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Fitch Affirms KUS at 'B+'; Outlook Stable

Fitch Ratings-Moscow-20 March 2020. Fitch Ratings has affirmed Kazakhstan-based utility Limited Liability Partnership Kazakhstan Utility Systems' (KUS) Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'B+'. The Outlook is Stable. A full list of rating actions is at the end of this commentary.

The affirmation reflects Fitch's expectations that the company will remain within our guidelines for the rating, as we expect funds from operations (FFO) adjusted credit metrics to remain elevated in 2019 with limited headroom to our negative rating triggers, but to then gradually decline towards 3x over 2020-2023. The rating is constrained by weak corporate governance, reflected in credit-negative transactions with third parties, still limited scale of operations and an evolving regulatory framework, but positively also considers the company's vertical integration and limited FX exposure.

KEY RATING DRIVERS

Evolving Regulation: The new electricity market model was introduced in Kazakhstan in 2019, which foresees the introduction of a capacity market and a double-rate tariff system. This resulted in downward revision of electricity tariffs with simultaneous introduction of capacity tariffs. The regulator approved flat maximum electricity tariff caps for almost each generator for seven years up to 2025 with possible revisions.

Distribution tariffs are currently set until 2020-2022 depending on the company. In October 2019, the government approved the electricity generation tariffs for KUS with 13%-14% increase and distribution tariffs were either flat or slightly increased. Post-2020 tariffs are not yet approved. We expect tariffs to growth at slightly below inflation level from 2021.

Limited Headroom in Leverage: We expect KUS's FFO adjusted gross leverage to have remained elevated at end-2019 on the back of lower than initially expected electricity and capacity tariffs, following the introduction of new market model in 2019 and inclusion of YDD Corporation's debt in KUS's credit metrics calculations. YDD's debt is secured by KUS's assets and we treat it as off balance sheet debt. We anticipate KUS to gradually deleverage towards 3x over 2020-2023 on the back of capex moderation.
Capex Moderation Expected: We forecast KUS to generate healthy cash flow from operations averaging around KZT26 billion annually over 2019-2023. We expect high capex of about KZT26 billion in 2019 to have resulted slightly negative free cash flow (FCF) in 2019, but FCF may turn positive on the back of capex moderation to about KZT18 billion on average over 2020-2023, as the company has completed several large projects over the recent years. This would also support gradual deleveraging over the same period.

Weak Corporate Governance: Fitch continues to view KUS's corporate governance as weak, reflecting sizeable third party transactions with limited disclosure and a non-transparent ownership structure. KUS has historically been involved in related party transactions, but their size has materially increased and their economic benefit to KUS is uncertain.

In 2018 KUS attracted a rouble-denominated loan of RUB9.6 billion (KZT53 billion at the exchange rate at end-2018) from Sberbank of Russia (BBB/Stable) and on-lent the proceeds to Ansagan Petroleum, a Kazakhstan-based oil for refinancing Ansagan's existing loan. KUS also provided a KZT3 billion interest-free loan to a third party and lent USD5.1 million to a related party Dragon Fortune PTE Ltd at 2% interest, which the company expected to be repaid by end-2018, but which were extended to 2020 and 2022, respectively.

In addition, certain KUS assets are pledged under a KZT24.1 billion loan agreement between YDD Corporation (third party) and Development Bank of Kazakhstan JSC (DBK, BBB-/Stable). YDD Corporation is using the loan proceeds for the construction of a new ferrosilicium plant. KUS expects that the pledge of its assets would be released in June 2020. However, this is not reflected in our rating case and we maintain the adjustment for the entire rating horizon.

Vertical Integration; Small Scale: KUS's business profile benefits from vertical integration and its strong position in electricity generation, distribution and supply in highly populated central Kazakhstan (Karaganda Region), the south and eastern regions, and from a near-monopoly position in electricity transmission and distribution in the Region of Mangistau, one of Kazakhstan's strategic oil- and gas-producing regions, which in total account for 35% of the country's population. The business profile is constrained by KUS's small scale of operations relative to Kazakh peers like JSC Samruk-Energy (BB/Stable) and Kazakhstan Electricity Grid Operating Company (KEGOC; BBB-/Stable).

ESG Impact: KUS has an ESG Relevance Score of 4 for Governance Structure and 4 for Group Structure due to non-transparent ownership structure and sizeable related party and third party transactions with limited disclosure and uncertain economic benefit to KUS. These factors have an impact on the rating, together with other considerations.

DERIVATION SUMMARY

KUS's closest peers are Kazakhstan-based utility holding JSC Samruk-Energy (BB/Stable) and transmission operator KEGOC (BBB-/Stable). The latter two have higher scale of operations and wider geographical presence within Kazakhstan. KUS has weaker corporate governance that Samruk-Energy and KEGOC due to credit-negative related party transactions. KUS's financial profile is similar to that of Samruk-Energy, but weaker than that of KEGOC.

