OREANDA-NEWS. Fitch Ratings has affirmed Czech Republic-based CEZ a. s.'s Long-Term Issuer Default Rating (IDR) at 'A-', with Stable Outlook, and Short-Term IDR at 'F2'. Fitch has also affirmed CEZ's foreign currency senior unsecured rating at 'A-'.

The affirmation reflects the profitable generation fleet of CEZ even in a distressed power price environment and its strong position in Central Europe. According to our projections, the company's substantial investment programme, combined with a generous dividend policy and a challenging operating environment, will increase CEZ's funds from operations (FFO) adjusted net leverage close to 3x in 2018-2019, leaving little headroom under the current ratings.

KEY RATING DRIVERS

Leverage Mitigates Weaker Business Profile

Financial leverage is low compared with CEZ's western European peers. However, the company has also a higher exposure to the more volatile conventional power generation business (45% of 2015 EBITDA) compared with its European peers. This business is under cash flow pressure from low wholesale electricity prices, declining margins and a rising share of renewables, which are supported by subsidies.

At the same time, the company has a fairly low share of more predictable, regulated income from distribution (31% of EBITDA in 2015) and quasi-regulated income from renewables compared with many of its European peers.

Investment Drives Strategy

CEZ's strategy focuses on three pillars: 1) excellence in conventional generation operation; 2) delivering a wide range of products; and 3) a strong position in Central Europe. CEZ has a capex plan of CZK165bn for 2016-2020, with an annual spending of around CZK30bn-CZK35bn. Investments in new energy projects may add another CZK50bn-CZK60bn to the existing business plan but should lead to a CZK6bn EBITDA increase by 2020.

Projected Leverage Increase

CEZ's leverage policy has been relaxed to a targeted net financial debt ratio of 2.5x-3.0x EBITDA, from a maximum 2.3x, to accommodate abovementioned potential additional investments in new energy projects. This ratio range translates into FFO adjusted net leverage of about 2.7x-3.2x.

Our forecasts are based on the company's CZK165bn capex plan but they do not include any additional investments or acquisitions as CEZ has flexibility on such investments. CEZ has some capex flexibility given that some projects may be delayed or cancelled, including for instance, its wind farm projects in Poland following the recent introduction of additional legal and technical requirements to construct and operate wind farms in the country. These requirements are likely to substantially limit the number of new wind farms in Poland.

We will review our ratings should projected FFO adjusted net leverage be consistently above our negative guidelines of 3.0x, for instance due to the full implementation of CZK50bn-CZK60bn of additional investments or acquisitions for 2016-2020.

Dominant Position in the Czech Market

CEZ produces about two thirds of total electricity generated in the Czech Republic, it owns and operates five out of eight power distribution networks in the country, it supplies a third of the country's power and produces about 22mt if lignite per year. We view CEZ's strong, vertically integrated operations in the Czech Republic as positive for the ratings. The fully liberalised Czech power market has transparent regulations and is less exposed to unfavourable energy policy shifts.

Profitable Generation

A good mixture of low-cost generation assets, mostly lignite and nuclear, allow CEZ to be profitable even under unfavourable market conditions. Nuclear clean spreads (after fuel and storage costs) for 2016 are EUR18/MWh, while lignite spreads (post cash costs for own mining) are EUR12/MWh, assuming power prices at EUR25/MWh. Upgrade projects at Prunerov and Ledvice lignite plants will increase efficiency to 39% and 42.5% contributing to lower costs of production.

Short-Term Hedges

CEZ's hedges are shorter-term than most peers, with 85% hedged for 2016 at end-April (assuming 55-57TWh total production) at EUR35/MWh and only 72% hedged for 2017 at EUR31/MWh and 41% for 2018 at EUR30.5/MWh. While this offers less protection in a declining power price environment it may offer some short-term upside should power prices recover, following a recovery in commodity prices, for example. Coal prices have currently recovered to about USD60/t from low levels of below USD40/t at the beginning of the year.

Rated on Standalone Basis

CEZ is 69.8%-owned by the Czech state (A+/Stable), but Fitch rates it on a standalone basis with no consideration for potential state support. This is because the company operates on a wholly commercial basis and we assess legal, operational and strategic links with the state as moderate in line with our Parent and Subsidiary Linkage criteria.

No Uplift from Regulated Earnings

In 2015 distribution contributed CZK20bn (31%) to the company's total EBITDA. The majority of networks are in the Czech Republic with a small percentage of assets in Romania and some in Bulgaria. Returns are 7.95% (nominal) in the Czech Republic, 7.7% (real) in Romania and 7.04% (nominal) in Bulgaria. Fitch views regulated earnings as stronger than earnings from other activities; however, given that CEZ's share of regulated and quasi-regulated activities is less than half of total EBITDA we do not consider any additional uplift for the senior unsecured rating.

Generous Dividend Policy

CEZ's dividend policy aims for a payout ratio of 60%-80% and in recent years the payout was closer to the upper end of the range (at 73% in 2014 and 77% in 2015). We assume dividend payments will continue to be maximised but CEZ has some flexibility over its dividend payments, especially if new projects are identified.

KEY ASSUMPTIONS

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

-Dividend payments at the upper end of the company's guidance (payout ratio close to 80%)

-Capex for 2016-2019 in line with the company's public guidance, but not including additional new energy projects

-No large debt-funded acquisitions

-Achieved power prices in line with market prices, taking into account CEZ's existing hedges

RATING SENSITIVITIES

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

- Stronger business risk profile, for instance, due to markedly increased share or regulated and quasi-regulated businesses in EBITDA

- Projected FFO adjusted net leverage below 2x on a sustained basis, supported by management's more conservative leverage target

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

- FFO adjusted net leverage above 3x, FFO fixed charge cover below 5x, both on a sustained basis

- Unfavourable regulatory changes or substantially increased sector risk in CEZ's main markets

- Substantially less predictable cash flows due to large acquisitions in higher-risk countries

- Substantial capex in new nuclear power plants in the environment of low electricity and CO2 prices if it is not mitigated by a cash flow support mechanism, for instance, contracts for price difference, or state guarantees for funding.

LIQUIDITY

CEZ's liquidity was sufficient at 31 March 2016. At this date, debt maturing in the next 12 months of CZK13.1bn was covered by CZK31.9bn of cash and cash equivalents and additionally more than CZK10bn of financial assets, which Fitch views as highly liquid, and unused committed medium-term lines of CZK28.6bn. We expect CEZ to report negative free cash flow of about CZK5bn in 2016. At end-December 2015 the outstanding amount of long-term loans and bonds was CZK157.3bn, of which CZK28.2bn matures in 2016-2017, including a convertible bond of EUR470.2m (CZK12.4bn) maturing in 2017.