The FINANCIAL -- Fitch Ratings-London-16 February 2018: Fitch Ratings has affirmed Georgian Water and Power LLC's (GWP) Long-Term Foreign and Local-Currency Issuer Default Ratings (IDR) at 'BB-'. The Outlook is Stable.
The affirmation is supported by the company's natural monopoly position in Tbilisi's water supply and sanitation sector, solid profitability, the implementation of the new RAB-based regulatory tariff-setting mechanism along with increases in tariffs, good receivables collection rates so far, and low sector risk. These are offset by increased leverage resulting in reduced financial flexibility due to the company's accelerated capex and increase in dividend payments, increased exposure to foreign currency, heavily worn-out water infrastructure causing around 50% water losses, and a risk of related-party transactions, albeit on market terms.
KEY RATING DRIVERS
Increased Leverage: Fitch forecasts funds from operations (FFO) net-adjusted leverage (excluding connection fees) to increase to an average of 3x (2017-2020) from last year's forecast average of 1.3x (2016-2019), which is high compared to historical levels. This is mainly the result of the company's accelerated capex programme and new dividend policy. Fitch also forecasts FFO fixed charge coverage (excluding connection fees) to average about 3.9x over 2017-2020. The management has indicated that it is committed to keeping the net debt /EBITDA ratio below 3x in the short-term, and to fall below 2.5x by 2019.
Accelerated Capex, Increased Dividends: GWP is accelerating its capital investment programme and plans to complete it in three years versus the five previously anticipated. Drivers for this change are management's continued efforts to improve the water infrastructure assets and water losses performance, the new regulatory tariff methodology, which incentivises the company to invest more as it receives a higher return through the allowed cost of capital applied to its regulatory asset base (RAB), and the company's ability to access more attractive debt financing through international financial institutions.
Management has also revised the dividend policy in anticipation of the planned IPO in two to three years' time. Although management does not have a set dividend payout ratio, we expect it to remain relatively high at above 50% on average over 2017-2020 which limits GWP's financial flexibility.
"Slow Water Loss Reduction: Reduction in water losses continues to be one of the most significant drivers of EBITDA growth for the company in spite of the recent tariff increases. It has a multiplicative effect on earnings as it reduces water production costs and frees up electricity produced by GWP's hydro power plants for external sales. In 2016 the company reported water losses of about 49%, down from 51% a year before. We expect water losses to improve gradually, although at a slower pace than management.
New RAB-Based Regulation: We view the new regulatory framework as positive for the water supply and sanitation sector as it should ensure appropriate remuneration of the regulated asset base (RAB) and incentivise infrastructure investment and efficiencies. This was approved by the regulator in 2017. The regulatory framework is based on the (RAB) principle, which is a key component in determining capex, although it is based on assets' book values rather than replacement values. The first three-year regulatory period started in 2018. The weighted average cost of capital (WACC) was set at 15.99%," Fitch Ratings reported.
The new tariffs were implemented in January 2018 and reflect the capital investment plans submitted by GWP and approved by the regulator. Previously, GWP had not received any tariff increases since 2010. The new tariff methodology also provides a correction mechanism for expense. The regulator has also adopted new service commercial quality rules and a new normative losses methodology, which are aimed at improvements in the quality of services rendered by the utilities.
Change in Group Structure: In July 2017 BGEO Group PLC (expected to be delisted) announced a proposed demerger into two entities: a London-listed banking business comprising Bank of Georgia (BoG, BB-/Stable); and a London-listed investment business, Georgia Capital JSC (formerly known as JSC BGEO Investments). Georgia Capital JSC will remain a Georgia-focused investment platform targeting opportunistic investments. Georgia Capital JSC is expected to own 100% in Georgian Global Utilities Limited (GGU), which is in turn the parent of GWP.
The shareholder is looking to increase the value of GGU in the next two to three years and monetise it via an IPO.
"Related-Party Transactions: GWP is fully owned by GGU, which also owns Rustavi Water LLC, Mtskheta Water LLC, Gardabani Sewage Treatment Plant LLC and Saguramo Energy LLC. We assess GWP's and GGU's credit profiles similarly, as in 2017 GWP generated 97% of the group's EBITDA and held 100% of the group's debt.
