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Fitch Affirms Kazakhstan Utility Systems at 'BB-'; Outlook Stable

Fitch Ratings-Moscow/London-19 October 2017: Fitch Ratings has affirmed Limited Liability Partnership Kazakhstan Utility Systems' (KUS) Long-Term Foreign Currency Issuer Default Rating (IDR) at 'BB-' with a Stable Outlook. A full list of rating actions is at the end of this commentary.

The affirmation reflects Fitch's expectations that the company will maintain a solid financial profile over 2017-2021, despite an aggressive acquisitive strategy, dividends starting from 2017 and high capex. The company's vertical integration, favourable long-term tariffs for distribution and heat segments and minor FX exposure also supports the company's ratings. However, KUS's ratings are constrained by its limited size relative to larger peers and 'BB' rated CIS companies, unfavourable regulatory framework in generation and limitations in corporate governance.

KEY RATING DRIVERS

Business Profile Extension: In 2017 KUS followed its expansion policy, acquiring generation and distribution assets, which should double its electric and heat capacity and provide access to heavily industrialised west and east Kazakhstan. In March 2017 KUS acquired two combined heat and power plants in the east from AES Corporation for KZT9.6 billion plus KZT10.4 billion debt. In September 2017 KUS acquired jointly with its strategic partner (50%/50%) a 78.64% stake in Mangistau Electricity Distribution Company (MEDNC, BB-/Rating Watch Negative) from JSC Samruk-Energy (BB+/Stable) for KZT8.6 billion to be paid in instalments until 2020 plus KZT14.4 billion debt.

Rating-Neutral Acquisitions: Fitch estimates that KUS's leverage will increase by around 0.5x on average during 2017-2020 as a result of these acquisitions, other things being equal. These assets will contribute around KZT10 billion in total to the group's EBITDA, according to our estimates. However, a significant debt burden, potential dividends outflow to MEDNC's minorities and the capex obligations of all acquired assets might put pressure on KUS's financial profile, while Fitch expects credit metrics to remain within Fitch's guidelines for negative rating action.

Significant Capex Expected: Fitch expects consolidated capex to remain significant due to the recent acquisitions, averaging KZT25 billion annually in 2017-2021. This is close to the historical KZT21 billion for 2013-2016 and higher than the KZT13 billion forecast by the management. This also includes MEDNC's annual capex of KZT4.5 billion on average. We assume that MEDNC is fully consolidated by KUS.

Dividends Add Pressure: In our rating case we assume that the controlling shareholder will start extracting cash from the company through dividends from 2017. The management expects to pay around KZT5.6 billion (about 30% of net income) in 2017 for 2016 (KZT4.7 billion already paid in 1H17) and we forecast a 50% payout ratio from 2018, resulting in average KZT8 billion annual dividends.

Commensurate Leverage: We expect KUS's financial profile to remain solid to the rating horizon despite recent acquisitions, higher capex than management anticipates and dividend payments. This will be supported by approved tariffs, moderately increasing volumes and the acquisition of the two combined heat and power plants and MEDNC. We expect funds from operations (FFO) to average KZT28 billion in 2017-21 compared with KZT27 billion in 2016. Post-dividends free cash flow (FCF) will become negative during 2017-2021, with FFO adjusted gross leverage rising to around 2x in 2017-2021 (1.2x in 2016), but KUS will comfortably remain within its negative rating guideline of 3.0x.

Weak Corporate Governance: In Fitch's view, KUS has weaker corporate governance than many larger state-owned Kazakh corporations rated in the 'BB' category, mostly due to the non-transparent ownership structure and a potential non-disclosure of related-party transactions. The company-specific corporate governance negatively affects the ratings.

In 2016 KUS provided a KZT7.5 billion interest-free loan to its ultimate owner, Dinmukhamed Idrissov (KZT7.0 billion), and his private equity fund, Ordabasy Group (KZT0.5 billion), which supervises KUS operations. However, in 2015 there were shareholder equity injections totalling KZT6.2 billion for the repayment of KUS's debt, which partially explains the nature of the interest-free loans. The maturity date on these loans is 31 December 2017, but in 1H17 Ordabasy redeemed its loan ahead of time and Mr Idrissov repaid KZT4.9 billion.

Sound Business Profile, Vertical Integration: KUS's business profile benefits from the company's near-monopoly position in electricity generation, distribution and supply in highly populated central Kazakhstan (Karaganda Region) and South Region, which account for 25% of the country's population. However, the business profile is constrained by the company's scale of operations, which is smaller than that of rated Kazakh peers Samruk-Energy and Ekibastuz GRES-1 LLP (BB+/Stable), but similar in size to Joint Stock Company Central-Asian Electric-Power Corporation (CAEPCo; B+/Stable).

