OREANDA-NEWS. Fitch Ratings has affirmed Czech Republic-based EP Energy a.s.'s (EPE) Long-term Issuer Default Rating (IDR) at 'BB+', and its EUR1.1bn senior secured notes at 'BBB-'. Fitch has also affirmed holding company CE Energy a.s.'s (CEE) Long-term IDR at 'B+', and its EUR500m 7% senior secured notes due in 2021 at 'B+'/'RR4'. The Outlooks on the IDRs are Stable.

The affirmation reflects our expectation that after the disposal of the German assets the majority of EPE's cash flow (about 70%) will be generated by quasi-regulated district heating operations and from regulated network assets. The volatility of the remaining business, which consists of power generation, trading and supply, is mitigated, in our view, by EPE's intention to strengthen its balance sheet with the proceeds from the disposal. We forecast average funds from operations (FFO) adjusted net leverage of around 3.6x for 2016-2018, assuming the deconsolidation of Stredoslovenska energetika, a.s. (SSE). We forecast some leverage headroom at the current ratings; however, the developing group structure and lack of track record in its business strategy increase EPE's credit risk, in our view.

CEE has deposited funds with its trustees for the remaining outstanding EUR375m 7% notes that are due in 2021 to be redeemed and cancelled. After the cancellation of the 2021 notes Fitch intends to withdraw CEE's rating since there will be no outstanding bonds issued by CEE and CEE may be reorganised.

KEY RATING DRIVERS
Pending Reorganisation
EPE has disposed of its German operations (Mibrag, Schkopau and Buschhaus), including mining and lignite generation. The German businesses benefit from long-term off-take contracts, but the country's energy policy represents incremental long-term risks. These assets represent about 35% of the previous group EBITDA, assuming the full consolidation of SSE, and about 40% of EBITDA if SSE is proportionately consolidated.

The disposals reduce EPE's geographical diversification, with the majority of cash-flows now generated in the Czech Republic and Slovakia, and also somewhat decrease EPE's vertical integration through the loss of the mining business. EPE remains active in district heating, electricity distribution, generation and trading and supply. We are maintaining our leverage guidance unchanged for the 'BB+' IDR for the future EPE.

Transaction Proceeds to Reduce Leverage
The German operations were sold to Energeticky a prumyslovy holding, a.s (EPH), an ultimate owner of EPE, for EUR157m (equity price) with proceeds supplemented by the settlement of certain intercompany loans amounting to EUR335m. The transaction is not constrained by anti-monopoly laws and as such it should close with immediate effect. The proceeds of the transaction will be used to strengthen EPE's balance sheet and reduce leverage.

Emerging Structure and Integration
Despite the divestment of the German operations, EPE's group structure remains complex with a number of separate operating and holding companies. Operational integration is moderate, despite EPE's presence in the energy chain from power generation to retail supply. EPE's ratings remain constrained, in our view, by the company's continuing restructuring and lack of track record in pursuing a clear strategy.

Leader in District Heating
EPE is the largest heat supplier in the Czech Republic with an installed thermal capacity of 3.2 gigawatts (GW), mostly lignite-fired, and heat supplies of 15.6 peta joules (PJ) in 2014, mostly to households (57%) and large industrials (20%). The company supplies around 360,000 households in Prague and other major cities, which represent a stable customer base. It also operates one of the largest low-cost cogeneration plants in the country. EPE's heat prices are typically below the market average and those of alternative heating.

Cash Flow Visibility
EPE's credit profile is supported by low-cost heat supplies, cogeneration power sales as well as by regulated regional distribution monopolies and long-term power purchase agreements. These core divisions represent about 70% of EPE's cashflows, with the rest derived from power generation and supply, making its earnings and cash flows fairly predictable.

Leverage above Peers
EPE's leverage is higher than most Fitch-rated central European peers. Its bond terms allow restricted payments (including dividends) providing that leverage (net debt-to-EBITDA) is no higher than 3.0x (with SSE on a fully consolidated basis) and also limit further indebtedness once gross debt exceeds 3.25x EBITDA (full consolidation of SSE). On funds from operations (FFO) adjusted basis Fitch expects EPE's net leverage to be around 3.6x for 2016-2018 (assuming deconsolidating SSE and including only the dividend thereof), compared with the upper limit of our leverage guidance for the current rating at 4.0x.

CEE Restructuring and Merger
CEE represents a simple holding company structure for EPE, solely reliant on dividends as the only source of cash flow. Its own debt service and payments to the parent company EPH are the two main uses for its cash. No withholding or income taxes are expected to be incurred.

Following the early redemption of the CEE notes Fitch expects to withdraw CEE's rating when the notes are cancelled.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for EPE include:
- Electricity baseload prices achieved gradually declining to EUR26/MWh by 2018 from EUR30/MWh currently;
- Average capital expenditure of EUR90m/year, peaking in 2016 at about EUR110m;
- Average dividends up-streamed of about EUR70m/year;
- The CZK to EUR exchange rate strengthening to CZK 25/EUR by 2018 from about CZK 27/EUR currently;
- A gradual decline in net debt to about EUR650m by 2020 from EUR1.2bn in 2015;
- The proceeds from the disposal of German assets will be used to strengthen EPE's balance sheet and reduce leverage.

RATING SENSITIVITIES
FOR EPE:

Positive: Future developments that may, individually or collectively, lead to positive rating action include:
-Longer track record of the current business structure with a clear financial strategy for the medium- to long-term
-Reduction of target leverage to, and Fitch-expected leverage remaining at, a level comparable with regional peers' (FFO adjusted net leverage below 3.5x) on a sustained basis

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
-A more aggressive financial policy (including opportunistic M&A or higher dividends) that would increase Fitch-expected FFO adjusted net leverage to 4.0x or above on a sustained basis (this level would likely be in breach of EPE's bond covenants)
-A significant deterioration in business fundamentals due to structural regulatory shifts or structural decline in heat demand

FOR CEE:

Positive: Future developments that could lead to positive rating actions include:
-A reduction of Fitch-expected consolidated FFO adjusted net leverage of CEE (including EPE, but deconsolidating SSE) to below 4.75x on a sustained basis, combined with sustainable dividend cover of CEE in excess of 3.5x

Negative: Future developments that could lead to negative rating action include:
-A sustained drop in dividend cover to below 2.5x and an increase in the consolidated FFO adjusted net leverage to over 5.5x
-A dividend lock-up at EPE level triggered by a breach of the 3.0x net debt/ EBITDA covenant
-Available liquidity falling below six months' debt service

LIQUIDITY
At end-September 2015, cash and cash equivalents were EUR203m for EPE and EUR40m for CEE. Some EUR100m of EPE's cash was pledged as security for bond holders and readily available for the EPE group. We expect EPE's free cash flow to be neutral during 2016-2017, depending on the company's dividend policy and wider financial strategy.