However, we view as negative the new financing arrangements and increase in related-party transactions between GWP and other subsidiaries of GGU. In our view, the company is funding entities with weaker credit profiles. During 2017 GWP obtained debt financing from international financial institutions and on-lent around GEL35.5 million or 16.4% of the total debt raised to two of its sister companies which is in addition to the GEL12.5 million previously loaned to another sister company. We understand that these transactions are carried out on market terms.
Increased FX Exposure: GWP's exposure to foreign-exchange rate fluctuations increased during 2017 as foreign-currency denominated debt rose to around 50% of its total debt following the refinancing of its local-currency borrowings with more attractive debt financing from international financial institutions in foreign currencies (mainly euros). Although the company benefits from cheaper debt financing, we believe the significant exposure to FX fluctuations could lead to pressure on credit metrics in the event of marked adverse fluctuations in currency markets.
We believe the implementation of the FX hedging policy is challenging as the financial hedging products available in the local market are limited and expensive," Fitch Ratings said.
"GWP is a small water company in terms of its asset base and geographic diversity relative to the rated peer universe. It is also an outlier in terms of the asset quality as legacy underinvestment in Georgia's infrastructure has led to water losses of around 50%, which is extremely high compared to an average of 24% in Russia or 20% in the Czech Republic. The closest peer is Russia's private water and wastewater operator Ventrelt Holdings Limited (BB-/Stable) for which we expect average four-year forecast FFO connection fee-adjusted net leverage of 2.6x over 2017-2020 compared to 3.0x for GWP. We view Ventrelt's business profile as stronger than that of GWP due to the former's better asset quality and larger size, which is offset to some extent by the latter's asset ownership. As a result, GWP has stricter financial guidelines at the same rating level. The introduction of the RAB regulation in Georgia if successful should make it more comparable with the Russian regulation (although not based on RAB) in the water sector," Fitch Ratings reported.
Fitch's Key Assumptions Within Our Rating Case for the Issuer
- Georgian GDP growth of 4.3%-4.5% over 2017-2020
- Georgian CPI of 3%-6% over 2017-2020
- 5% average growth in the annual water consumption of commercial customers in 2017-2020
- Stable population in Tbilisi over the forecast period
- Water tariff increase in 2018 by 24% for metered and unmetered residential customers
- Zero water tariff increases for commercial customers
- Blended electricity price going up by 5% per annum on average in 2017-2020
- Water losses dropping from 49% in 2016 to below 45% in 2021
- Slow pace of further water metering roll-out
- Inflation driven cost increase
- Total capital expenditure of GEL261 million over 2017-2020, with most to be spent in 2017 (GEL98 million) and in 2018 (GEL74 million)
- Average weighted cost of debt at 7%
- Average dividends of around GEL22 per annum from 2017-2020
- Restricted cash of around GEL7 million from 2017-2020
Developments That May, Individually or Collectively, Lead to Positive Rating Action
Positive rating action is not anticipated in the near future. However, the developments that may lead to positive rating action include:
- a decrease in FFO net-adjusted leverage (excluding connection fees) below 2.0x on a sustained basis;
- a step improvement in asset quality and the share of network losses;
- track record of successful implementation of the RAB-based regulatory framework.
Developments That May, Individually or Collectively, Lead to Negative Rating Action
- A sustained increase in FFO net-adjusted leverage (excluding connection fees) above 3x
- A sustained reduction in profitability and cash flow generation through a failure to reduce water losses or deterioration in cash collection rates
- A material increase in the company's exposure to foreign-currency fluctuations
- A material increase in related-party transactions
Adequate Liquidity: At 31 December 2017, GWP had cash and cash equivalents of GEL37 million (excluding restricted cash of GEL7.6 million) and Fitch's projected negative free cash flow of GEL16 million in 2018. The company does not have any available committed credit facilities, and its liquidity profile is reliant on internal cash generation.
Currently, none of GWP's new debt (bond and loans) is secured on the shares of its parent GGU, unlike previously when most of GWP's debt was secured on the shares of its parent.
FULL LIST OF RATING ACTIONS
Georgian Water and Power LLC
- Long-Term Foreign-Currency Issuer Default Rating (IDR) affirmed at 'BB-'; Outlook Stable
- Long-Term Local-Currency Issuer Default Rating (IDR) affirmed at 'BB-': Outlook Stable;
- Foreign-currency senior unsecured rating affirmed at 'BB-';
- Local-currency senior unsecured rating affirmed at 'BB-'.