Fitch affirms ratings of Mangistau Distribution Power Grid, revises outlook from Stable to Negative

/Fitch Ratings, Moscow, November 25, 14, heading by KASE/ – Fitch Ratings has revised the Outlook on Kazakhstan-based Mangistau Electricity Distribution Company JSC's (MEDNC) Long-term Issuer Default Rating (IDR) to Negative from Stable and affirmed the IDR at 'BB+'. A full list of ratings actions is at the end of this comment. The revision of the Outlook reflects our expectation of the weakening of the links between MEDNC and its ultimate parent, Kazakhstan (BBB+/Stable) as a result of the intention to sell the 75% stake owned by 100% state-owned JSC Samruk-Energy (BBB-/Stable) in 2015. Fitch notes, that the loss of a controlling stake by the parent may result in Fitch taking a bottom-up approach to the rating instead of the top-down approach that is currently applied. We view MEDNC's standalone profile as commensurate with a 'BB-' rating. KEY RATING DRIVERS Three Notches below Sovereign MEDNC's ratings are notched down from Kazakhstan's by three notches, reflecting the moderate strength of the links between the company and ultimate parent. MEDNC's direct parent, indirectly fully state-owned Samruk-Energy, has not provided tangible financial assistance to MEDNC since we widened the notching from the sovereign rating to three notches from two in 2011. Samruk- Energy does not view MEDNC as strategic and is likely to sell its stake in MEDNC during 2015. Privatisation Might Change Rating Approach Weaker links with the ultimate parent, such as a reduction of Samruk-Energy's stake in MEDNC to a less than controlling interest may result in Fitch reconsidering its rating approach to one of bottom-up rather than top-down, as we currently apply. In April 2014, Kazakhstan's government approved the list of 106 companies earmarked for privatisation over 2014-2016. The terms and pricing details of these assets sales are not yet disclosed. Nine of these companies are owned by Samruk-Energy, including MEDNC. MEDNC is currently 75% owned by Samruk-Energy. We expect privatisation to be a two-stage process, the first stage a sale of a 24% stake + 1 share by Samruk- Energy via a public offering, the second stage being the remaining 51% to be sold to a strategic shareholder via an auction possibly as soon as at the beginning of 2015. 'BB-' Standalone Profile We view MEDNC's standalone profile to be commensurate with the weak 'BB' rating category, which reflects a balance between its relatively small size, industry and customer concentration, average projected credit ratios, the current supportive tariff regime and good quality counterparties. MEDNC's credit profile is supported by its near-monopoly position in electricity transmission and distribution in the Region of Mangistau, one of Kazakhstan's strategic oil and gas producing regions. It is also underpinned by prospects for economic development and expansion in the region, in relation to both oil and gas and transportation, and by favourable three-year tariffs. MEDNC further benefits from limited foreign- exchange risks and from the absence of interest-rate risks. Small Scale, Concentrated Customer Base The ratings are constrained by MEDNC's small scale of operations limiting its cash flow generation capacity, its high exposure to a single industry (oil and gas) and, within that, high customer concentration (the top four customers represented over 67% of 9M14 revenue). The latter is somewhat mitigated by the state ownership of some customers, and by prepayment terms under transmission and distribution agreements. Favourable Tariffs Approved tariff increases average about 5% for 2014 and 2015. Since 2013, MEDNC's tariffs have been approved by Kazakstan's Agency on Regulating Natural Monopolies and Competition Protection for three years, rather than one year previously, in conjunction with the capex programme. MEDNC expects its 2016-2019 tariffs to be approved by end-2014. Fitch views the switch to medium- term tariff approval positively. The tariff system for transmission and distribution segments, which is predominantly based on benchmarking efficiency, should result in favourable tariffs for MEDNC. Weaker Leverage Expected MEDNC's ratings are constrained by its large prospective investment programme relative to the small scale of its operations. At end-2013 MEDNC reported funds flow from operations (FFO) adjusted leverage of 1.3x, down from 1.5x at end-2012. The company's ambitious capex programme of about KZT26bn over 2014-2017 will likely result in negative free cash flow over the same period and require significant debt funding. Fitch expects that it may result in FFO-adjusted leverage increasing to around 3x by end-2015 and towards 4x by end-2016 under the agency's conservative assumptions. Capex to Drive Negative FCF Fitch expects MEDNC to continue generating solid and stable cash flow from operations (CFO) over 2014-2017. However, FCF is likely to turn negative in 2014 