Fitch puts Samruk-Energy (Kazakhstan) ratings on Rating Watch Negative

/Fitch Ratings, Moscow/London, February 11, 14, heading by KASE/ – Fitch Ratings has placed Kazakhstan-based JSC Samruk-Energy's ratings, including its Long-term foreign currency Issuer Default Rating of 'BBB', on Rating Watch Negative (RWN). The full list of rating actions is provided at the end of this commentary. The RWN reflects potential diminishing of state support for Samruk-Energy due to a reduction of the share of state-guaranteed debt in the company's total indebtedness. The RWN also reflects uncertainty regarding the state's willingness to support the company's sound credit metrics while encouraging its acquisitive and capital-intensive strategy. Following the determination of the funding structure for a potential acquisition, Fitch will re-assess the ties between Samruk-Energy and its ultimate sole shareholder, the Kazakh state. Any weakening of ties may result in a widening of notches between the state's (BBB+/Stable) and the group's ratings. KEY RATING DRIVERS Acquisition Financing a Test for State Support If Samruk-Energy's potential acquisition of a 50% stake in LLP Ekibastuzskaya GRES-1 is to be fully debt-funded, it would result in sustained deterioration of the company's credit metrics, despite an expected substantial contribution of the acquisition target to the group's EBITDA. Based on Fitch's forecasts this could result in the leverage covenant of 4.5x stipulated in the EBRD loan documentation being breached in 2014. Fitch would view funding for this acquisition as a test of the Kazakh government's willingness and ability to provide timely tangible support to Samruk-Energy and maintain its sound credit metrics. This is particularly important in light of the company's pursuit of acquisitive and capital-intensive strategy and its limited financial flexibility. Fitch believes a fully debt-funded acquisition of Ekibastuzskaya GRES-1 would signal the state's reduced willingness to provide financial support and may also serve as an indication of a preferred funding structure for other potential acquisitions. JSC Sovereign Wealth Fund Samruk-Kazyna (BBB+/Stable), which is 100% state-owned and is a sole direct shareholder of Samruk-Energy, is expected to purchase a 50% stake in LLP Ekibastuzskaya GRES-1 from Kazakhmys for KZT200bn provided by the state and to further transfer this asset to Samruk- Energy. Two options for financing this acquisition are being considered - an equity contribution to Samruk-Energy (potentially through preferred share issue) or debt funding by issuing long-term bonds under favourable terms to be purchased by Samruk-Kazyna. Top-Down Rating Approach Fitch continues to apply a top-down rating approach to Samruk-Energy with its Long-term IDRs being notched down from the Kazakh sovereign's ratings (BBB+/Stable). This notching reflects fairly strong strategic, operational and, to a lesser extent, legal ties between the state and the group, according to Fitch's Parent and Subsidiary Rating Linkage methodology. The strength of the ties is underpinned by the company's strategic importance to the Kazakh economy and by equity injections provided by the state for funding its investment projects. Fitch will re-assess the strength of the ties following the determination of the acquisition terms and taking into account provision of other forms of state support. Weakening of ties may result in a widening of notches between the company's and the sovereign's ratings. We also believe that Samruk-Energy's standalone business and financial profile has deteriorated due to weaker credit metrics over 2012-2016 (assuming a debt- funded acquisition) to a mid 'B' rating category compared with its Russian and Kazakh peers. State Support Continues While Samruk-Energy continues to benefit from tangible state support, including equity injections and asset contributions, the strength of the legal ties (e.g. state guarantees for debt), which are the key driver for the current one notch difference between the company's and state's ratings, is diminishing. The share of fully state-guaranteed debt (directly by the state or via Samruk- Kazyna) in Samruk-Energy's gross debt declined to 12% at end-1H13 from 19% in 1H12, due to an increase in total debt. In addition, Samruk-Kazyna provided a guarantee for the loans of one of Samruk-Energy's JVs. At the same time, the company received equity injections from the state of KZT95bn over 2008-2012 and expected to receive around KZT11bn in 2013 and further KZT61bn over 2014-2016, for modernisation of the Almaty and Balkhash power stations. It also received about KZT123bn over 2008-2012 and KZT11bn in 2013 in form of the asset contribution. Strategic Importance The strength of strategic links is underpinned by Samruk-Energy's dominant market position. It controls 47% of total installed capacity in Kazakhstan, about one third of total electricity production in the country, operates 64 thousand km of transmission lines and extracts 38% of total coal output in Kazakhstan. Credit Metrics under Pressure Fitch expects Samruk-Energy's funds from operations (FFO) adjusted gross leverage to remain high, at above 6x over 2013-2016 and its FFO fixed charge cover to deteriorate to below 4x by 2016 (6x in 2012). This is due to an intensive capex programme of KZT300bn (about USD2bn) over 2013-2015. The