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Fitch Affirms Kazakhstan Utility Systems at 'B+'; Outlook Stable

Fitch Ratings - Moscow - 04 Mar 2021: 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 provided below.

The rating continues to be constrained by weak corporate governance, as reflected in credit-negative transactions with related and third parties, still limited scale of operations and an evolving regulatory framework.

Positively, it reflects our expectation that KUS gradually reduce its funds from operations (FFO) gross leverage to 3.4x on average over 2021-2024 from about 4x at end-2020. This will be driven by tariff increases approved from July 2020 for generation and from 2021 for the majority of distribution companies. It also reflects KUS's vertical integration and manageable FX exposure.

Key Rating Drivers
Long-Term Generation Tariffs: Electricity generation tariffs are approved for 2020-2025. From July 2020 electricity generation tariffs were approved for 18% and 20% increase for KUS generation companies, Karaganda Energotsentr and Ust-Kamenogorskaya TPP, respectively, and to remain flat thereafter until 2025 with possible revisions. KUS, however, expects the regulator to approve tariff increases from April 2021. We expect tariffs to grow at slightly below inflation in 2021-2024, which is below management expectations. Long-term tariffs add visibility to the company's cash flows but flat tariffs from 2021 will weigh on the credit profile.

Long-term Distribution Tariffs: Electricity distribution tariffs for KUS's MRENC and Karaganda Zharyk (KZh) are approved for 2021-2025. MRENC's distribution tariffs were approved at a 25% increase for legal entities (90% of electricity distribution volumes) in 2021 and at about 1.5% on average over 2022-2025. For households and utilities companies tariff increases were approved at 0%-5% annually over 2021-2025. KZh electricity distribution tariffs were approved at around 7% annually on average in 2021-2025. The approval of long-term tariffs provides greater visibility to cash flows and favourable tariffs are supportive of KUS's credit metrics.

Some Deleveraging Expected: We expect KUS's FFO gross leverage to have remained high at end-2020, but then to gradually deleverage towards 3.4x on average in 2021-2024 on approved tariff increases. We continue to include YDD Corporation's debt of KZT24 billion in KUS's credit metrics calculations, as it is secured by KUS's assets. We continue to treat it as off-balance sheet debt over our forecast period of 2020-2024. We also include financial interest-free aid received from related companies of about KZT6 billion as debt.
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 in the last couple of years and their economic benefit to KUS is uncertain. As a result, KUS has an ESG Relevance Score of '4' for Governance Structure and '4' for Group Structure.

Third-Party Loans: In 2018 KUS had on lent proceeds from a loan obtained from Sberbank of RUB9.6 billion (KZT54 billion at end-2020 exchange rate) to a third party, Ushkuyu, a Kazakhstan-based oil company, with a further KZT500 million provided in 2019. Following the refinancing of this loan KUS disbursed another RUB1.3 billion (KZT7 billion at end-2020 exchange rate). KUS had also provided two loans, of KZT3 billion and USD5.1 million, to two third parties and extended their maturities to 2021 and 2022, from the initial 2018. It provided financial aid to third parties of KZT121 million at end-2019. These transactions increase leverage.

Off-Balance Sheet Debt: Certain KUS assets are also pledged under a KZT24.1 billion loan agreement between YDD Corporation and Development Bank of Kazakhstan JSC (BBB-/Stable). KUS now expects the pledge of its assets for YDD Corporation's debt to be released in June 2021, versus June 2020 initially. However, the pledge release is not reflected in our rating case and we maintain the off-balance sheet adjustment (increasing leverage) for the entire rating horizon until 2024.

Neutral Free Cash Flows Expected: We forecast KUS to generate healthy cash flow from operations averaging around KZT27 billion annually over 2021-2024. But free cash flow (FCF) is likely to be neutral or slightly positive over the same period on the back of Fitch-expected capex on average of KZT25 billion annually and Fitch-expected dividends outflow of about KZT1 billion. The favourable tariff increases would support gradual deleveraging.

