Fitch Affirms EDP at 'BBB-'; Outlook Stable
The affirmation mainly reflects the resilience of economic results and the improvement of the operating environment in Portugal and Spain from both a regulatory and demand perspective. It also factors in the still challenging scenario in Brazil and the shift to a liberalised market in 2017 of the capacity currently managed under long-term contracts in Portugal.
Fitch's revised forecasts result in average funds from operations (FFO) adjusted net leverage of 4.6x and FFO interest coverage of 4.1x for 2015-2018, trending towards the positive guidelines for an upgrade. The management's commitment to deleveraging, a strategy consistent with this target and a fairly limited market risk are key issues supporting the ratios' evolution, in our view.
KEY RATING DRIVERS
Earnings Resilience in a Challenging Scenario
In the past three years, EDP has faced a tough regulatory environment in Iberia, which from 2014 was coupled with a severe drought in Brazil. However, the group has been able to post stable EBITDA at around EUR3.6bn, including non-recurring items.
This has been achieved thanks to the group's diversified business mix in terms of activity (regulated activities 37% and quasi-regulated, long-term contracted activities 51%) and geography (Portugal 48%, Spain 20%, Brazil 17%, US 10%). We understand that EDP's earnings stability is also helped by positive non-recurring items largely under management control (i.e. assets disposals and cost restructuring measures). Therefore, we consider EDP is well placed to take advantage of increased stability in Iberian regulation and potentially normalising weather in Brazil.
Net Debt Decrease
Fitch-adjusted net debt decreased to EUR17.4bn in 2014 from EUR19.3bn in 2012. Free cash flow (FCF) improved to become broadly neutral in 2014, mainly as an effect of a stricter capex policy and ongoing securitisations of Portuguese regulatory receivables (RR). Cash-inflows from asset disposals were offset by negative FX movements leading to stable net debt by year end.
We view the target of net debt below EUR17bn as reachable by end of 2015 down from EUR17.4bn in 2014, even including the negative impact on debt of the 50% Pecem (coal plant in Brazil) acquisition and debt consolidation, which was partially absorbed by the equity content of the EUR750m hybrid notes issued in September.
Easing Regulatory Risk
We believe the group's regulatory risk exposure will reduce, due to the recent completion of structural reforms in Iberia, which successfully addressed the tariff deficit (TD) issue. We anticipate a decreasing balance of Iberian RR on EDP's balance sheet (EUR2.3bn in 9M15, 98% related to Portugal) from 2016, assuming the current level of TD securitisations. In Spain, the system is expected to be in balance in 2014, and might even show a surplus, whereas in Portugal, we expect the system's outstanding debt to decrease from 2016. The expected decreasing balance of Iberian RR is a key factor in our assessment of deleveraging through 2018.
EDP could be exposed to higher Brazilian RR if the support from the regulator, mainly in the form of extraordinary tariff reviews, is reduced. Finally, we see some political uncertainty in Spain and Portugal coming from the most likely need to form new coalitions after general elections this year, which has been already the case in Portugal.
In addition, EDP has increased its exposure to other mature and well stablished regulatory frameworks, such as the US, lowering the historically high business concentration in Iberia to 65% by 2018, according to Fitch's estimates, from 71% in 2012.
Slow Recovery in Market Fundamentals
We expect slightly better prospects for energy market fundamentals, with electricity demand increasing on the back of the Iberian economy recovery. In this context, assuming normalised wind and hydro volumes, gross profit could improve based on slightly higher baseload power prices and particularly more profitable and re-powered assets coming into operation (i.e hydro pumping). EDP has a low-cost and modern generation assets portfolio, largely composed of hydro and wind (70% of total capacity in 2014), which benefits from priority of dispatch.
Largely Offset Shift to Merchant
From 2017, all power purchase agreements (PPA)/Costs from the maintenance of the contractual balance (CMEC) plants in Portugal will enter into a new phase with exposure to price and volume risk. The CMEC system will only end in 2027 with the maturity date of the last hydro PPA. At gross profit level, the shift could be accretive if market prices are above EUR50/MWh and assuming normalised hydro conditions. In 2018, the expected EBITDA contribution from unregulated activities will rise, according to Fitch's estimates, to 24% (from 11% in 2014), still below the average of other EU peers, often at 30%-50%.
Fitch assumes this move will be slightly negative for the credit profile, but mitigated by an improved operating environment since 2012 and new capacity additions in wind and hydro in Brazil through secured PPAs with priority of dispatch. In addition, we see this shift well matched with the ongoing deleveraging process until 2017.
Market Conditions in Brazil Still Tough
EDP Brazil, EDP's 51%-owned listed subsidiary, is one of the largest integrated players of the country. Generation and distribution contribute broadly on a 50-50% basis to the EBITDA of the subsidiary (17% of total EBITDA in 2014). The Brazilian electricity system relies heavily on hydroelectric plants (73% of the energy generated in 2014) and has suffered from the drought over the past two years.
