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

Fitch Ratings - Moscow - 29 October 2018: Fitch Ratings has affirmed Kazakhstan-based utility Limited Liability Partnership Kazakhstan Utility Systems' (KUS) Long-Term Foreign Currency Issuer Default Rating (IDR) at 'BB-' with a Stable Outlook.

The affirmation reflects Fitch's expectations that the company's funds from operations (FFO) adjusted gross leverage will average 2.8x over 2018-2021, which despite deterioration, is within our negative leverage guideline of 3x, but with limited headroom. The forecast credit metrics deterioration is primarily driven by related party transactions. The rating is constrained by weakening corporate governance, reflected in credit-negative transactions with third parties, still limited scale of operations and an evolving regulatory framework. The rating is supported by the company's vertical integration, the introduction of a capacity market from 2019 and negligible FX exposure.

KEY RATING DRIVERS

Weak Corporate Governance: In Fitch's view, KUS has weaker corporate governance than other Kazakh corporations rated by Fitch in the 'BB' category, mostly due to sizeable third party transactions with limited disclosure and a non-transparent ownership structure. KUS has been historically involved in related party transactions, but their size has materially increased and materialisation of their economic benefit to KUS is uncertain.

In May 2018 KUS took a KZT51 billion loan from Sberbank of Russia (BBB-/Positive) on its balance sheet and on-lent the proceeds to Ansagan Petroleum, a Kazakhstan-based oil company related to KUS's ultimate owner Dinmukhamet Idrissov, for refinancing of Ansagan's existing loan. In 1H18 KUS provided a KZT3 billion interest-free loan to a third party, which KUS expects to be paid back by end-2018, and also lent USD5.1 million to a related party Dragon Fortune PTE Ltd at 2% interest, which the company expects to be repaid in December 2018. In 2016 KUS provided KZT7.5 billion to Mr. Idrissov and his private equity fund, Ordabasy Group, which were mostly repaid in 2017. 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 plans to use the loan proceeds for the construction of a new ferrosilicium plant.

Increased Leverage: We forecast KUS's FFO adjusted gross leverage to increase to about 2.8x on average over 2018-2021, from an average of 1.7x over 2014-2017, approaching Fitch's negative leverage guideline of 3x. This is driven by the provision of the loan to Ansagan Petroleum (KZT51 billion), which we do not expect to be repaid due to the financial weakness of the counterparty. We also treated the pledge of some of KUS's assets under YDD Corporation's loan as a potential obligation of KUS (KZT24.1 billion) included as off-balance sheet debt for credit metrics calculation. This may result in limited rating headroom in 2018-2020.

We expect the company to continue generating healthy FFO of about KZT30 billion on average over 2018-2021 and free cash flow (FCF) to remain positive over the same period, despite our assumption of KZT3 billion-KZT5 billion of annual dividend outflow.

M&A Drives Scale Expansion: In 2017 KUS increased its stake in Mangistau Electricity Distribution Company (MENDC, BB-/Stable) to 52.6% from 6.5% and acquired 100% of LLP Ust-Kamenogorskaya CHP (U-K CHP) and Sogrinskaya CHP, before selling the latter in early 2018. This increased electric- and heat-installed capacity and electricity production and distribution by around 50% and heat production by an approximate 80%. We estimate KUS's market share to increase to about 6% from slightly below 5% as a result. We positively view the business scale expansion as we expect it to increase EBITDA by about a third and wider geographic coverage in Kazakhstan.

Capacity Market Introduction: From 2019 the electricity market will be split into electricity and capacity sub-markets, which will remain fully regulated. This will result in the transition from the current single electricity tariff to a double-rate tariff that will include electricity and capacity components. A maximum electricity tariff cap will be approved for each group of generators determined by the regulator for a seven-year period, with possible revisions, and will cover maximum 2018 electricity production costs within the generators group and allow a fixed margin of around 12%. Maximum capacity payment cap will be set for seven years at KZT700,000/MW/month with possible higher caps for certain power units. We believe the capacity market will mostly focus on the modernisation of existing capacity instead of new construction. We believe the new electricity market model would improve generators' earnings predictability.

Vertical Integration; Small Scale: KUS's business profile benefits from the company's strong position in electricity generation, distribution and supply in highly populated central Kazakhstan (Karaganda Region), south and eastern region, 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. However, its business profile is constrained by KUS's small scale of operations relative to rated Kazakh peers like JSC Samruk-Energy (BB/Stable) and Kazakhstan Electricity Grid Operating Company (KEGOC) (BBB-/Stable), but is comparable to Joint Stock Company Central-Asian Electric-Power Corporation (CAEPCo, B+/Stable) and Ekibastuz GRES-1 LLP (BB/Stable).

