OREANDA-NEWS. Fitch Ratings has revised Kazakhstan-based Joint Stock Company Central-Asian Electric-Power Corporation's (CAEPCo) Outlook to Negative from Stable and affirmed its Long-term foreign currency Issuer Default Rating (IDR) at 'BB-'. A full list of ratings actions is available at the end of this commentary.

The Negative Outlook reflects expected deterioration of the company's credit metrics over 2015-2018 as a result of Kazakh tenge devaluation by more than 30% in the past three days. CAEPCO is subject to foreign currency fluctuation risks, with 45% of its debt at 20 August 2015 denominated in US dollar versus all revenue generated in local currency. This may result in a breach of Fitch's negative rating guidelines of funds from operations (FFO) adjusted gross leverage of 3.0x and FFO interest coverage of 4.5x over 2015-2018. As at 20 August 2015, the company's liquidity is satisfactory assuming uninterrupted access to cash deposits mostly held at local banks and to external funding for expected negative free cash flow in 2015-2016.

The 'BB-' rating reflects CAEPCo's vertical integration and a stable regional market position (despite overall small size) with access to cheap regulated coal supplies. The rating also takes into account a currently relatively benign regulatory regime, although there is uncertainty regarding the regulatory regime post-2015. CAEPCo's ageing assets are in need of significant renewal and Fitch expects the company's planned investment programme to result in negative free cash flow (FCF) in 2015-2016.

KEY RATING DRIVERS

Tenge Devaluation Increases Leverage
The recent Kazakhstan tenge devaluation has weakened CAEPCo's credit profile due to a currency mismatch between the company's debt and revenues and the absence of hedging to reduce foreign exchange risk exposure. At 20 August 2015, 45% of the company's outstanding debt was denominated in US dollar, versus all local currency-denominated revenue.

We expect the devaluation to increase CAEPCo's gross leverage to above 3x over 2015-2017 and reduce interest coverage to below 4.5x over the next four years, other things being equal. This may result in a breach of Fitch's negative rating guidelines in 2015-2018. However, Fitch notes that CAEPCo has some flexibility in dividend payments as well as in capex, as committed capex for 2015 amounts to 62% of total forecast capex.

While the company does not have any hedging policy in place, it maintains a portion of cash in US dollars. At 20 August 2015, CAEPCo had KZT690m (out of KZT3.8bn) of cash and KZT4.3bn (of KZT14.3bn) of deposits with maturity over three months in US dollars. CAEPCO is also exposed to interest rate risk since about half of its outstanding loans are drawn under floating interest rates.

Generation Dominates despite Integration
CAEPCo is one of the largest privately-owned electricity generators in the highly fragmented Kazakh market, responsible for only 6.4% of electricity generation in 2014. Consequently, it is somewhat smaller than its rated CIS peers. It is vertically integrated across electricity generation, supply and distribution, which gives the company access to markets for its energy output and limits customer concentration.

CAEPCo covers electricity and heat generation, distribution and supply in the Pavlodar and Petropavlovsk regions through its 100% subsidiaries Pavlodarenergo JSC and Sevkazenergo JSC, and electricity transmission and supply in Akmola region through AEDC and AESbyt. Electricity and heat generation services dominate CAEPCo's EBITDA, accounting for about 75% and 94% in 2014, respectively.

Cheap Fuel Supports EBITDA
Kazakh coal prices are significantly below international market rates, reflecting their regulated nature and low transport costs. An unexpected and significant increase in the price of coal above Fitch's current inflationary driven estimates of 7%-9% annually would have a negative impact on EBITDA, although we consider this unlikely. Fuel cost is reflected in power tariff caps to protect energy affordability and the coal price charged to utilities is regulated annually, limiting price exposure.

Solid CFO, Negative FCF Expected
Fitch expects CAEPCo to continue generating solid cash flow from operations (CFO) of KZT20bn on average over 2015-2018, although FCF is likely to remain negative at KZT5bn over 2015-2018. The negative FCF will be mainly driven by the company's ambitious investment plans of KZT57bn for 2015-2016 as well as dividend payments of about 30% of net profit over the medium term. Fitch expects CAEPCo to rely on new borrowings to finance cash shortfalls.

High Capex
We expect CAEPCo's intensive investment programme to be partially funded by debt. We expect FFO adjusted gross leverage to peak at just below 3.5x in 2015-2016, before declining in line with capex. However, CAEPCO's investment programme has some flexibility until 2016 and will depend on the approved tariffs thereafter. The company expects maintenance capex on average of KZT8.5bn over 2015-2019. CAEPCo's group committed capex for 2015 is KZT21bn.

The company aims to modernise over 60% of its ageing 1960s and 1970s generation capacity by 2017 and upgrade its distribution network. Capacity expansion will be moderate at 16% by 2019, but additional benefits are likely to accrue from improved efficiency in production and distribution of heat and electricity.

Loss-making Heat Business
The heat distribution business is loss-making due to large heat losses and regulated end-user tariffs, which Fitch assumes are kept low for social reasons (heat generation is reported within overall generation and cash flow-accretive). We expect tariffs to gradually improve but to remain low in general.

