Croatia's HEP S&P ratings cut to BB-, placed on CreditWatch Negative

At the same time, the ratings were placed on CreditWatch with negative implications, S&P said in a statement.

The ratings agency also said in the statement:

"[..] The downgrade reflects our view that HEP's business prospects have deteriorated; that poor hydrological conditions, rising commodity prices, and an increased share of electricity imports to be procured at volatile market prices likely will lead to persistent cash flow pressures. Negative cash flows have already led to aggressive use of short-term credit lines and deferral of investments. However, we understand that to alleviate its immediate funding needs and extend debt maturities, the company aims to raise medium-to-long-term financing, which we expect to happen in October.

We have revised our assessment of HEP's business risk profile to "fair" from "satisfactory." This reflects the company's inherent earnings volatility in the context of unpredictable, politically determined, regulated tariffs. Although the government raised tariffs by 18.9% in May 2012, we are uncertain as to whether future tariff resets will allow an adequate return on investments and sufficient and timely compensation of cost overrun.

However, the company benefits from some flexibility as most of its new generation projects are non-committed (that is, discretionary at this stage). It is also pursuing a plan to optimize costs, which aims to achieve about Croatian kuna HRK2.0 billion of savings over 2012-2016. Also, we expect the state to potentially support the investments by forgoing dividends, as in the past (excluding a one-off dividend in 2011).

Over the next approximately three to five years we expect HEP to generate consistently negative free operating cash flows (FOCF) (after capital expenditures, net of connection income). This is because HEP has an ambitious capital investment program, planned at HRK19.0 billion for the period between 2012 and 2016, which will result in ongoing funding needs and increase of leverage. What's more, HEP faces HRK1.3 billion of principal repayments in 2013 alone (notwithstanding new loans) and risks related to the annual renewal of its HRK1.0 billion fully used committed credit lines. Even factoring new planned financing, we see little prospect for a sustainable recovery in HEP's liquidity position over the next 12 months. This is why we have revised HEP's financial risk profile to "highly leveraged" rom "aggressive."

The 'BB-' rating on HEP is based on the company's stand-alone credit profile (SACP), which we assess at 'b', as well as on our opinion that there is a "high" likelihood that the government of the Republic of Croatia (BBB-/Negative/A-3) would provide timely and sufficient extraordinary support to HEP in the event of financial distress. In accordance with our criteria for government-related entities (GREs), our view of a "high" likelihood of extraordinary government support is based on our assessment of HEP's "very important" role for the energy sector and the broader economy in Croatia; and on its "strong" link with the Croatian government, which is the sole shareholder and is actively involved in defining the company's strategy.

We continue to view HEP's liquidity position as "less than adequate" under our criteria. We base our assessment on what we view as HEP's "weak" stand-alone liquidity arrangements, combined with our view that the Croatian government has the ability and willingness to provide sufficient liquidity support to HEP in a timely manner.

As of June 30, 2012, HEP had the following liquidity sources:

- HRK240.5 million of cash balances (about €32.5 million). Furthermore, we understand that HEP has about HRK350.0 million (about €47.3 million) available for specific project financing facilities and has concluded €123.2 million (HRK925.5 million) of long-term funding from the European Bank for Reconstruction and Development. About HRK2.4 billion of Standard & Poor's-adjusted funds from operations over the next 12 months.

As of the same date, we believe liquidity uses comprise:

- About HRK0.9 billion of principal repayments under its bonds and mostly amortizing loans. Furthermore, the company has fully used HRK1.3 billion under revolving lines and framework agreements, out of which HRK1.0 billion is due for renewal in June 2013, with the remainder due earlier. About HRK3.0 billion capex (net of connection charges), which we understand is about 35% deferrable. No dividend payout on 2011 profit as per the shareholders' decision. We see HEP's interest costs and principal repayment as sensitive to any domestic currency depreciation and increase in loan pricing. On Dec. 31, 2011, HEP reported that about 72% of its total debt is euro-denominated. The company does not hedge its foreign currency exposure.

Furthermore, HEP has stated that framework agreements of a total HRK68.6 million are available for short-term borrowing purposes. The company has said that at June 30, 2012, it was in breach of financial covenants, but has procured waivers from all lending banks.

We aim to resolve the CreditWatch placement within a month. During this period, we will monitor whether HEP completes its planned financing. We could affirm the ratings and remove them from CreditWatch if HEP completes the planned financing in October and if, at the same time, we believe the company will meet its financial covenants as per the end of 2012. This will require a stabilization of operational performance and active management of investment levels.

We will likely lower HEP's SACP if the company is not successful with its planned financing, as this will exert pressure on the company's liquidity. In such a case, we will assess how the government and HEP intend to find alternative ways to fund the liquidity shortfall by the end of 2012. We could reassess our opinion of "high" likelihood of extraordinary state support if we were to doubt the government's capacity or willingness to provide timely liquidity support. A combination of one notch lower SACP and "moderately high" likelihood of state support could result in a one notch lowering of the corporate credit rating."