Long-Term Tariffs in Distribution: KUS's distribution tariffs are approved until 2020-2022. Electricity distribution tariffs are flat for 2016-2020 in Karaganda region and are approved to increase at 3% annually (which is below inflation) in South-Kazakhstan region in 2018-2022. Long-term tariffs add visibility to the company's cash flows, but below-inflation tariff growth is a drag on the company's credit profile.

DERIVATION SUMMARY

KUS's closest peers are Kazakhstan-based regional companies Ekibastuz GRES-1 (BB/Stable) and CAEPCo (B+/Stable). KUS, CAEPCo and GRES-1 have similar business profiles in terms of scale of operations, and their EBITDA is dominated by electricity generation. However, KUS has weaker corporate governance. KUS's financial profile is similar to that of GRES-1, but slightly stronger than CAEPCo's due to higher margins and lower leverage. A small share of KUS's debt (3%) includes FX exposure, which places the company favourably against Kazakhstan peers like CAEPCo and KEGOC (BBB-/Stable), which have around 45% of their debt in foreign currencies. KUS, CAEPCo and GRES-1 are rated on a standalone basis.

KEY ASSUMPTIONS

Fitch's Key Assumptions within our Rating Case for the Issuer

  • Domestic GDP growth of 3.1%-3.8% and inflation of 6%-6.6% in 2018-2021
  • Slight decline in electricity and heat generation volumes in 2018 following the sale of Sogrinskaya CHP. Electricity generation volume to grow slightly below GDP's and flat heat volumes thereafter
  • Electricity distribution volumes to increase by about halfin 2018 following consolidation of MEDNC and slightly below GDP growth thereafter
  • Electricity generation tariffs to decline in 2019, with gradual below-inflation increase threreafter with simultaneous introduction of capacity sales from 2019
  • 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 KZT22 billion annually over 2018-2021
  • Dividend payments of about KZT3 billion-KZT5 billion annually in 2018-2021
  • Fitch treats KUS's asset pledge on the loan agreement between YDD Corporation and DBK as a potential obligation of KUS and therefore includes it as off-balance sheet obligation to an amount of KZT13.2 billion in 2018 and KZT24.1 billion thereafter
  • No repayment of loans of KZT51 billion and KZT3 billion by third parties is assumed

RATING SENSITIVITIES

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

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

  • Deterioration of corporate governance (eg 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 3x (2017: 1.7x) and FFO fixed charge cover below 4.5x (2017: 6.5x)
  • Worsening overall liquidity position
  • The senior unsecured rating may be downgraded if the ratio of prior ranking debt/EBITDA is above 2x-2.5x on a sustained basis

LIQUIDITY AND DEBT STRUCTURE

Manageable Liquidity: Fitch views KUS's liquidity as manageable as cash and cash equivalents of KZT8.7 billion at end-1H18 and credit lines totalling around KZT14 billion (including KZT6.3 billion committed) from EBRD and Sberbank are sufficient to cover short-term debt of KZT13.5 billion. Debt mostly comprised secured loans from local banks, which are raised at both holdco and opco level and bonds at KUS and MEDNC level. The largest creditors are Sberbank (KZT69.2 billion), DBK (KZT16.4 billion) and EBRD (KZT8 billion). All bank loans have fixed interest rates. Ninety-seven percent of KUS's debt (except one MEDNC bond of KZT3.2 billion, which is linked to the KZT/USD exchange rate) is denominated in tenge and Russian rouble.

Senior Unsecured Aligned with IDR: KUS's KZT12.3 billion local currency bond programme and the notes issued under this programme are rated 'BB-', in line with the group's Long-Term Local Currency IDR. The bonds will benefit from sureties totalling KZT12.3 billion provided on a several basis by Karaganda Zharyk LLP, Ontustik Zharyk Transit LLP, Energopotok LLP, Karagandy Zhylu Sbyt LLP and Raschetniy Servisniy Centr LLP, all wholly-owned subsidiaries of the group. The combined EBITDA of subsidiaries providing sureties for the bonds comprised 48% of the group's 2017 EBITDA.

We also continue to align the senior unsecured rating with the IDR as the level of prior-ranking debt relative to EBITDA is within Fitch's threshold of 2.0x-2.5x and we view the expected increase in the ratio to 2.4x in 2018 as temporary. We would consider decoupling the senior unsecured rating if the amount of prior-ranking debt-to-EBITDA remains above 2x-2.5x on a sustained basis, which would indicate structural subordination of the unsecured debt.

SUMMARY OF FINANCIAL STATEMENT ADJUSTMENTS

Cash: KZT51 million was treated as restricted cash. Operating lease: a multiple of 6x was used as the company is based on Kazakhstan

For full details, see the official website of Fitch Ratings: https://www.fitchratings.com/site/pr/10049944

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