Regulatory Uncertainty
The Kazakh authorities are currently considering draft legislation on the implementation of an electricity capacity market. When fully implemented, the capacity market should ensure an economically sound return on investment and provide incentives for construction of new generation assets or for expanding current capacity.

An effective launch of the capacity market should provide a stable revenue stream to fund utilities' capital investment programmes. A successfully functioning capacity market is likely to support the credit profiles of power generators. However, no final decision regarding a capacity market has been made.

Fitch expects that generation tariffs will continue to reflect fuel cost and other cost inflation while capacity payments will cover capex needs. Tariff caps for a seven-year period with possible annual revisions are currently under discussion.

Electricity distribution tariffs could switch from the 'benchmarking' methodology introduced in 2013 to long-term tariff (five years) approval using a 'cost plus allowable profit margin' methodology. Long-term (five years) approval based on the same methodology is also being considered for heat generation, distribution and sales tariffs, which are currently approved on an annual basis. While the potential switch to long-term tariff approval would bring more revenue predictability, until this new tariff system is approved there remain uncertainties in the regulatory regime post 2015.

No Parent Uplift or Constraint
Unlike most Fitch-rated utilities in CIS, CAEPCo is privately owned and therefore not affected by sovereign linkage. The company is run as a standalone enterprise and as such we do not assume any credit linkages with the 62.6% controlling parent, Kazakhstan-based Central-Asian Power-Energy Company JSC (CAPEC). The remaining shares are held by two foreign institutional shareholders. The ratings therefore reflect CAEPCo's standalone credit profile.

Dividends to Delay Deleveraging
CAEPCo's financial policy to pay dividends could delay de-leveraging in the long term. However, we believe that should the tenge devaluation undermine the company's credit metrics CAEPCo retains the flexibility to lower dividends to preserve cash, as demonstrated in 2011 when it cut dividend to offset higher capex. The company expects to pay about 25%-30% of net profit in dividend over the medium term.

Potential IPO
CAEPCo is considering undertaking an IPO in 2016-2017. It expects to sell 35%-40% of current shares, proportionally reducing the stake of the current shareholders.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
- Electricity volume growth in line with Fitch GDP forecasts of 2.5%-3.5% over 2015-2019.
- Tariffs growth as approved by the government for 2015 and in line with inflation, which Fitch forecasts at 6%-8% in 2016-2019.
- Capex in line with the company's plan.
- Inflation-driven cost increase.
- Exchange rate of USD/KZT255 over 2015-2018

RATING SENSITIVITIES
Negative: Future developments that could lead to negative rating action include:
- Sustained slowdown of the Kazakh economy, further tenge devaluation, increase in coal prices that is substantially above inflation and/or tariffs materially lower than our forecasts, leading to FFO adjusted gross leverage persistently higher than 3x and FFO interest coverage below 4.5x.
- Committing to capex without sufficient available funding and worsening overall liquidity.

Positive: Future developments that could lead to a revision of the Outlook to Stable include:
- A stronger financial profile than forecast by Fitch supporting FFO adjusted gross leverage below 3x and FFO interest coverage above 4.5x on a sustained basis.

LIQUIDITY AND DEBT STRUCTURE

Satisfactory Liquidity
Fitch views CAEPCo's liquidity as satisfactory assuming uninterrupted access to cash deposits mostly held at local banks as well as availability of external funding for the forecast negative FCF over 2015-2016. At 20 August 2015, cash and cash equivalents stood at KZT3.8bn, which together with short-term bank deposits with a maturity up to one year of KZT14.3bn and unused credit facilities of KZT2.2bn are sufficient to cover short-term debt maturities of KZT12.9bn. However, the impact of the tenge devaluation and negative FCF over 2015-2016 means CAEPCo will need to raise further debt to finance cash shortfalls. CAEPCo has placed local bonds (at the CAEPCo and Sevkazenergo level) of up to KZT6.8bn so far in 2015.

At 20 August 2015, the majority of CAEPCo's debt was secured bank loans (KZT58bn or about 70%) and unsecured local bonds maturing in 2017- 2023 (KZT23bn in total or 30%). All current debt facilities (both secured and unsecured) are largely at the operating company level.

Senior Unsecured Notched Down
Fitch rates CAEPCo's KZT7.3bn notes one notch below the company's Long-term local currency IDR of 'BB-' as the notes are issued at the holding company level (CAEPCo). They do not benefit from upstream guarantees from operating subsidiaries, have no security over operating assets and no cross defaults with other facilities. At end-2014 pledged assets amounted to KZT92bn.

FULL LIST OF RATING ACTIONS
Long-term foreign currency IDR affirmed at 'BB-', Outlook revised to Negative from Stable
Long-term local currency IDR affirmed at 'BB-', Outlook revised to Negative from Stable
National Long-term Rating affirmed at 'BBB+(kaz)', Outlook revised to Negative from Stable
Short-term foreign currency IDR affirmed at 'B'
Local currency senior unsecured rating affirmed at 'B+'
National senior unsecured rating affirmed at 'BBB-(kaz)'.