This forced generation companies to buy electricity in the market at a very high cost in order to deliver the full energy amount defined in their PPAs (negative EBITDA impact of around EUR89m in 9M2015 for EDP). However, the level of the reservoirs at October 2015 was substantially higher than October 2014 (28% vs. 19%), increasing the likelihood of an improving scenario. As for distribution, the recent decisions of the regulatory body are aimed at reducing the time needed to recover the costs related to the involuntary exposure to the spot market.
We believe that the main risks for the group's activity in Brazil (sovereign IDR: BBB-/Negative) are represented by a persistent drought, a rising possibility of political interference in a weakening macroeconomic scenario (which is not currently the case) and adverse foreign exchange movements, albeit mitigated by the local funding of the activities in Brazil.
CTG Partnership Delivering Results
The partnership between EDP and China Three Gorges (CTG, EDP's main shareholder, A+/Stable), which dates back to 2012, foresees that CTG invests EUR2bn (including co-funding capex) for stakes between 34%-49% in 1.5GW of operational and ready-to-build renewable projects. Around EUR1bn has been already executed and there is visibility on a further EUR300m related to the 49% of the assets assigned to EDP from the split of ENEOP in September 2015.
We think that further transactions bringing the overall amount close to the initial target of EUR2bn would sustain deleveraging and strengthen the link between CTG and EDP.
Deleverage Targets Confirmed
FFO adjusted net leverage reduced to 5.4x in 2014 from 5.7x in 2012 and we forecast a further decrease in 2015 to 5.3x. Fitch's rating case shows FFO adjusted net leverage below 5x from 2016 (4.6x on average 2015 - 2018) and slightly below our positive guideline for an upgrade from 2017. The company's internal target of 3.0x net debt adjusted by RR to EBITDA by 2017 is compatible with our guideline for an upgrade. FFO interest coverage (4.1x on average 2015-2018) is also in compliance with Fitch's positive guideline of above 4.0x.
Overall, we see the group well positioned to achieve its commitments up to 2017 due to the predictability of the regulated and quasi-regulated revenues, high visibility of new capacity additions in the next two years, moderate capital spending, sound track record of asset monetisation (assets disposals plus TD securitisations) and flat dividends (albeit at a high level). We have a limited view beyond 2017 as no guidance has been communicated. The business plan presentation next year will disclose the group's updated strategy.
HC's Rating Aligned
HC is wholly owned by EDP and its ratings remain aligned with those of EDP according to Fitch's "Parent and Subsidiary Rating Linkage Methodology", reflecting the two companies' close integration. HC is strategically and operationally important to EDP as it provides the parent with a strong platform in Spain, enabling the group to optimise its positioning in the Iberian market.
Fitch's key assumptions within our rating case for the issuer include:
- FY15 EBITDA at EUR3.6bn (excluding non-recurring items) and a low single-digit CAGR for 2016 to 2018, driven by wind & hydro organic growth and efficiency improvements.
- Persistent drought in Brazil with Generation Scaling Factor (GSF) around 90% and Settlement Price for Differences (PLD) around BR300/MWh.
- New capacity additions as per management disclosure. Total transfer to liberalised activities of Portuguese hydro and coal plants under PPA/CMEC by 2017.
- Average capex of EUR1.35bn per year for 2015-2018.
- Stable dividends of EUR0.185 per share up to 2017 and EUR0.20 in 2018
- Around EUR800m of additional cash-in for disposals in 2016.
- Excess FCF positive (after dividends) deployed for de-leveraging.
- Cost of new debt 100bps above the company's assumptions.
- Stable RR on balance sheet for 2015 before moderately declining in 2016 to 2018. This implies EDP will continue with TD securitisation. No new TD in Spain.
- FX devaluation for BRL and appreciation of USD over 2014-2018. However, major FX impacts already occurred in 2015.
Positive: Future developments that may potentially lead to positive rating action include:
- FFO adjusted net leverage trending towards 4.5x and FFO interest coverage above 4.0x on a sustained basis, assuming no major changes in the activities' mix other than expected by Fitch
- Sustained positive FCF, together with the consolidation of the new regulatory framework in Spain and Portugal showing a consistent reduction of the tariff deficit in both countries.
Negative: Future developments that could lead to negative rating action include:
- Projected FFO net adjusted leverage above 5.0x and FFO interest coverage below 3.5x over a sustained period.
- Adverse regulatory or fiscal changes affecting the predictability of cash flows.
- A substantial increase of operations in emerging markets with a higher business risk or a substantial shift towards unregulated activities, higher than expected by Fitch, could lead us to tighten the ratio guideline for the rating.
EDP's liquidity is strong. At September 2015 the readily available cash position was around EUR1.1bn with undrawn committed credit lines of EUR3.75bn. This compares with debt maturities of EUR3.4bn until the end of 2016. Fitch expects the company to generate about EUR600m free cash flow in 2016, which should be coupled with disposals of around EUR400m (49% of the assets split from ENEOP and mini-hydro in Brazil). The group benefits from continuous access to capital markets and strong banking relationships.