Fitch Affirms KEGOC at «BBB-», Outlook Stable

English

Fitch Ratings-Moscow-06 March 2020: Fitch Ratings has affirmed Kazakhstan Electricity Grid Operating Company's (KEGOC) Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'BBB-'. The Outlook is Stable. A full list of ratings actions is at the end of this commentary. 

Fitch continues to rate KEGOC by using a top-down minus one notch approach under its Government-Related Entities Rating Criteria. This is underpinned by KEGOC's strong links with its ultimate dominant (90%) shareholder, the Republic of Kazakhstan (BBB/Stable), whose support includes debt guarantees. We view KEGOC's Standalone Credit Profile (SCP) as commensurate with 'bb+', mainly reflecting less mature and transparent regulation, the company's monopoly position in electricity transmission, its size relative to Kazakh peers and sound financial profile.

Key Rating Drivers Partially

State-Guaranteed Debt: We assess status, ownership and control as strong as the Kazakh government is the ultimate dominant shareholder and approves the company's strategy and capex through the board of directors. We also view the support track record and expectations as strong, as the state provided guarantees for about one-third of KEGOC's debt at end-3Q19. KEGOC has also received equity injections to fund capex in the past and the National Pension Fund is the main investor for KEGOC's local bonds. 

We assess the socio-political impact of a theoretical default as strong, as the company is a large employer and a natural monopoly and runs the major energy infrastructure in the country, with significant development capex plans. KEGOC is funded indirectly by the state and international financial institutions (European Bank for Reconstruction and Development (EBRD) and International Bank for Reconstruction and Development (IBRD)), but there are no cross-default provisions with Kazakhstan. Therefore, we view the financial implications of its theoretical default on the state or other government-related entities as moderate.

Evolving Regulation: KEGOC operates under five-year tariff plans, which are currently set until 2020. Tariff increases are linked to the implementation of a certain capex programme, but KEGOC has some flexibility in shifting capex spending between years. However, tariffs were revised down in 2019 without a proportional capex revision, confirming the framework's less reliable nature compared with several others across the EU. In our ratings case, we expect 2020 tariffs to be below the initially approved long-term level.

Post-2020 tariffs are not yet approved. We expect them to grow at slightly below inflation from 2021. Under the current framework, the company is exposed to volume risk.

Healthy CFO, Negative FCF: We expect KEGOC to continue to generate healthy cash flow from operations (CFO) of about KZT60 billion on average over 2019-2023 under Fitch's assumptions. However, its free cash flow (FCF) is likely to be negative in 2020-2023 on the back of expected average capex of about KZT46 billion, and an 80% dividend pay-out ratio over the same period. This will add to funding requirements.

Meaningful FX Exposure: KEGOC remains exposed to foreign-exchange (FX) fluctuations as about 44% of its debt at end-3Q19 was denominated in foreign currencies, mainly US dollars and euros. This contrasts with almost all revenue being local currency denominated. The company does not use any hedging arrangements, except for holding a portion of cash and deposits in US dollars (around 40% at end-3Q19). We expect FX exposure to remain, although decreasing, due to the amortisation of FX loans.

SCP Constrained by Regulation, Operating Environment: We view KEGOC's SCP as commensurate with 'bb+', reflecting the company's large size relative to Kazakh peers, its monopoly position and its sound financial profile, but also the less mature regulatory framework, FX exposure and relatively weak operating environment. We expect KEGOC's FFO adjusted gross leverage to average slightly below 2.5x and FFO fixed charge coverage to average 5.5x over 2019-2023, which is within our guidelines for the rating. The SCP is also constrained by large capex and dividends, which are likely to result in negative FCF. We see limited headroom for SCP improvement, given the current regulatory framework and operating environment.

Mixed Effect from Capacity Market: From 2019 KEGOC's via its 100% subsidiary acts as a single buyer of the capacity and collects capacity payments from electricity consumers and redirects them to generators. The cost of a single buyer's service will be included in the capacity tariff, but it will only compensate the company's administrative costs. Although KEGOC plans to net capacity proceed with payments to generators, it will bear the risks of non-payment, in our view.

In our rating case, we expect the effect of capacity market introduction on EBITDA to be neutral on average. We expect the company to earn around KZT 6 billion in 2019, which we consider to be mostly one off, and to be slightly negative of about KZT3 billion on average over 2020-2023.

