OREANDA-NEWS. Fitch Ratings has affirmed Germany-based HSE Netz AG's Long-term Issuer Default Rating (IDR) at 'BBB-' with a Stable Outlook and its senior unsecured rating at 'BBB'.

The ratings reflect target leverage of around 5.5x on a funds from operations (FFO) adjusted net basis, the low business risk of the networks assets and the weak earnings of HSE Netz's parent group. The ratings also reflect the structural enhancement of the financing structure, including a debt service reserve account.

KEY RATING DRIVERS
Forecast Financials Improving
HSE Netz has progressed with implementing efficiency measures in order to follow the cost path embedded into the tariff settlement, indicating now incrementally higher earnings over the rating horizon. Fitch forecasts funds from operations (FFO) adjusted net leverage to increase to around 5.5x and FFO interest cover to reduce to around 2.8x in the medium term. These metrics are in line with Fitch's ratio guidelines for an upgrade of the Long-term IDR to 'BBB'.

Parent Company Constrains Rating
Fitch would like to have greater visibility around how the parent company and the wider group manage to enhance the earnings situation over the medium term and reduce group net debt. If implementation of the restructuring plan for the generation and retail businesses progresses according to plan, an upgrade of HSE Netz over the next one or two years is a real prospect.

Profit and Loss Transfer Agreement
Residual cash flow available for distribution as stipulated by the bond provisions is the limiting factor for dividends, not net income. This sufficiently ring-fences the operating company from the parent, HSE AG, which is in the process of reducing group net debt and improving earnings. Measures pursued include material cost savings, sizeable cuts to personnel costs have already been implemented, more focused sales efforts for electricity, gas, district heating and ancillary services, finalising existing renewables projects, some asset disposals and a sustainable dividend.

In 2013, HSE Netz entered into a profit and loss transfer agreement with its parent to optimise the group's tax position. At the same time, the agreement provides for a termination without notice in case the bond provisions were infringed. As a result, HSE Netz continues to be required to fund day-to-day operations of the regulated business, maintain debt service reserve of EUR16.5m and retain monthly instalments for the bond coupon, before being able to pay any dividends.

Slow Evolution of Regulatory Regime
Network regulation in Germany is following a similar path to the UK, but given the short history since introduction there remain many aspects where the regulator to date has not expressed a firm view and precedents have not been established. For the next price control, ratings may be more strongly driven by, among others, the regulatory benchmarking of operating and capital expenditure, and the treatment of its existing capital structure (we note that the coupon for HSE Netz's bond is 6.125%). For the 'BBB-' Long-term IDR Fitch does not expect any downside risk for the next regulatory period.

Group Re-organisation Neutral
Following a restructuring, HSE Netz is the asset owner, while e-netz Suedhessen GmbH & Co. KG (a sister company) is the asset operator and executes the capital expenditure programme. As long as e-netz Suedhessen does not divert any part of the regulated income stream to group companies other than HSE Netz, for example by means of dividends, intercompany loans or other, this arrangement should be neutral for HSE Netz's ratings.

RATING SENSITIVITIES
Negative: Future developments that could lead to negative rating action include:
- FFO adjusted net leverage increasing above 7x or FFO net interest cover falling below 2.25x.
- Changes to the regulatory framework that led to an increase in business risk.
- Difficulties meeting the efficiency targets embedded into price limits.

Positive: Future developments that could lead to positive rating action include:
- Improvement of the financial profile of HSE AG, the parent, and its wider group.
- A stronger business profile, with German network regulation developing over time, demonstrating that the Federal Network Agency pursues a reasonable approach founded on sound economic principles and evidence of how the regulator balances consumer and investor interests, there is scope for transparency and predictability to improve for Fitch to take a more favourable view on German regulation.
- FFO adjusted net leverage reducing below 6x on a sustained basis and FFO net interest cover comfortably above 2.5x may be positive for the rating.

LIQUIDITY AND DEBT STRUCTURE
Adequate Liquidity
HSE Netz does not have any committed, undrawn credit facilities. The company relies on prudent planning of monthly cash management as part of ordinary treasury activities for liquidity. As a fall-back, HSE maintains a debt service reserve of EUR16.5m (representing a minimum of three-month lease payments from Verteilnetzbetreiber Rhein-Main-Neckar GmbH & Co. KG) in accordance with the transaction documentation. Furthermore HSE Netz holds additional cash against contingent liabilities. Once those liabilities lapse, the excess cash will be repatriated to the parent company.