OREANDA-NEWS. Fitch Ratings has downgraded E.ON SE's (E.ON) Long-term Issuer Default Rating (IDR) and senior unsecured rating to 'BBB+' from 'A-' and removed them from Rating Watch Negative. The Short-term IDR has been affirmed at 'F2'. The Outlook on the Long-term IDR is Stable.

The downgrade reflects Fitch's preliminary assessment of E.ON's business risk following the upcoming demerger and incrementally higher leverage, given that the spin-off, Uniper SE, is expected to receive sizeable financial asset contributions in order to facilitate an investment-grade rating for this entity. Fitch is confident that E.ON's management has scope to steer the financial profile within ratio guidelines for a 'BBB+' rating. However, we note that the choice of capital structure and financial policies will need to support the target metrics. Fitch expects more guidance on these topics by May 2016.

KEY RATING DRIVERS
De-merger Removes Uncertainties
E.ON will cede control of conventional power plants, oil & gas assets, global commodities and Russian operations. This will remove many less manageable risks from its balance sheet, including political risks related to intervention in the carbon and capacity markets, risks related to the structural shift in power generation markets, a restatement of nuclear provisions at a later date (eg due to implementation of the German Site Selection Act), earnings and working capital swings of the midstream gas business as well as rouble and oil price exposure.

More Focused Business Model
E.ON will concentrate on activities that are integral to the de-carbonised energy markets. Networks provide for mostly stable and predictable earnings based on economic regulation. Renewables benefit from feed-in-tariffs or other support mechanisms for an initial period, mostly 15 to 25 years, after which the assets will be written down and exhibit earnings volatility. The business with end-consumers can be expected to visibly change, with less margin from pure supply and more earnings from services, including advice on how to reduce energy consumption.

The new business model will eventually also face structural change of associated markets. This provides opportunities and risks. By becoming a more customer-centric organisation, E.ON may be able to lead the transition/shape the future energy product offering.

Less Integration, Some Dis-Synergies
E.ON will be less integrated, but continue to have geographically diversified operations across Europe and renewable assets in the US. The joint venture in Turkey supplements the portfolio and provides opportunity for growth over the long term. The de-merger will also create some dis-synergies by doubling functions, including senior management, support services and the infrastructure for risk management.

Updated Peer Group
Following the de-merger, E.ON could derive around 60% of EBITDA from regulated energy networks, 15%-20% from renewables that benefit from support mechanisms and 20%-25% from retail and customer services (EBITDA is quoted before taking account of dividend income to be received from Uniper SE). Fitch expects the business profile to be broadly comparable to Iberdrola, S.A. (BBB+/Stable) and SSE plc (BBB+/Stable). EnBW (A-/Stable) can also be used as a suitable peer, but has no meaningful geographic diversification and more exposure to competitive markets.

Credit Metrics
Fitch expects the prospective ratio guidelines for E.ON's 'BBB+' Long-term IDR to be around the 4.5x mark for FFO adjusted net leverage (maximum) and 3.5x mark for FFO fixed charge cover (minimum). Fitch will confirm the precise levels once the de-merger is finalised and there is more certainty around the earnings contributions from the business segments. Fitch's rating forecast indicates that management has the means to steer the financial profile within the expected guidelines.

Financial Policies To Be Confirmed
Ultimately, the dividend policy, growth aspirations of management and other financial policies post-demerger are determining factors as to whether the group will maintain a 'BBB+' rating. While management has indicated that capital expenditure can be expected to be twice the amount of depreciation and that E.ON will be free cash flow negative after dividends, more detailed guidance on financial policies will only be given in May 2016.

Execution Risk Remains
The Federal Ministry for Economic Affairs and Energy is currently scrutinising the calculation of nuclear provisions. There is even a debate over whether an independent nuclear fund should be established, with the target of fully funding the liabilities over a number of years. This reflects the interest that the government and other stakeholders have in ascertaining that the entity responsible for dismantling and disposal of the waste is well capitalised.

Any conditions imposed by the government before the de-merger is completed could potentially require changes to the proposed transaction.

Senior Unsecured Notching
Fitch applies a generic one-notch uplift to the bond instrument ratings of integrated utilities that derive at least 50% of their earnings from regulated activities with a robust and established tariff setting process. If E.ON post-demerger derives comfortably above 50% EBITDA on a forecast basis from regulated network activities (mostly in Germany and Sweden), then its senior unsecured bonds will be upgraded by one notch.

Rating View Without De-Merger
Fitch revised the Outlook on E.ON's Long-term IDR to Negative on 23 April 2014. Since then, the oil price has tumbled, the rouble depreciated and electricity prices in continental Europe have incrementally weakened. As a result, forecast credit metrics without the de-merger would indicate a 'BBB+' Long-term IDR, absent additional portfolio optimisation after 1H15.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for E.ON include:
- Capital expenditure to be twice the amount of depreciation
- Dividends for external shareholders of E.ON and Uniper SE together to be EUR800m over the rating horizon (excluding dividends paid by E.ON to non-controlling interests, which are already deducted for purposes of calculating FFO in Fitch's standard presentation of cash flow; non-controlling interests are expected to remain broadly unchanged in comparison to FY14)
- EUR200m pension deficit repair per annum
- Moderately negative free cash flow
- Some additional asset disposals to optimise the portfolio
- Newly raised debt to be priced at 4.5%
- An effective tax rate of 25%
- Around 60% EBITDA from regulated network activities
- Funding requirements for the de-merger to be fulfilled by means of senior unsecured issuance before June 2016; any hybrid issuance would provide support to the rating level

RATING SENSITIVITIES
The following are indicative guidelines for E.ON post de-merger. We will review them as and when more information becomes available about the business mix and financial profile post de-merger.

Positive: Future developments that may lead to positive rating action include:
- FFO adjusted net leverage materially below 3.75x and/or corresponding fixed charge cover materially above 4.0x on a sustained basis.
- The German Constitutional Court rendering the nuclear fuel tax as unconstitutional, with funds being returned to the nuclear operators (highest rating impact, if it takes place before de-merger is concluded).
- Further asset disposals, particularly of assets with little earnings contributions such as Turkey.

Negative: Future developments that may lead to negative rating action include:
- FFO adjusted net leverage materially above 4.5x and/or corresponding fixed charge cover materially below 3.5x on a sustained basis.
- Too ambitious growth and/or dividend policy.
- Increasing competitive pressures in the retail markets in Europe.

The following are ratio guidelines for E.ON before de-merger. We note that guidelines related to market developments or qualitative aspects from the previous section equally apply.
Positive: Future developments that may lead to positive rating action include:
- Lease- and nuclear-adjusted FFO net leverage sustainably below 3.75x and/or corresponding fixed charge cover sustainably above 4.0x.

Negative: Future developments that may lead to negative rating action include:
- Lease- and nuclear-adjusted FFO net leverage sustainably above 4.25x and/or corresponding fixed charge cover sustainably below 3.5x.

LIQUIDITY
E.ON's liquidity remains strong. As of 30 June 2015, the group held EUR5.1bn of unrestricted cash and cash equivalents, around EUR1.9bn of short-term securities and fixed income deposits and EUR5bn of committed, undrawn credit facilities with maturity in November 2019.

Considering short-term maturities of EUR3.9bn and operating requirements of the business, the group is well funded until the de-merger proceeds.

E.ON will have to provide substantial (financial and cash generative operating) assets to Uniper SE to allow the new entity to operate as a viable business and pay for nuclear provisions and other asset retirement obligations over time as they fall due/crystallise. Depending on the composition of the asset pool that is contributed, E.ON can be expected to arrange additional funding before finalising the de-merger.