OREANDA-NEWS. Fitch Ratings has affirmed Comision Federal de Electricidad's (CFE) ratings as follows:

--Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'BBB+';

--Long-Term Local-Currency IDR at 'A-';

--USD3.7 billion senior unsecured notes at 'BBB+';

--MXN10.0 billion unsecured Certificados Bursatiles Issuances at 'A-';

--National Long-Term Rating at 'AAA(mex)';

--MXN87.8 billion unsecured Certificados Bursatiles at 'AAA(mex)';

--National Short-Term Rating at 'F1+(mex)';

--Short-term Certificados Bursatiles Program at 'F1+(mex)'.

The Rating Outlook is Stable.

KEY RATING DRIVERS

CFE's ratings incorporate the company's strong linkage with the Mexican government and the government's implicit support. CFE's Foreign - and Local-Currency IDRs are at the same level as Mexico's sovereign rating. The ratings also reflect CFE's position as the largest electric utility in Mexico and its monopoly on transmission and distribution activities, which makes it strategically important for the country. CFE's ratings also incorporate high debt levels, unfunded pension liabilities, negative free cash flow (FCF) during the cycle, and risk of political interference.

Strong Linkage with Government

The relationship between CFE and the government is strong and extends beyond its ownership. CFE is governed by a board of directors, which includes the ministers of energy, finance, economy, and environment and natural resources. The board also includes the undersecretary of the Secretaria de Energia (SENER), four independent members, and the minister of the national executive committee of the only union of electrical workers in Mexico. In addition, the government, through the Comision Reguladora de Energia (CRE), directly sets electricity tariffs to all electricity users, except for those high tension industrial users that decide to participate in the wholesale electricity market and establishes subsidies for specific customers. CFE's debt is booked as national debt despite not being explicitly guaranteed.

Largest Electricity Generator

CFE will remain Mexico's largest electricity generator in the country. At the end of March 2016, the company had a total installed capacity of 54,981 MW, of which 42,028 MW is directly generated by CFE and 12,953 MW by Independent Power Producers (IPPs). Overall, there are 188 centrals (159 CFE and 29 IPPs) and 613 generation units (532 CFE and 81 IPPs). CFE is 8.4 times(x) larger than the IPP with higher capacity. Approximately 80% of installed capacity of the IPPs is sold to CFE's through agreements that last 25 years and the rest, is sold to industrial users through private agreements. In Fitch's opinion, high investments requirements in this industry results in entry barriers and competing against CFE's infrastructure could be difficult.

Strategically Important for the Country

In Fitch's opinion, CFE's scale, its position as sole electricity marketer to unqualified users and its monopoly on transmission and distribution activities make the company strategically important for the country. Fitch views CFE transmission and distribution business, where it retains a monopoly position, to have lower business risk than the generation business. Qualified users will have access to the wholesale electricity market (WEM), starting with those who consume a minimum peak demand of 3 MWh in 2016, 2 MWh in 2017, and 1 MWh in 2018. New energy reform laws enable CFE to apply certain fees to those private investors (PI) who would participate in the WEM and will have to use CFE's transmission and distribution network. Also, energy reform enables the company to enter into agreements with PI to develop and finance the transmission and distribution infrastructures on its behalf.

Diversification of Operations

Service and customer diversification supports CFE credit profile by reducing concentration risks. Additionally to the sale of electricity, the energy reform allows CFE to sell natural gas to third parties and to generate income through the rent of its transmission and distribution network. Also, the company can market its products to both qualified and unqualified users, new private investors and third parties.

Energy Reform Opens Sector

The energy reform enables PIs participation and IPPs excess capacity to sell electricity, at spot prices or under negotiated contracts, to high tension industrial users. Large industrial users will be able to contract their demand directly with private generators at lower than current rates. Fitch believes CFE would be able to offer electricity at competitive rates through higher generation with natural gas. Thirteen pipelines are expected to start operation in the next three years, and CFE is expected to use them under 25-year agreements.

Fitch's estimate that the transportation, distribution and sale of natural gas could add income and reduce electricity generation cost to CFE. Also, in order to improve generation unit costs, CFE is transforming seven thermoelectric plants to combined cycle plants with the purpose of reducing the use of heavy fuel oil in the generation of electricity and increasing the use of natural gas. From 2013 - 2015, CFE reduced heavy fuel oil consumption by 38.8% and increased natural gas consumption in the generation of electricity. Electricity generation with the use of natural gas is about 3.6x per MWh cheaper than heavy fuel oil, which improves profitability.

