Fitch Assigns SmVaK Final 'BBB-' Senior Unsecured Rating
The final ratings reflect SmVaK's capital structure following a CZK5.4bn bond issue and an agreement on CZK150m RCF due 2018. The proceeds of the bonds are being used to refinance the company's existing CZK2bn bonds due in November 2015, repay immediate parent company's debt, and for distribution to ultimate shareholders. The final financing documents are in line with preliminary documentation already reviewed by Fitch.
KEY RATING DRIVERS
Supportive Business Profile
The business profile is supported by SmVaK's status as the monopoly water and wastewater network owner and operator in the Moravia and Silesia region in the Czech Republic. It also benefits from a benign and predictable regulatory framework with a proven track record, strong operational history and a diversified customer base. We believe the regulatory environment could become more challenging over time and that water demand could continue to decline, putting pressure on allowed tariffs and, ultimately, revenues.
Cash-Generative Operations; Concentrated Funding
The company is cash-generative, but assuming post-refinancing dividend maximisation potentially up to reported net income, we expect free cash flows (FCF) to be neutral. Further, the company's limited size has resulted in concentrated debt funding with bullet maturity, leading to a need to periodically refinance the bulk of its debt and exposing it to the capital market environment at that time. However, the company has proven domestic bond market access, does not face FX risk and carries low interest rate risk (the bonds are fixed-rate for seven years).
Aggressive Refinancing
We view the refinancing as aggressive as some of the proceeds are being used to fund shareholder distribution. Resulting leverage is a chief constraint on the ratings.
Interest Pass-through Uncertainty
Further risk stems from the uncertainty on the eventual treatment of full interest cost as allowed cost for tariff-setting. We therefore forecast that not all of the interest will be 'allowed' (funded by revenues), with the rest funded from profit allowance. We assume dividend payments will be flexible, depending on the eventual regulatory decision on interest cost, leaving credit metrics little changed.
Stand-alone Operation and Funding
We view SmVaK on a stand-alone basis, reflecting the final bond provisions including additional debt restriction, and with limited links to its majority shareholder FCC Group. In addition, the presence of a strong minority shareholder, Mitsui & Co, supports our view that a potential financial distress at FCC would not lead to increased burden on SmVaK. Overall, the legal, operational and strategic links with the parents are weak in our opinion. All related-party transactions are made on an arms-length basis. However, there are no licence or regulatory ring-fence provisions around SmVaK.
Low-Cost Asset Owner
Unlike many peers in the country, SmVaK benefits from being the owner and operator of its assets. Its geographic location places the company in a fairly densely populated area of the country where it benefits from raw water supply from three separate water reservoirs in elevated (mountainous) locations (each able to fully supply the whole region, greatly improving the security of supply). The reservoirs' location translates into reasonable raw water quality (reducing the need for chemicals) and a gravity-fed network (less energy for pumping), allowing the company to achieve below-average prices.
Tariffs Mitigate Structural Challenge
The Moravian-Silesian region has traditionally been heavily industrialised. The partial de-industrialisation of the last 25 years (industry now represents 33% of water demand, down from 50%) has also seen some regional population decline (down 2.5% in 2014 compared with 2008), which together with lower consumption per customer, results in revenue pressure. Importantly, this is offset through tariff-setting (ie volume declines are accounted for through rising unit price; there is only a 7% cap on profit component growth, not on cost-driven component growth).
Benign Regulatory Regime
Overall the regulatory regime is supportive of SmVak's credit profile. There is no independent regulator, but unlike with municipality-owned water companies, local politicians have no formal input in SmVak's tariff-setting. The tariffs are self-determined (within the legal boundaries) and approved by the company's Board of Directors. The Ministry of Finance has a formal audit function, but the company retains the right to appeal to a court.
Long Track Record
The company's 20 plus-year track record further benefits from recent positive changes, including clearer allowed profit determination since 2013. Volume risk is mitigated by predictable volume trends and annual (or possibly more frequent) tariff adjustments in case volumes or cost inflation change beyond plans. Fundamentally, SmVaK's low cost service reduces external pressure on tariffs.
Regulation Could Become Challenging
We see a risk of less benign tariff determination with efficiency challenges, although SmVaK is well-positioned compared with peers. This is in addition to the interest cost funding uncertainty, and ongoing operational risks to maintaining water and wastewater quality and to possibly strengthening quality standards.
Supportive Environment vs. Peers
Compared with central European peers rated by Fitch, we view SmVaK's tariff-setting as less exposed to political risks, which together with less onerous development capex (even if partially grant-funded in the case of peers also not typically paying dividends) support a higher debt capacity for a given rating level. However, SmVaK has less leverage headroom than its peers compared with their leverage rating guidance.
Robust Organic Cash Flows
SmVaK's product diversification (retail, bulk, waste) and counterparty diversification with favourable payments terms are credit-supportive. The company enjoys a long track record of steady and high profit margins, sound working capital dynamics (most customers pay quarterly; high-volume customers pay monthly), and is able to invest just above depreciation. On the other hand, the company has limited growth potential.
Generic Senior Unsecured Uplift
The unsecured bond ratings benefit from a generic single-notch uplift from the IDR to reflect SmVaK's fully regulated network-based earnings profile. Although the regulatory framework for water and sewerage does not benefit from an independent regulator and has other limitations compared, for example, with the UK framework, it is benign with a long track record and the company's asset values have been well preserved over the last 20 years.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for SmVaK include:
-Cost of debt at 2.625% (CZK5.4bn bond coupon)
-Interest cost pass-through on some debt
-0.5% volume decline annually
-Capex between 22%-26% of revenues and above depreciation
-No significant change to allowed cost definition
-Allowed weighted cost of capital (WACC) at 7%
-Dividend maximisation to the extent it is not funded by new debt
RATING SENSITIVITIES
Positive: Future developments that could lead to a positive rating action include:
-Lower business risk, such as independent, yet still benign regulation
-Funds from operations (FFO) net adjusted leverage below 5.0x, fixed charge coverage above 5.0x, both on a sustained basis
Negative: Future developments that could lead to negative rating action include:
-Higher business risk, such as less benign or more politically exposed tariff determination, lower WACC
-FFO net adjusted leverage above 5.5x, fixed charge coverage below 4.0x, both on a sustained basis
LIQUIDITY
We expect liquidity to remain adequate reflecting available cash balances of around CZK150m (7% of revenues) and an undrawn three-year CZK150m revolving credit facility.
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