2019).

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
- A reduction of EBITDA in 2016 to reflect a WACC below 5% in the new regulatory period
- Inflation gradually rising to 1% in 2018
- A decrease of the tax rate to consider the recent cancellation of the Robin Hood Tax in Italy
- Capital expenditure sharply decreasing to an annual average of around EUR570m in 2016-2018 (excluding the capex potentially arising from FS assets), from an average of EUR1.2bn in 2012-2014
- Dividends broadly stable at 2014 levels
- Potential acquisition of FS grid at the beginning of 2016 (with an increase of net debt equalling the increase of the RAB, and slightly higher incremental capex than incremental EBITDA)

RATING SENSITIVITIES

Positive: An upgrade is not likely in the next 24 months due to expected reduction of regulated return and increased FFO net adjusted leverage. However, future developments that could lead to a positive rating action include:
- FFO net adjusted leverage declining below 6.0x on a sustained basis

Negative: Future developments that could lead to negative rating action include:
- Deterioration of FFO net adjusted leverage above 6.75x, FFO interest coverage below 4.0x or net debt/RAB approaching 65% over a sustained period, for instance as a result of the regulatory review or debt-funded acquisitions
- Growing exposure to unregulated activities or upward revision to Terna's dividend policy
- A downgrade of the Italian sovereign rating to 'BB+' from current 'BBB+'/Stable which would lead to a downgrade of Terna's Long-term IDR to 'BBB' in line with Fitch's approach to eurozone sovereign and corporate links

LIQUIDITY

Terna's liquidity is healthy. Its FYE14 readily available cash position was around EUR1.2bn with an undrawn committed credit line of EUR750m. In addition, at the beginning of 2015 Terna issued a EUR1bn seven-year bond. This compares comfortably with debt maturities of around EUR800m in 2015-2016 and negative post dividend FCF of around EUR800m that we estimate for the same period.