KUS is rated on a standalone basis. Samruk-Energy is rated three notches below the sovereign under the GRE Criteria. KEGOC is rated one notch below the sovereign under the GRE Criteria.

The broader peer group includes DTEK Energy (B-/Stable), a coal-fired generator in Ukraine, which, like Kazakhstan, is in the process of ongoing utilities market transformation. Compared to DTEK, KUS benefits from vertical integration, but has much lower scale of operations. KUS's financial profile is stronger than that of DTEK.

KEY ASSUMPTIONS

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

• Electricity generation and distribution volumes to grow slightly below GDP in 2020-2023 and flat heat volumes at 2019 level
• Electricity generation tariffs to increase by 13%-14% from October 2019 as approved, with subsequent below-inflation increase after 2021; capacity tariffs as approved for 2020-2023
• Electricity distribution tariff growth as approved by the regulator until 2020-2022 and slightly below inflation following the end of regulatory period
• Cost inflation slightly below expected CPI
• Capex averaging KZT18 billion annually over 2020-2023, which is below management guidance
• Zero dividend payments in 2019 and at about KZT1 billion annually thereafter
• Fitch treats KUS's asset pledge under the loan agreement between YDD Corporation and DBK as a potential obligation of KUS and therefore includes it as off-balance sheet obligation for KZT24.1 billion for 2019-2023
• No repayment of loans of KZT53 billion and KZT3 billion by third parties is assumed

KEY RECOVERY RATING ASSUMPTIONS

• The recovery analysis assumes that KUS would be a going concern in bankruptcy and that the company would be reorganised rather than liquidated
• 10% administrative claim.

Going-Concern (GC) Approach
• The going-concern EBITDA estimate reflects Fitch's view of a sustainable, post-reorganisation EBITDA level upon which we base the valuation of the company
• The going-concern EBITDA is 15% below average 2019-2020 EBITDA, resulting in EBITDA of around KZT32 billion.
• An enterprise value multiple of 4.5x.

These assumptions result in a recovery rate for the senior unsecured debt at 'RR2'. However, this was capped at 'RR4'due to the application of a country cap for Kazakhstan. This is explained in our Country-Specific Treatment of Recovery Ratings Criteria dated 27 February 2019.

RATING SENSITIVITIES

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

• Improved credit metrics with FFO gross adjusted leverage persistently below 3x and FFO fixed charge cover above 4.5x
• 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

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

• Deterioration of corporate governance (eg a significant increase in loans and guarantees to companies outside the group, etc) leading to weaker-than-expected financial performance or aggressive M&A resulting in FFO gross adjusted leverage persistently higher than 4x and FFO fixed charge cover below 3.5x
• Worsening overall liquidity position

LIQUIDITY AND DEBT STRUCTURE

Liquidity Reliant on Cash Flow and Credit Lines: At end-3Q19 cash and cash equivalents of KZT5.9 billion, together with expected positive FCF one year ahead of KZT3.7 billion and available uncommitted credit lines with availability over one year of KZT2 billion are sufficient to cover short-term debt of KZT9.7 billion. Debt mostly comprised secured loans from local banks, which are raised at both holdco and opco level and bonds at KUS and MRENC level. The largest creditors are Sberbank (KZT69 billion), Development Bank of Kazakhstan (KZT13 billion) and EBRD (KZT11 billion). Around 5% of KUS's debt is US dollar-denominated and around 60% of debt is in roubles, with the remaining part in tenge.

Summary of Financial Adjustments

A lease capitalisation multiple of 6x was used as the company is based in Kazakhstan. KZT51 million at end-2018 was treated as restricted cash.
Loan of YDD was included in off balance sheet debt as KUS's assets are pledged against this loan.

ESG Considerations

Limited Liability Partnership Kazakhstan Utility Systems: 4.4; Group Structure: 4, Governance Structure: 4

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or to the way in which they are being managed by the entity.

KUS has an ESG Relevance Score of 4 for Governance Structure and 4 for Group Structure due to non-transparent ownership structure and sizeable related party and third party transactions with limited disclosure when economic benefit to KUS is uncertain.

For more information on our ESG Relevance Scores, visit www.fitchratings.com/esg.
Limited Liability Partnership Kazakhstan Utility Systems; Long Term Issuer Default Rating; Affirmed; B+; RO:Sta
Local Currency Long Term Issuer Default Rating; Affirmed; B+; RO:Sta
National Long Term Rating; Affirmed; BBB(kaz); RO:Sta
senior unsecured; Long Term Rating; Affirmed; B+
senior unsecured; National Long Term Rating; Affirmed; BBB(kaz)

For full details, see the official website of Fitch Ratings: https://www.fitchratings.com/site/pr/10114901

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