OREANDA-NEWS. Fitch Ratings has affirmed Umgeni Water's National Long-Term and senior unsecured ratings at 'AA+(zaf)'. The agency has also affirmed the National Short-Term rating at 'F1+(zaf)' for the South African state-owned bulk water utility. The Outlook on the Long-Term rating is Stable.

The ratings are notched down one notch from the sovereign's rating. They continue to reflect strong links between the company and the state, including the strategic importance of South Africa's water sector, and reflect a high level of implied support from the national government. Umgeni Water continues to maintain its strong regional position as the main bulk water distributor in the greater Durban region in the KwaZulu-Natal province.

Fitch views Umgeni Water's standalone profile as at the same level as the support-driven rating, underpinning the 'AA+(zaf)' rating. This is due to the cost-reflective tariffs and strong credit metrics we expect over the medium term, balanced by large capex plans (which are partly funded by the government), lack of independent regulator exposing the tariff determination to political risks and counterparty concentration.

KEY RATING DRIVERSjavascript:togglePRTab(6); confirmation();

Strong Shareholder Links

The strong links between fully state-owned Umgeni Water and the government are evidenced by Umgeni Water's status as a non-commercial entity, a zero dividend policy, non-payment of taxes, procurement of raw water from the Department of Water & Sanitation (DWS) and direct grants from the government to certain Umgeni Water infrastructure projects. Most customers are municipalities. Fitch assumes that further tangible support would be provided, if needed.

In addition, Umgeni Water's 12-member non-executive board of directors is appointed by the Minister of Water and Sanitation. The government's ownership of Umgeni Water is further entrenched through the approval of the company's capex programme and the setting of its borrowing limit.

No Breach of Borrowing Limit

We believe Umgeni Water has sufficient headroom remaining under borrowing limits set by the Ministry of Finance and we do not envisage a breach of it in the next three years. Borrowing limits approved by the ministry in August 2016 for core water infrastructure projects in financial year ending 30 June 2017 (FYE17), FYE18 and FYE19 are ZAR2,550m, ZAR2,450m and ZAR2,400m, respectively. Umgeni Water can increase this by ZAR300m per year with approval from the Treasury.

Volume Decline

Fitch expects bulk water volume to decline about 2% in FY16 and FY17 and EBITDA margins to decline to about 34% in FY16 from about 37% in FY15. Umgeni Water could receive a drought levy, which could limit the EBITDA decline. However, we have not included this in the rating case. The forecast revenue uplift of about 7% and 16% in FY16 and FY17 is mainly linked to the approved above inflation tariff increase of 7.8% in FY16 (9% in FY17) and increase in section 30 activities.

Possible Drought Levy

A drought levy is approved by the Minister of DWS in exceptional circumstances (for example when a drought is officially declared). Umgeni Water is in consultation with DWS, and could implement a drought levy to encourage curtailment of water use. The levy could assist the utility from cash-flow perspective to limit the impact from a reduction in bulk water volume sales.

Deferral of Uncommitted Capex

The government provides support via a subsidy due to the developmental nature of mainly rural projects. These project costs typically cannot be recovered through the existing tariff structure. Umgeni Water has some ability to defer parts of these investments as around 50% of capex is uncommitted should the grant funding be insufficient to support certain infrastructure projects.

Funding Needs Met

In the short to medium term, funding needs are satisfied through cash reserves and the monetisation of short-term investments. Umgeni Water also has access to bond issuance through an existing ZAR4bn domestic medium term note programme (with ZAR2.5bn available at September 2016). In FY16, the utility issued a bond for ZAR935m and we expect total debt for FYE16 and FYE17 to be about ZAR2bn.

Natural Monopoly Position

Umgeni Water's credit profile is supported by its regional monopoly position in the KwaZulu-Natal region. Local municipalities and local authorities make up almost 99% of Umgeni Water's sales, with its largest customer being eThekwini at around 75%. We view the counterparty concentration as a risk, but it is mitigated by the good payment track record and the fact that this provides insulation from some end-users with weaker payment ability.

Expansion of Service Area

Fitch believes the increase of service area for Umgeni Water will be over the next 18 to 36 months in a phased approach. DWS has initiated a process that will likely lead to the establishment of Umgeni Water as Regional Water Utility in Kwa-Zulu Natal. We believe the concept of 'implementing agent', whereby DWS channels infrastructure grants through Umgeni Water, will become increasingly prevalent. Umgeni Water controls the project but the funding for non-viable capex will made by the Municipality and/or DWS.

Fitch does not believe the South African government and Ministry of DWS will issue a directive to Umgeni Water to take on projects that are not financially viable. This is evidenced in the Water Services Act, No. 108 of 1997.

Healthy Liquidity

Liquidity is supported by a cash balance of ZAR1.6bn and committed facilities of ZAR70m as of 30 June 2015. There are no major debt maturities in the medium term. However, Fitch expects negative free cash flow due to capex, especially before including government grants. Furthermore, implementation of capex will largely be contingent on the company obtaining funding.

KEY ASSUMPTIONS

-No impact from the expansion of the Umgeni Water service area.

-The average approved Umgeni Water bulk water tariff increase for FY16 is 7.8%, and 9% in FY17.

-Volume decline of about 2% per year in FY16 and FY17 because of drought, with a recovery expected in 2018.

-We expect a decrease of over 1% in Umgeni Water's cost of raw water in FY16 due to lower water volumes.

-Energy costs increases of over 17% in FY16 and FY17 resulting from an average tariff increase of 12.7%, coupled with additional pumping due to drought.

-The double-digit revenue growth in FY17 is attributed to the increase in section 30 activities and tariff increase

RATING SENSITIVITIES

Future developments that could lead to positive rating action include:

- Strengthening of the standalone profile, particularly a significant improvement in negative free cash flow.

- Explicit government guarantee for Umgeni Water's debt.

Future developments that could lead to negative rating action include:

- Weakening linkages with the sovereign in conjunction with deterioration in FFO adjusted net leverage to over 2.0x and FFO interest cover to less than 4.0x on a sustained basis.

RATING SENSITIVITIES FOR THE SOUTH AFRICAN SOVEREIGN

The following risk factors, individually or collectively, could trigger negative rating action:

- A loosening of fiscal policy, such as upward revisions to expenditure ceilings, leading to a failure to stabilise the ratio of government debt/GDP; or an increase in contingent liabilities.

- Failure of GDP growth to recover sustainably, for example due to a lack of policy changes to improve the investment climate.

- Rising net external debt to levels that raise the potential for serious financing strains.

- Heightened political instability that adversely affects the economy or public finances.

The following risk factors, individually or collectively, could trigger positive rating action:

- A track record of improved growth performance, for example bolstered by the successful implementation of growth-enhancing structural reforms.

- A marked narrowing in the budget deficit and a reduction in the ratio of government debt/GDP.

- A narrowing in the current-account deficit and improvement in the country's net external debt/GDP ratio.