Fitch Affirms MOESK at 'BB '; Outlook Stable
The ratings reflect the company's solid business profile, supported by a regulated electricity distribution business in the fairly wealthy Moscow and Moscow region. Although tariff uncertainty and elevated borrowing costs are weighing on MOESK's financial metrics, we view the company's efforts to mitigate the impact of the economic downturn, namely capex and cost-cutting, sufficient for maintaining a financial profile commensurate with the ratings. We expect that funds from operations (FFO) fixed charge cover (net of connection fees) would remain under pressure in 2016 and 2017 due to the impact of high interest rates in 2015, but would return to levels compliant with our guideline of 3.25x by 2018.
The company's ratings incorporate one-notch uplift for parental support from its majority shareholder, PJSC Russian Grids, and ultimately the state. The precedents of the state providing capital injections for the benefit of Russian electricity distribution companies underpins our view of the ultimate parent's willingness to provide support if needed.
KEY RATING DRIVERS
High Tariff Uncertainty
Although formally long-term regulatory asset base (RAB) regulation was introduced in 2011, and key regulatory parameters were set for 2012-2017, the RAB regulation for MOESK continues to be implemented in a managed way. Tariff increases remain unpredictable, particularly during macroeconomic instability. A change in the regulatory body (the abolition of the Federal Tariff Service and transfer of its decision-making powers to the Federal Antimonopoly Service) adds to the uncertainty. Uncertainty over tariff increases for 2016 and 2017 and that of the regulatory framework post-2017 is one of the key rating risks for the company.
Following a 4.9% average tariff increase in 2015, the company expects 2016 tariff to be raised 7.5%, or roughly half of expected consumer inflation. Tariff increases in 2017 and 2018 are expected to be 7% and 6.2%. This is in line with the current Russian Ministry of Economic Development's forecast. The final decision regarding 2016 tariff increases will be made in 4Q15.
Regulatory Decisions Drive Financials
MOESK's financial profile is significantly impacted by tariff decisions as nearly all of its revenues and around half of its operating costs are regulated. Regulated costs include electricity transmission services of Federal Grid Company (FGC UES, BBB-/Negative), distribution services of local network companies and purchases of electricity lost in the networks.
Regulated costs are paid out of the 'common pot' tariff received by the company. Therefore the 'common pot' tariff increase alone is not indicative of its impact on MOESK's financial position. For example, a fairly modest average 'common pot' tariff increase of 2.8% in 2014 resulted in a much higher net tariff increase for MOESK since local network companies received an increase of 0.6% only. The pace of the regulated cost growth is therefore as important as the tariff increase itself and there is a potential for a negative mismatch.
In 2014 and 1H15 MOESK was successful at containing its operational cost increases. Total controllable operating costs (operating expenses excluding the cost of electricity transmission, depreciation and amortisation and fixed assets impairments) went up just 3.7% in 2014 versus 2013, and decreased 0.5% in 1H15 versus 1H14. Consumer price inflation in 2014 and 1H15 was 11.4% and 9.4%, respectively. While the cost cutting efforts of the last 18 months were successful, it may be difficult to achieve similar results if high inflation persists. Meaningful tariff increases, comparable with inflation, are therefore vital in the context of healthy operating cash flow generation.
Geography Aids Volume Dynamics
Although the RAB regulatory framework is designed to capture volume changes in tariff dynamics, we believe that MOESK is not immune to volume risk during the economic downturn, when tariffs are not managed in accordance with RAB framework. MOESK's distribution volumes grew 1.1% in 2014 and 0.6% in 1H15, in spite of Russia's GDP slowing to a 0.6% growth in 2014 and contracting 3.5% in 1H15. Volume is growing slowly rather than contracting, reflecting the company's advantageous geographic location and diversified customer base.
The company benefits from the geographical location of its networks in growing Moscow and the Moscow region. Electricity consumption on the territory of MOESK's operations grew 2% annually in 2012-2014 versus broadly stable consumption in Russia as a whole. A fairly high income per capita compared with the Russian average supports consumer purchasing power and adds to the resilience of distribution volumes.
Elevated Debt Cost
As Russian Central Bank's base rate remains elevated at 11% after its increase in December 2014, MOESK's new bank and bond financing has become considerably more expensive. In April 2015 the company issued three-year rouble bonds with a one-year call option at 13.25%, which is significantly more expensive than rouble bonds or loans raised in 2013 at 8%-9%. Given the company's fairly short debt maturity profile, higher cost of debt would translate into weaker interest cover in 2016-2017. Elevated cost of financing in the longer term would be credit-negative.