onwards, mainly driven by substantial capex plans. Capex will be spent on the construction of two new electricity transmission lines and the reconstruction of existing transmission lines and substations. The currently approved capex programme is KZT9bn for 2014-2015. At end-2013 FFO interest cover improved to around 10x from 5x at end-2012 and we expect that it will remain in the single digits over 2014-2017. For 2014, Fitch estimates MEDNC's CFO at KZT2.6bn, before capex (KZT3.5bn) and dividends (KZT434m). Fitch expects MEDNC to rely on new borrowings to finance cash shortfalls. Elevated Dividend Payout Fitch notes that for 2013 MEDNC's dividend payout ratio decreased to 38% (or KZT434m) from 76% (or KZT255m) for 2012. However, management expects a payout ratio of 50% over the medium term. If dividends remain elevated at a time of increasing capex, Fitch may view it as a sign of weakening links with the ultimate parent and may revise its rating approach to bottom-up from top-down even if the company's ownership does not change. RATING SENSITIVITIES The Negative Outlook reflects the possible sale of MEDNC by Samruk Energy, and the likelihood change to our rating approach that would result. The main factors that may individually or collectively lead to rating action are as follows: Positive: – Stronger links with the ultimate parent. – Enhancement of the business profile, such as diversification and scale with only modest increase in leverage would be positive for the standalone profile. Negative: – Negative rating action on Kazakhstan's ratings. – Weaker links with the ultimate parent, such as a reduction of Samruk-Energy's stake in MEDNC to less than 50% or an elevated dividend payout, insufficient tariffs and increased capex contributing to weaker credit metrics. This may result in Fitch reconsidering its rating approach to one of bottom-up from the top-down that is being currently applied. – Deterioration in MEDNC's FFO adjusted leverage to 4x or above and FFO interest cover to 2.0x or below on a sustained basis would be negative for the standalone profile. For the sovereign rating of Kazakhstan, Samruk-Energy's ultimate parent, Fitch outlined the following sensitivities in its rating action commentary of 7 November 2014: The Stable Outlook reflects Fitch's assessment that upside and downside risks to the rating are currently well-balanced. The main factors that individually or collectively might lead to rating action are as follows: Positive: –Steps to reduce the vulnerability of public finances to oil price shocks, for example by narrowing the non-oil fiscal deficit –Effective restructuring of bank balance sheets -Entrenching low and stable inflation under a more flexible exchange rate regime –Substantial improvements in governance and institutional strength Negative: –Policy management leading to a sustained decline in sovereign assets or reduced economic or financial stability –A sustained commodity price shock –Renewed weakness in the banking sector and crystallisation of contingent liabilities- –A political risk event LIQUIDITY AND DEBT STRUCTURE Fitch views MEDNC's liquidity as manageable, comprising solely cash as the company does not have any available credit lines. At end-3Q14, MEDNC's cash balance of KZT2.3bn was sufficient to cover short-term maturities of KZT217m. Cash balances are mostly held in local currency with domestic banks including Halyk Bank of Kazakhstan (BB/Stable) and Nurbank, which is a risk. At end-3Q14, most of MEDNC's debt was represented by two unsecured fixed-rate bonds of KZT1.7bn and KZT2.4bn maturing in 2023 and in 2024, respectively. The rest of the debt is represented by interest-free loans with maturity up to 2036 from MEDNC's customers to co-finance new network connections. MENDC's ambitious capex programme will likely require additional debt funding over the medium term. MEDNC has proven access to the domestic bond market. During 2014 MEDNC issued KZT2.4bn of bonds to partly finance its substantial capex need (KZT3.5bn) for the year. The remainder is expected to be financed by MEDNC's own funds. FULL LIST OF RATING ACTIONS Long-term foreign currency IDR affirmed at 'BB+', Outlook revised to Negative from Stable Long-term local currency IDR affirmed at 'BBB-', Outlook revised to Negative from Stable National Long-term rating affirmed at 'AA(kaz)', Outlook revised to Negative from Stable Short-term foreign currency IDR affirmed at 'B' Foreign currency senior unsecured rating affirmed at 'BB+' Local currency senior unsecured rating, including that on KZT1.7bn and KZT2.4bn bonds, affirmed at 'BBB-'. Contact: Principal Analyst Alexey Evstratenkov Analyst +7 495 956 9984 Supervisory Analyst Elina Kulieva Associate Director +7 495 956 9975 Fitch Ratings CIS Ltd 26 Valovaya Street Moscow 115054 Committee Chair Paul Lund Senior Director +44 20 3530 1244 Contacts for media in Moscow: Kseniya Ivanova, Moscow, tel. + 7 495 956 6810/9901, ksenia.ivanova@fitchratings.com [2014-11-26]