OREANDA-NEWS. June 09, 2015. Fitch Ratings has affirmed Slovakia-based eustream, a.s.'s Long term Issuer Default Rating (IDR) at 'A-' and SPP Infrastructure Financing B.V.'s (SPPIF) senior unsecured notes guaranteed by eustream at 'A-'. The Outlook on the IDR is Stable.

The affirmation reflects eustream's strong business profile as the national gas transmission system operator (TSO) and its long-term ship or pay transmission contracts. This is offset by increased debt, counterparty concentration with a high exposure to a major Russian shipper, and higher market risk exposure compared with many peers.

In Fitch's view, the recent debt increase has eliminated additional debt capacity for the rating, while the average quality of earnings has slightly weakened. However, we assume dividends will continue to be maximised subject to maintaining shareholder's agreement on eustream's maximum net debt to EBITDA of 2.5x, and so we expect credit metrics to remain adequate for the rating in the short to medium term.

In the long term, we consider that eustream's business risk may increase as short-term bookings increase in importance and the Russian shipper develops alternative routes. We may therefore tighten our leverage guidance for the rating and expect the company to also adjust its targeted leverage in accordance with evolving business risk. Failure to do so, or if debt increases further in the short to medium term would likely lead to a downgrade.

KEY RATING DRIVERS
SPP Group Restructuring
As a result of SPP's restructuring in 2014, eustream is directly fully owned by SPP Infrastructure, a.s. (SPPI). However, the ultimate ownership and control of eustream did not change. The ultimate shareholders are Energeticky a prumyslovy holding, a.s. (EPH) through Slovak Gas Holding B.V., with an indirect 49% and management control and the Slovak Republic (A+/Stable) through Slovensky plynarensky priemysel, a.s.'s (SPP) 51% but without management control.

SPP Infrastructure
We believe that the shareholder agreement in place for SPPI, which also defines its dividend policy and maximum leverage for SPPI and each of its subsidiaries, provides it with some ring-fence protection from its shareholders (SPP and EPH). This can be changed without the consent of the creditors of SPPI and its subsidiaries, but there is an emerging track record for the shareholders' agreement. As well as eustream, SPPI also owns SPP - distribucia, a.s. (A-/Stable) a gas distribution network owner and operator in Slovakia and other subsidiaries focused on gas storage.

Key Transit Route
eustream's business and financial profile is largely determined by its status as the national transmission system operator in Slovakia and the largest transit route for the major Russian shipper's gas supplies to Europe (around half of the total gas transporting capacity from Russia to western Europe, and around a quarter of Europe's total piped gas import capacity). Most of eustream's cash flows (55%-60%) are based on its long-term contracts with the major Russian shipper expiring in 2028 (for 50 billion cubic metres (bcm) annually or 63% of eustream's physical capacity in east-to-west direction) and several other long-term contracts with central and western European gas suppliers with an average remaining life of five years. In addition to a growing number of small and short-term contracts, eustream opened a new connection with Ukraine. Although the related entry capacities are booked on a short-term basis, 100% of the exit capacity is contracted until the end of 2016 and 80% of the exit capacity until the end of 2019.

Concentration of Contracts
Significant counterparty concentration is a key credit risk for eustream, although this is mitigated by the historical performance of the parties under the contracts, the generally long-term duration of contracts and the continued importance of the eustream route in reaching the shippers' ultimate customers and source of cash flows. The slightly increased counterparty diversity with the new connection to Ukraine is offset by the weak financial position of certain shippers (reflected in the agreed payment terms). We believe that while the average counterparty quality worsened only marginally as both western and Ukrainian shippers booked this capacity, the long-term viability of the flow may be affected by the macroeconomic weakness there.

Ship or Pay
The contractual provisions of all the legacy contracts are beneficial for eustream because they are 100% ship or pay, where the shipper pays full (annually escalated) capacity payments irrespective of the actual volumes shipped. These terms passed the test of unexpected flow disruption in January 2009 (when capacity payments continued in full despite the gas flow being halted for around two weeks). However, we believe that eustream would be vulnerable to a significantly prolonged halt of gas transit across Ukraine in an unlikely scenario of severe escalation of political and economic tension between Russia and Ukraine leading. All transmission tariffs are independently regulated (using the benchmarking principle) and applied uniformly to all new shippers.

Market Risk Exposure
Although the transit business is the dominant source of eustream's cash flows and its strong profitability, it also distinguishes it from domestically focused TSOs (such as National Grid Gas plc; A-/Stable or Enagas S.A.; A-/Stable) because it exposes eustream to market risks and greater stranded asset risk in the long term. This is also reflected in the lack of uplift for the senior unsecured notes over eustream's IDR typically applied for developed markets regulated network utilities.