Capex Flexibility Mitigates Cost Pressures
For 2015 MOESK has reduced its capex by RUB8bn or 17% to RUB40bn (VAT-inclusive) to preserve its financial profile. Although such measures are not planned for 2016, the company has flexibility in its contingency plans. Fitch assumes that in the exceptional circumstances of a tariff freeze or a prolonged period of high interest rates MOESK would cut its investment by 10%-20%.
Solid Leverage, Stretched Fixed Charge Cover
Fitch expects the company's FFO adjusted gross leverage (net of connection fees) to average 3.3x in 2015-2017, which is comfortably within our guideline. FFO fixed charge cover (net of connection fees), however, is expected to be slightly below our guidance of 3.25x for negative rating action, at around 3.0x over 2015-2017. This is based on our conservative assumptions for tariff growth and cost of new debt. Ultimately, FFO fixed charge cover will largely depend on the Russian Central Bank's policy rate. Should the policy rate remain in double-digits over the medium term, we would target to reflect a step change in MOESK's FFO fixed charge cover in the rating.
One-Notch Uplift for Parental Support
Fitch incorporates a one-notch uplift into MOESK's 'BB+' Long-term IDR for implied parental support as we assess as moderately strong the overall strategic, operational and, to a lesser extent, legal ties between the company and its majority shareholder, JSC Russian Grids and ultimately the Russian Federation (BBB-/Negative).
The relative strength of the strategic and operational ties is underpinned by MOESK's near-monopoly position in electricity distribution in Moscow (BBB-/Negative) and Moscow region (BB+/Stable) and its sizeable contribution to the parent's EBITDA (22% in 2014). Although the company has not received any tangible financial support (eg equity contributions) in the past given its solid financial profile, the track record of JSC Russian Grids in providing capital injections to its other subsidiaries and holdings demonstrates the parent's willingness to provide support if needed.
Fitch's key assumptions within our rating case for the issuer include:
- Average ('common pot') tariff increase of 5.8% per annum during 2015-2018
- 7.1% average annual growth rate of operating expenses during 2015-2018
- Distribution volumes growth of 1.1% CAGR over 2015-2018
- Average annual capex of RUB32.5bn (excluding VAT) in 2015-2018
- Average cost of new borrowings of 11.5% in 2015, 10% in 2016 and 9% in 2017-2018
- Dividend pay-out at 30% of net profit
Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- Improvement of the Russian regulatory framework for electricity distribution and track record of its stability and predictability.
- Evidence that the company can maintain FFO adjusted gross leverage (excluding connection fees) well below 3.0x and FFO fixed charge cover (excluding connection fees) above 4.5x on a sustained basis, which would be positive for the standalone rating.
Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Significant deterioration of the credit metrics on a sustained basis (FFO adjusted gross leverage (excluding connection fees) above 4.0x and FFO fixed charge cover (excluding connection fees) below 3.25x) due to, for example, low tariff growth, insufficient to cover inflationary cost increases, or elevated borrowing costs, not compensated by capex cuts.
- Material adverse changes to the regulatory framework, especially from 2017 onwards.
- Weaker links with the parent and, ultimately, the state.
We have tightened our FFO adjusted gross leverage (excluding connection fees) sensitivity to 3.0x-4.0x from 3.5x-4.5x. This is due to our assessment of an increased business risk because of heightened regulatory uncertainty and adverse regulatory developments of the last few years, including frequent amendments of key RAB parameters and tariff increases below inflation level. The tightening also reflects a reduction of the gap in business risk between Russian electricity distributors and generators.
MOESK's liquidity is satisfactory with RUB41.4bn of available long term credit lines maturing in 2016-2021 and RUB1.7bn of cash and cash equivalents at end-1H15 sufficient to cover short-term debt maturities of RUB22.7bn and Fitch-expected negative free cash flow of RUB8bn.
The company's debt maturity profile is rather short with average weighted maturity of portfolio of 2.5 years. This is due to the concentration of debt maturities in 2015 and 2018 of RUB17.7bn and RUB35.5bn, respectively, at end-1H15. We forecast MOESK to remain free cash flow negative over 2015-2018 and expect the company to rely on external funding for debt refinancing. We assess its FX risk as low as both the company's debt and revenue are rouble-denominated.
FULL LIST OF RATING ACTIONS
Long-term foreign currency IDR: affirmed at 'BB+'; Outlook Stable
Short-term foreign currency IDR: affirmed at 'B'
Long-term local currency IDR: affirmed at 'BB+'; Outlook Stable
National Long-term Rating: affirmed at 'AA(rus)'; Outlook Stable
Local currency senior unsecured rating: affirmed at 'BB+'
National senior unsecured rating: affirmed at 'AA(rus)'