Derivation Summary

KEGOC's business profile is similar to that of PJSC Moscow United Electric Grid Company (MOESK, BB+/Stable), the principal electricity distribution company in Moscow and the wider Moscow region, and weaker than that of PJSC Federal Grid Company of Unified Energy System (FedGrid, BBB/Stable), the Russian electricity transmission operator, due to the latter's larger scale of operations and lower exposure to volume risk. KEGOC's financial profile is similar to that of FedGrid and stronger than that of MOESK. The investment programmes of all three companies are usually large, although they have some flexibility.

KEGOC, FedGrid and MOESK are rated under our GRE Criteria. KEGOC has an SCP of 'bb+' and is rated one notch below the sovereign. FedGrid's rating incorporates a single-notch uplift to the SCP of 'bbb-' to the same level as Russia. MOESK is rated under a bottom-up plus-one notch approach.

The wider peer group includes Romanian distribution operator Electrica SA (BBB/Stable), which benefits from more predictable regulatory framework and lower risk of political interference, which is only partly offset by more risky distribution operations compared to transmission. Electrica's financial profile is also stronger than that of KEGOC. Other peers are REN - Redes Energeticas Nacionais, SGPS, S.A. (BBB/Stable), Red Electrica Corporacion S.A. (A-/Stable) and Terna S.p.A. (BBB+/Stable), which are electricity transmission operators in Portugal, Spain and Italy, respectively. Their SCPs are higher due to more predictable and transparent regulation and operating environment, despite higher leverage.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

- Kazakh GDP to grow at 3.9%-4.0% and CPI at about 4.6%-5.2% over 2020-2023;

- transmission volumes to grow at around 2% in 2020 and 1.5% annually thereafter;

- tariffs growth slightly below inflation over 2020-2023;

- capex of around KZT47 billion annually on average over 2020-2023;

- 80% dividend pay-out ratio in 2020-2023

RATING SENSITIVITIES

Developments That May, Individually or Collectively, Lead to Positive Rating Action

- Positive sovereign rating action

- Significant strengthening of legal ties, for example if the share of guaranteed debt rises above 75%, which we view as unlikely

Developments That May, Individually or Collectively, Lead to Negative Rating Action

- Negative sovereign rating action

- Weaker links with the state

- If the state tolerates a deterioration of the company's SCP, for example through an increased capex programme without sufficient funding or downward revision of tariffs, leading to FFO-adjusted gross leverage persistently higher than 4x and FFO fixed-charge coverage below 4x, it may be negative for the SCP, but not necessarily the rating.

For the sovereign rating of Kazakhstan, KEGOC's ultimate parent, Fitch outlined the following sensitivities in its rating action commentary of 21 February 2020:

The main factors that could, individually or collectively, trigger positive rating action, are:

- Improved governance indicators and strengthening of the policy framework to enhance its predictability and effectiveness.

- Sustainable improvement in the health of the banking sector, e.g. demonstrated by improved financial intermediation and asset quality.

- Improvement in the economy's and public finances' resilience to commodity price shocks through economic diversification.

The main factors that could, individually or collectively, trigger negative rating action, are:

- Policies that widen the consolidated fiscal deficit materially or undermine monetary policy credibility.

- Materialisation of additional significant contingent liabilities from the banking sector on the public sector balance sheet. 

Liquidity and Debt Structure

Adequate Liquidity: At end-3Q2019, KEGOC's readily available cash and deposits (Fitch-calculated) of about KZT49.5 billion were sufficient to cover short-term debt of KZT13.9 billion and expected negative FCF. Cash and deposits were mainly held at domestic banks, namely ForteBank JSC (B/ Positive), Halyk Bank of Kazakhstan (BB+/Positive), Bank Centercredit and ATF Bank (B-/Stable). We believe that the company's access to liquidity for daily operations is adequate, but full access to all cash held at Kazakh banks may be limited, which we take into account in our rating case.

ESG Considerations

ESG issues are credit neutral or have only a minimal credit impact on the entity(ies), either due to their nature or the way in which they are being managed by the entity(ies). For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

Kazakhstan Electricity Grid Operating Company (KEGOC); Long Term Issuer Default Rating;

Affirmed; BBB-; RO:Sta; Short Term Issuer Default Rating; Affirmed; F3; Local Currency Long Term Issuer Default Rating; Affirmed; BBB-; RO:Stasenior unsecured; Long Term Rating; Affirmed; BBB-