OREANDA-NEWS. Fitch Ratings has affirmed Kemble Water Finance Limited's (Kemble Water) Long-term Issuer Default Rating (IDR) at 'BB-' with a Stable Outlook and its senior secured rating at 'BB'. The agency also affirmed Thames Water (Kemble) Finance PLC's (TWKF) GBP400m senior secured bond issue at 'BB', which is guaranteed by Kemble Water.

Kemble Water is a holding company of Thames Water Utilities Limited (Thames Water), the regulated monopoly provider for water and wastewater services in London and the surrounding areas.

The rating affirmation reflects Fitch's expectation that Kemble Water will have adequate ability to service its debt despite our expectation of weak dividend cover in the first two years of period April 2015 to March 2020 (asset management plan 6; AMP6) due to low inflation expectations and Thames Water's high capital expenditure. It also reflects the company's satisfactory operating and regulatory performance. Fitch views the efficiency challenge embedded in the final determination of tariffs for AMP6 as increasing business risk in the water sector. Ofwat, the economic regulator for the UK water industry, is more focused on consumer interests in relation to investor interests than in the past.

KEY RATING DRIVERS

Reducing Financial Flexibility
We forecast Kemble Water will maintain gearing below 90% pension-adjusted net debt/economic regulatory asset value (RAV; FY14: estimated at 89.6%), post-maintenance interest cover on average around 1.05x (FY14: 1.36x) and dividend cover on average around 2.1x (FY14: 2.86x).

These financial ratios differ from Kemble Water's investor report. Fitch adjusts cash interest to reflect non-cash debt movements resulting from certain index-linked swaps. The agency also reviews the RAV for variations of capital investment and anticipated prospective changes to be made by the regulator, for example related to the performance-sharing mechanism for total expenditure.

Dividend Cover Temporarily Weak
In FY16 and FY17 dividend cover is expected to be slightly above 1x, ie the operating company will only distribute sufficient funds to service holding company debt, before rising to around 3x in the later years of the price control. This is due to lower expected inflation and materially higher capital expenditure in the early years. Therefore, the agency has affirmed the Long-term IDR with Stable Outlook. If there are any developments that would restrict dividend cover for longer, a downgrade would be considered.

Achievable Total Expenditure Targets
Over the period April 2010 to March 2015 Thames Water managed operating and capital expenditure broadly in line with allowances (particularly after removing any impact from retail operations, which are subject to a separate price control going forward); many companies managed to outperform over the same period.

For AMP6 Thames Water will receive an increase of around GBP240m compared with its business plan, while a few schemes were not fully funded by the regulator. Thresholds for some outcome delivery incentives were tightened by Ofwat, which will likely result in some additional expenditure to meet targets. Fitch's rating case assumes that the company will be able to meet allowances from the final determination, which incorporates some headroom for exceptional expenditure and, possibly, some additional pension deficit repair.

Scope for Retail Performance Improvement
In terms of the service incentive mechanism, which measures customer satisfaction, the company scored 71 out of 100 for FY14, a low ranking in the industry. The doubtful debt charge and debt management costs remain at a high level. Fitch includes GBP125m of underperformance in the rating forecast for the retail function, reflecting i) the efficiency challenge related to the average cost to serve and de-linking retail costs from RPI and ii) additional expenditure to enhance expertise and improve workflow processes for customer service.

Meeting Regulatory Targets
In the financial year to March 2014 (FY14) Thames Water reported marginal asset serviceability for sewerage infrastructure and the number of sewer flooding incidents exceeded its target. The company met leakage targets for the eighth consecutive year. The agency expects that stable asset serviceability should be achieved for all asset categories in the medium term, given that some of the reference thresholds applicable to sewerage infrastructure assets have been re-set as part of the price control settlement.

KEY ASSUMPTIONS

Fitch's key assumptions for Thames Water include:
- Regulated revenues in line with the final determination of tariffs for AMP6, ie assuming no material over- or under-recoveries
- Total expenditure to be broadly in line with the final determination over the five-year period
- Retail costs around GBP125m above allowances over the five-year period (profile of under-performance skewed towards the later years of the price control)
- Non-appointed EBITDA of around GBP10m per annum
- Retail price inflation of 0.75% for FY15, 1% for FY16, 2% for FY17 and 2.5% thereafter
- No impact on cash flow generation from outcome delivery incentives, given that financial rewards and penalties will all be taken into account as part of the next price review

Fitch's key assumptions for Kemble Water include:
- Gross debt at holding company level GBP125m higher at GBP875m, reflecting the potential for existing out-of-the-money interest rate swaps to be closed out as part of the bank debt re-financing. Bond holder consent would be required, given that terms and conditions of the bond limit net debt to GBP750m (not taking into account drawings under its revolving credit facility)
- The annual finance charge at holding company level at around GBP62.5m

RATING SENSITIVITIES

Negative: Future developments that may, individually or collectively, lead to a negative rating action:
- Dividend cover at Kemble Water sustainably below 2.5x, increase of gearing above 90% and/or decrease of post-maintenance and post-tax interest cover below 1.05x (as per Fitch's forecasts)
- RPI remaining at or below 1.5% for an extended period of time
- Possibility of a dividend lock-up at Thames Water
- Weakening of operational and regulatory performance at Thames Water

We have tightened above guidance in terms of dividend cover (previously below 2x) and gearing (previously above 95%) due to incrementally higher business risk in the sector following the conclusion of the price review 2014.

Positive: Rating upside is limited. A higher rating for the holding company would be contingent on Thames Water materially reducing its regulatory gearing.

LIQUIDITY AND DEBT STRUCTURE

Kemble Water mainly relies on dividends for debt service. As of end-December 2014, Kemble Water held GBP4.1m in cash and cash equivalents and had access to a committed GBP75m revolving credit facility to bridge short-term liquidity needs. Compared with Kemble Water's annual finance charge of around GBP62.5m, Fitch deems available back-up liquidity as adequate.

Bank debt at Kemble Water will mature in 2015 and 2016: a GBP150m term loan is due in September 2015, a GBP200m term loan is due in April 2016 and the GBP75m revolving credit facility available for back-up liquidity also expires in April 2016. The group is in advanced discussions to re-finance those facilities, including potentially reducing the revolving credit facility to GBP65m (slightly more than 12 months annual finance charge). Fitch expects documentation to be finalised and signed no later than June 2015.