forecast also assumes the impact of a potential debt-funded acquisition of Ekibastuzskaya GRES-1. The company already reported a surge in FFO gross adjusted leverage to 7.8x in 2012 from 4.6x in 2011, which was mainly driven by an eurobond issue of USD500m, the proceeds of which were used for capex and working capital funding rather than refinancing of existing debt. While we expect the company to continue generating solid and stable cash flow from operations over 2013-2016 due to tariff rise and stable dividends flow from its JVs, we forecast free cash flow to remain negative over the same period, due to the capital intensity of operations. We view the company's dividend policy as conservative. Shift to Vertical Integration Samruk-Energy's standalone ratings benefit from the company's gradual shift towards vertically integrated operations, with activities ranging from coal mining to generation, transmission and distribution of power and heat. Fitch expects the generation segment to remain the main cash flow driver for the group, accounting for 56% of Samruk-Energy's 1H13 EBITDA (excluding income from associates). Supportive Tariffs at Present Since 2013 electricity grid companies in Kazakhstan have been operating under three-year tariffs that are approved until 2015 and are determined based on a benchmarking mechanism. We believe that longer-term tariffs establish a foundation for clearer rules and a more stable operating environment, and the introduction of a benchmarking mechanism should motivate companies to increase efficiency, supporting their operational performance. A shift to the competitive, de-regulated market for generating companies is unlikely to happen before 2016. The Kazakh authorities expect to implement an electricity capacity market, which should ensure economically sound returns on investments and provide incentives for the construction of new generation assets or for expanding current capacity. Prior Ranking Debt The foreign currency senior unsecured rating is notched down a level from Samruk-Energy's Long-term foreign currency IDR, due to the structural and contractual subordination in the group's debt structure. Although the share of secured and prior-ranking debt at the operating company level has declined since 2011 (63% of total debt at Samruk-Energy level at end-1H13), it was still around 2x of group's projected 2013 EBITDA. In addition to the reduction of prior ranking debt, Fitch will consider aligning the senior unsecured rating with the IDR if the group achieves further clarity and consistency in its financial policy and group debt management. RATING SENSITIVITIES Negative: Future developments that could lead to negative rating action include: - Negative sovereign rating action - Diminishing level of state support The ratings are on Rating Watch Negative. As a result, Fitch's sensitivities do not currently anticipate developments with a material likelihood, individually or collectively, of leading to an upgrade. Future developments that could, nonetheless, lead to a positive rating action include: - Positive sovereign rating action - Increase of the level of state support (e.g. state guarantees for a larger portion of the company's debt) - Material reduction in the structural and contractual subordination in the group's debt structure along with adherence to a clearly defined debt management policy LIQUIDITY & DEBT STRUCTURE Fitch views Samruk-Energy's liquidity as adequate. At end-3Q13 Samruk-Energy's cash and cash equivalents stood at KZT57bn (excluding cash held at Alliance Bank), which was sufficient to cover short-term maturities of KZT11bn. The company has a fairly balanced debt maturity profile with annual maturities averaging KZT10bn until 2016, reflecting the long-term nature of the company's investments. Fitch expects negative free cash flow driven by substantial investment programme to continue to add to funding requirements. Almost all of the group's cash position is held at domestic banks. While we believe that the company's access to liquidity for daily operations is likely to be adequate, its full access to all the cash held at Kazakh banks may be limited. We treat the company's cash held at Alliance Bank (rated C) as restricted. In addition, we assess Samruk-Energy's foreign currency risk as high, as 60% of its debt as of end-3Q13 was USD-denominated whereas most of its revenue and costs are based in local currency. Devaluation of tenge announced on 11 February 2014 will contribute to pressure on the company's credit metrics. FULL LIST OF SAMRUK-ENERGY's RATINGS Long-term foreign currency IDR of 'BBB' placed on RWN Long-term local currency IDR of 'BBB+' placed on RWN Short-term foreign currency IDR of 'F3' placed on RWN Long-term National rating of 'AAA(kaz)' placed on RWN Foreign currency senior unsecured rating of 'BBB-' placed on RWN Local currency senior unsecured rating of 'BBB' placed on RWN National senior unsecured rating of 'AA+(kaz)' placed on RWN. Contact: Principal Analysts Oxana Zguralskaya Associate Director +7 495 956 70 99 Supervisory Analyst Angelina Valavina Senior Director +44 20 3530 1314 Fitch Ratings Limited 30 North Colonnade London E14 5GN Committee Chairperson Josef Pospisil Senior Director +44 20 3530 1287 Media Relations: Peter Fitzpatrick, London, tel. + 44 20 3530 1103, E-mail: peter.fitzpatrick@fitchratings.com [2014-02-13]