Limited Volume Risk
eustream's short- to mid-term exposure to volume risk is limited due to its contractual (ship or pay) terms. However, within that a part of the compensation related to provision of gas in kind (largely to be used to fuel its compressor stations) exposes the company to a small degree of volume risk.

Contract Expiry Risk
There is a risk that some of the contracts expiring over the next five years will not be replaced and therefore the our forecast assumes only existing long-term contracts, which explains the expected funds from operations (FFO) reduction in 2017. We also only include a reduced part of the growing base of short-term contracts in our rating case, despite the expectation that the gas market liquidity will increase with added interconnectors (to Hungary in 2015 and possibly Poland in 2019) and the recently established reverse flow of gas (north to south) that allows gas from Nord Stream to reach the southern transit and supply routes. We expect that in the long term, business risk will increase as legacy contracts are increasingly replaced by short- and mid-term bookings (even if these may be more profitable).

Long-term Competition
eustream's core contract with the major Russian shipper was signed in 2008 when plans for the Gazprom-led Nord Stream (both phases representing around 68% of eustream's east-to-west capacity) were already advanced. The contract therefore reflects this competing transit route. Plans for other competing routes, such as Gazprom's South Stream have recently been cancelled, cementing the position of the existing routes. Gazprom is still looking for ways to cut its reliance on Ukraine's gas transit, which it plans to stop altogether in 2019, for example via additional Nord Steam capacity and a new Turkish stream. However, we think this is unlikely in this decade and even if successful eventually, it would not change the contractual position of eustream, although its long-term position would weaken and thus weigh on its business risk.

Limited Price Risk
eustream's exposure to gas price risk is small and stems from the sale of residual gas received in kind under its contracts. Nevertheless, we view this as a limiting factor compared with some TSOs. Fitch assumed a 20% gas price haircut for unhedged volumes compared with the company's assumptions (driven by forward prices and some near-term forward sales in place).

Cash Generative Business
eustream is strongly profitable (with forecast EBITDA margins of above 75%), cash-generative (cash conversion forecast close to 80%) and has limited capex needs (of around EUR30m annually or up to 10% of FFO). We forecast credit metrics with FFO net adjusted leverage between 2.5x and 3.0x during 2015-2018 and FFO fixed charge cover of above 7.5x (both assuming the total debt around EUR1.35bn) to remain adequate for the rating in the medium term.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for eustream include:
-Capital expenditure of EUR20m to EUR30m per year, in line with eustream's own expectations. These include existing projects and improvements but may be reviewed if new material projects are agreed.
-All profits paid as dividend to SPPI to the extent that the leverage ratio of either eustream or SPPI does not exceed 2.5x net debt/EBITDA as stipulated in the shareholders' agreement.
-Revenues based on 100% of eustream's booked capacity but we take a more conservative view on uncontracted bookings or any revenues related to gas-in-kind.

RATING SENSITIVITIES
Positive: Assuming the current debt level and business risk, positive rating action is unlikely. However, future developments that may, individually or collectively, lead to positive rating action include:
- Increased counterparty diversification and/or a stronger counterparty credit profile.
- FFO adjusted net leverage decreasing to below 1.5x on a sustained basis.

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- Significant weakening of the unconstrained credit profile of as well as an increase in exposure to eustream's key counterparty.
- Adverse change in eustream's contract portfolio.
- FFO adjusted net leverage increase to above 3.0x on a sustained basis. We expect to reduce this as short-term capacity bookings replace existing long-term contracts towards the end of this decade.

LIQUIDITY
Fitch's forecast metrics reflect the long-term fixed-rate notes of EUR1,250m, EIB loan of EUR75m, and RCF (EUR150m due 2019, currently undrawn) usage with repayment over the forecast period. The dividend policy is expected to remain aggressive with all excess cash flows to be distributed. However, despite dividend targets set in absolute (rather than profit-based) terms for the consolidated SPPI for 2014 to 2017, the current shareholders' agreement also stipulates maximum leverage (defined as net debt to EBITDA for SPPI and subsidiaries at 2.5x), which could limit dividends.

eustream plans to maintain a cash liquidity buffer of at least EUR30m, which is adequate considering its cash-generative nature, the RCF and the lack of short-term debt. Approximately 90% of revenues are euro-denominated (with the rest in US dollars), limiting eustream's exposure to FX risk.