Vertical Integration; Small Scale: KUS's business profile benefits from vertical integration and a 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 such as JSC Samruk-Energy and Kazakhstan Electricity Grid Operating Company (KEGOC).

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 larger scale of operations and a wider geographical presence within Kazakhstan. KUS has weaker corporate governance than 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's under our Government-Related Entities (GRE) Criteria. KEGOC is rated one notch below the sovereign's under the GRE Criteria.
The broader peer group includes DTEK Energy (RD), a coal-fired generator in Ukraine, which, like Kazakhstan, is in the process of reforming and liberalising its power market. Compared with DTEK, KUS benefits from vertical integration, but has lower market share and smaller 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
    • GDP growth of 3.8%-4.1% and CPI of 6%-7.5% annually in 2021-2024
    • Electricity generation and distribution volumes to grow at low single-digit percentages in 2021-2024; flat heat volumes over the same period
    • Electricity generation tariffs to increase 18%-20% from July 2020 as approved, with subsequent below- inflation increases in 2021-2024; capacity tariffs as approved for 2020-2024
    • Electricity distribution tariff growth at around inflation rate as approved by the regulator until 2025
    • Cost inflation slightly below expected CPI until 2024
    • Capex averaging KZT25 billion annually over 2021-2024, which is close to management guidance
    • Zero dividend payments in 2020 and at about KZT1 billion annually in 2021-2024
    • Fitch treats KUS's asset pledge under the loan agreement between YDD Corporation and Development Bank of Kazakhstan as a potential obligation of KUS and therefore includes it as off- balance sheet obligation for KZT24.1 billion for 2020-2024
    • No repayment of loans by third parties

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.
    • The going-concern EBITDA estimate of KZT32 billion reflects Fitch's view of a sustainable, post- reorganisation EBITDA level upon which we base the valuation of the company
    • An enterprise value multiple of 4.5x.
    • The resulting recovery rate for the senior unsecured debt is capped at 'RR4'/50% due to the
application of a country cap for Kazakhstan. This is explained in our Country-Specific Treatment of Recovery Ratings Criteria.

RATING SENSITIVITIES
Developments That May, Individually or Collectively, Lead to Positive Rating Action/Upgrade
    • Increased transparency of the ownership structure and generally stronger corporate governance with significantly reduced related-party transactions
    • Improved credit metrics with FFO gross leverage persistently below 3x and FFO interest coverage 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 business scale

Developments That May, Individually or Collectively, Lead to Negative Rating Action/Downgrade
    • Deterioration of corporate governance (eg a significant increase in loans and guarantees to companies outside the company, etc) leading to weaker-than-expected financial performance or aggressive M&A resulting in FFO gross leverage persistently higher than 4x and FFO interest coverage below 3.5x
    • Worsening overall liquidity position

Best/Worst Case Rating Scenario
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure
Tight Liquidity: At end-3Q20 cash and cash equivalents of KZT5.6 billion and available uncommitted credit lines with availability period over one year of KZT5 billion were sufficient to cover short-term debt of KZT8.9 billion. We expect close to neutral FCF in 2021. We expect KZT6.9 billion at end-9M20 of financial aid from related parties to be extended or refinanced on an annual basis.
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 (KZT65 billion), EBRD (KZT12 billion) and Development Bank of Kazakhstan (KZT8 billion). Around 6% of KUS's debt is denominated in US dollars and around 60% of debt in Russian roubles, with the remainder in tenge.

Summary of Financial Adjustments
Loan of YDD Corporation included in off balance-sheet debt as KUS's assets are pledged against this loan.
Interest-free short-term loan from related parties for working-capital needs reclassified to debt from other accounts payable.
Cash with restricted use reclassified to restricted cash from other current assets.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG Considerations
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. These factors have a negative impact on the credit profile and are relevant to the rating, in conjunction with other rating factors.
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 the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

For full details, see the official website of Fitch Ratings: https://www.fitchratings.com/research/corporate-finance/fitch-affirms-kazakhstan-utility-systems-at-b-outlook-stable-04-03-2021

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