DERIVATION SUMMARY

KUS's closest peers are Kazakhstan-based regional companies GRES-1 and CAEPCo. KUS, CAEPCo and GRES-1 have similar business profiles in terms of scale of operations, and their EBITDA is dominated by the electricity generation segment. KUS's financial profile is similar to that of GRES-1, but stronger than CAEPCo's due to higher margins, lower leverage and minimal debt exposure to FX. KUS and CAEPCo are rated on a standalone basis, while GRES-1's ratings include one notch of uplift for parental support.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:

  • moderate electricity generation growth of average 1.5% over 2017-2021;
  • zero tariff growth in 2016-2018 in electricity generation and as approved by the regulator for electricity distribution and heat sales;
  • capex averaging KZT25 billion, which is above management guidance;
  • inflation-driven cost increases;
  • 50% dividend pay-out from 2018;
  • MEDNC fully consolidated from October 2017.

RATING SENSITIVITIES

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

  • Long-term predictability of the regulatory framework, with less political interference and a cost-reflective heat segment in a stronger operating environment
  • Increased transparency of the ownership structure and generally stronger corporate governance
  • Increased scale of business

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

  • Weaker-than-expected financial performance or financial guarantees for parent debt or aggressive M&A, leading to FFO gross adjusted leverage persistently higher than 3x (2016: 1.2x) and FFO interest coverage below 4.5x (2016: 9.4x)
  • Committing to capex without sufficient available funding, worsening overall liquidity position

LIQUIDITY AND DEBT STRUCTURE

Weak, but Manageable Liquidity: Fitch views KUS's liquidity as weak, assuming that the cash and cash equivalents of KZT6.7 billion at end-1H17 are not sufficient to cover the company's short-term debt totalling KZT8.4 billion and forecast negative FCF of KZT0.4 billion. However, KUS expects to repay its short-term maturities with its operating cash, as demonstrated by the company's strong 8M17 results. The company is centrally managed, including its treasury functions, across operating subsidiaries by a single management board; we therefore focus on the consolidated group in our credit analysis.

At end-1H17, KUS's debt comprised secured loans from local banks raised at both holdco and opcos' level. The largest creditors are Development Bank of Kazakhstan (KZT20.3 billion) and Sberbank (KZT16.7 billion). All loans are nominated in tenge and have fixed interest rates.

Manageable FX Exposure: Almost all KUS's debt (except one newly acquired MEDNC bond issue of KZT3.2 billion, which is linked to the tenge-dollar exchange rate) is denominated in tenge, which places the company favourably compared with CAEPCo, Samruk-Energy and Kazakhstan Electricity Grid Operating Company (BBB-/Stable), which have 40%-60% of their debt in foreign currencies.

Senior Unsecured Aligned with IDR: KUS's KZT12.3 billion local currency bond programme is rated 'BB-', in line with its Long-Term Local Currency IDR, as the bonds will benefit from sureties totalling KZT12.3 billion provided on a several basis by Karaganda Zharyk LLP, Ontustik Zharyk Transit LLP, OntustikZharyk LLP, Energopotok LLP, Karagandy Zhylu Sbyt LLP and Raschetniy servisniy centr LLP, all wholly owned subsidiaries of the group.

The senior unsecured rating is equal to KUS's Long-Term Local Currency IDR, reflecting that the level of prior-ranking debt is below Fitch's threshold of 2.0x-2.5x EBITDA. In addition, the combined EBITDA of subsidiaries providing sureties for the bonds comprised 53% of the group's 2016 EBITDA. An increase in prior-ranking debt to above 2.0x-2.5x EBITDA, a lower level of sureties from group entities or a material drop in the share of operating entities providing sureties in the group EBITDA would indicate a material possibility of subordination and, as a result, the senior unsecured rating could be notched down from the IDR.

FULL LIST OF RATING ACTIONS

Long-Term Foreign and Local Currency IDRs affirmed at 'BB-'; Outlook Stable
National Long-Term Rating affirmed at 'BBB+(kaz)'; Outlook Stable
Local currency senior unsecured rating affirmed at 'BB-'
National senior unsecured rating affirmed at 'BBB+(kaz)'.

For full details, see the official website of FitchRatings: https://www.fitchratings.com/site/pr/1030936

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