OREANDA-NEWS. Fitch Ratings has affirmed China-based ENN Energy Holdings Limited's (ENN) Long-Term Issuer Default Rating (IDR) and its senior unsecured rating at 'BBB'. The Outlook is Stable.

ENN's ratings are underpinned by favourable government policies towards the city-gas distribution sector in China, ENN's strong business profile and its strong credit metrics.

KEY RATING DRIVERS

Strong Operating and Financial Performance: ENN, together with other large city-gas operators in China, continued to expand their operational footprint and increase gas sales volumes and new connections in 2015, despite slower gas demand growth in China. ENN's revenue rose 10.2% to CNY32.1bn and EBITDA climbed 16.1% to CNY5.9bn in 2015. The company increased its number of city-gas projects to 152 at end-2015, from 142 a year earlier. Its residential connections rose 16% to 12.3 million and commercial and industrial (C&I) connections increased 19% to 56,858 during the year.

Slower, but Steady Demand Growth: Fitch expects ENN's gas sales to increase at a low double-digit percentage pace, which is slower than previous expectations, to reflect the slower energy consumption growth in China in the longer term. China's overall gas consumption growth has recovered so far in 2016, helped by the city-gate-level gas price cut in November 2015, which made gas more competitive against other fuel sources, such as coal and oil, whose prices have fallen.

China's gas consumption increased 10.6% in the first five months of 2016 compared with the same period last year and 5.7% in 2015. While this significant uptick in demand was supported by higher demand during the last winter, we believe China's overall gas demand will continue to increase at 6%-7% a year. Fitch expects ENN's gas volume growth to continue to be supported by the increased use of natural gas in China and relatively low natural gas penetration. Within ENN's regions of operation, natural gas penetration was at 51.8% at end-2015.

Gas Sales' Contribution Increasing: Fitch estimates that EBITDA from the sale and distribution of gas fuel and related products rose to about CNY3.4bn in 2015 from CNY3.1bn in 2014. Although the increased contribution of lower-margin recurring gas sales may have narrowed the overall profit margin of the company, the higher contribution to EBITDA from gas sales is positive because gas sales are more stable than gas connection fees. This is a trend we have observed across the leading operators as the industry matures.

Dollar Margin Maintained: ENN's dollar margin on the sale of gas, measured by EBITDA per cubic meter of gas (cbm), has remained broadly stable with city-gas operators able to pass through changes to city-gate level prices implemented by China's National Development and Reform Commission, albeit with a time lag. Fitch estimates the EBITDA dollar margin in 2015 was around CNY0.41 per cbm compared with CNY0.39 per cbm in 2014. Maintenance of the dollar margin is key to the financial profile of city gas operators, as this is an important indicator of a city-gas operator's ability to pass through fuel cost increases to its customers, especially as there is no clear regulation protecting city-gas operator's returns. There have been some isolated incidents of provincial-level intervention in city-gas prices, such as those announced by Zhejiang Province, in May. However, we do not expect such interventions to be a material risk for the sector. (see Fitch: Zhejiang Price Cap has Little Impact on City Gas Operators)

Improving Credit Metrics: ENN's credit metrics is strong for its 'BBB' ratings. Barring any material increase in investments or cash returns to shareholders in the medium term, Fitch expects ENN's funds flow from operations (FFO) to adjusted debt to be strong at below 3x (2015: 3.6x), FFO-adjusted net leverage at below 2x (2015: 2.0x), FFO fixed-charge coverage maintained at over 6x (2015: 6.3x), and free cash flows to remain neutral to positive.

Evolving Business Profile Constrains Ratings: ENN has invested in businesses outside of its core city-gas operations in China, including acquiring a 1.13% stake in Sinopec Marketing, buying 33 gas refuelling stations in North America and a recently announced move into electricity retailing to be an integrated energy supplier in China. In the short term, the agency does not expect ENN's new strategy to negatively impact its ratings, unless ENN aggressively increases its investment in such areas. At the same time, the uncertainties of such expansions and risks associated with these businesses will constrain any positive rating action on the company.

KEY ASSUMPTIONS

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

- Gas sales volume growth remains in the low double digits

- Turnover from connection fees remains stable

- Dollar margin remains stable, that is, increases or decreases from gas procurement costs are passed through to end-users

- Capex at above historical levels

- Neutral to positive free cash flow before acquisitions and non-city-gas capex

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to positive rating action include:

- Continued demonstration of the company's ability to pass through cost increases without materially affecting margins; and

- FFO-adjusted gross leverage lower than 3x and FFO fixed-charge coverage higher than 6x, on a sustained basis;

- Free cash flows after capex, acquisitions and dividends at least reaching broadly break-even on a sustained basis;

- The overall business risk profile not weakening due to investments outside of the city-gas distribution business, and greater clarity on the company's long-term business and financial strategy

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

- FFO-adjusted net leverage higher than 4x on a sustained basis; and

- FFO fixed-charge coverage lower than 4x on a sustained basis; or

- Expansion into non-city gas businesses that will materially weaken the company's business risk profile; or

- A material deterioration in the regulatory environment or worse-than-expected weakening of profitability of the city-gas distribution operations, which may arise from not being able to translate higher gas procurement costs into higher tariffs.