Company's Profitability Affected

Subsidies for residential and agricultural customers, technical losses and exposure to exchange rate volatility affect CFE's profitability. Electrical losses have declined to approximately 12.8% in 2015 from 16.1% in 2010, underpinned by improvement in Mexico's metropolitan area, which used to be operated by Luz y Fuerza del Centro (LyFC). The company's strategy is to reach 10% of electricity losses in 2018. The Energy Reform allows CFE to establish partnerships in transmission and distribution activities to share costs, expenses, investments and to reduce the technical losses through the modernization of the distribution network giving flexibility in funding options for investments.

CFE is exposed to exchange rate volatility. Approximately, 43% of total costs and expenses are denominated in U. S. dollars and in practice 99% of its revenues are denominated in Mexican pesos. However, 70% of revenues have tariffs that are adjusted monthly for fuel prices, which some of them are linked to U. S. dollars. Considering currency swaps, approximately 48% of CFE's total debt is denominated in U. S. dollars. Assuming that 99% of revenues are denominated in Mexican pesos, Fitch estimates that a 10% devaluation of the Mexican peso increases 1.3x the company's leverage.

Risk of Political Interference

The electricity rate settlement by CRE exposes the company to regulatory risk and political interference. Subsidies to agricultural and residential sectors also expose CFE to unfavourable tariffs, which at times could be set below operating costs. However, for 2016 Mexico's Federal Expenditure Budget establishes a budget allocation of MXN30.0 billion to compensate CFE for the electricity tariffs subsidy. This amount represents approximately 50% of 2015 subsidies.

Fitch believes preferential tariffs for agricultural and residential customers will continue due to their social component and the political cost of eliminating them. The government often sets electricity rates at levels below CFE's operating costs to maintain the affordability of electricity for different residential and agricultural customers, which represented approximately 24% of the company's revenues for the latest-12-months (LTM) ending March 31, 2016.

Improvement in Unfunded Pension Liabilities

Recent negotiations with the union should reduce by 50% the unfunded pension liability which as of March 31, 2016, amounted to MXN634.9 billion. Approximately half of the 93,000 CFE's employees are in a defined contribution pension plan, which the company adopted in 2008. In May 19, 2016, the company reviewed the workers contracts conditions with its labor union, where CFE achieved a pension liability reduction of approximately MXN160 billion pesos. According to the Energy Reform, the Secretaria de Haciendo y Credito Publico (SHCP) should provide to CFE an equal amount, resulting in a MXN320 billion reduction to the unfunded pension liability.

Stand-Alone Credit Quality

CFE's stand-alone credit quality is commensurate with a 'BB-' Long-Term Rating if the company was not owned by the Mexican government and if it did not receive financial support from the sovereign. This stand-alone view incorporates the actual regulation from the energy reform and the continuing establishment of subsidies to agricultural and residential sectors due to their social component and the political cost of eliminating them. Fitch believes CFE's exposure to subsidies for agricultural and residential customers will continue due to their social component and the political cost of eliminating them. The stand-alone credit quality is limited by CFE's high leverage, limited free cash flow generation and the unfunded pension liability.

KEY ASSUMPTIONS

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

--Revenue growth of around 1.0% - 1.5% from 2016 onward;

--EBITDA margin around 27.7%, adding the estimated actuarial cost of labor obligations into EBITDA;

--Capex at around MXN45,000 million per year;

--Cash balance at around MXN35,000 million;

--Capex funded with CFO and debt;

--Debt-to-EBITDA levels around 4.6x.

RATING SENSITIVITIES

Absent an improved operating and financial profile, an upgrade of CFE's ratings could result from an upgrade of the sovereign or increased financial support from the government. Negative rating actions could be triggered by a downgrade of the sovereign's rating, the perception of a lower degree of linkage between CFE and the sovereign as a result of the energy reform in conjunction with a weak operating and financial profile.

LIQUIDITY AND DEBT STRUCTURE

High Leverage with Manageable Debt-Maturity Profile

As of March 31, 2016, total on-balance-sheet debt was MXN415.6 billion and its leverage level was 5.7x compared to 4.9x, 3.6x, and 4.6x in 2015, 2014 and 2013, respectively (adding back the estimated actuarial cost of labor obligations into EBITDA). The leverage increase is a combination of higher debt and lower EBITDA generation. CFE's debt maturity profile is manageable, with MXN67.5 billion maturing in the short-term, compared to MXN50.0 billion in cash and MXN13.3 as positive FCF. Free Cash Flow has been negative, on average, during the last five years, mainly due to high capital expenditures. Fitch estimates over the next 4 years, CFE leverage will be around 4.7x and will generate neutral to negative FCF as a result of lower electricity generation cost and stable debt levels.