Moody's rates Croatia's HEP proposed senior unsecured notes (P)Ba2

The amount is subject to the prevailing market conditions during the placement. The outlook on the assigned rating is negative, the ratings agency said in a statement.

Moody's also said in the statement:

"[..] The assigned provisional (P)Ba2 rating reflects Moody's assumption that the notes will rank pari passu with the other senior unsecured debt of HEP and is in line with the company's Ba2 corporate family rating," says Richard Miratsky, a Moody's Vice President - Senior Analyst and lead analyst for HEP. In line with the LGD methodology, Moody's will finalise the ratings and LGD assessment upon receipt of final bond documentation and the confirmation of the issue amount.

The proposed notes are subject to restrictions on creation and incurrence of certain liens and include put options for noteholders in the event that there is a change of control of HEP or ownership unbundling. The noteholders have the option to require HEP to redeem the notes should the Republic of Croatia cease to control the company or cease to own, directly or indirectly, at least 75% of the entire issued share capital of the company. The ownership unbundling put option entitles the noteholders to require HEP to redeem the notes in the event that regulated assets relating to the transmission of electricity cease to be owned by the company as a result of implementation of Directive 2009/72/EC.

Based on 30 June 2012 financial results, HEP was not in compliance with certain covenants under agreements on loans amounting to approximately 20% of the company's total debt. One half of those loans with breached covenants are secured by government guarantee. HEP obtained waivers for the 30 June 2012 covenant breaches from each of the respective loan providers until the next covenant test on 31 December 2012. The company plans to repay all loans at risk of a covenant breach by year-end.

The (P)Ba2/Ba2 ratings of HEP assume that the bond will be issued and that these loans are repaid. If this is not the case, the company is likely to face downwards pressure on its ratings given the potential for ongoing covenant breaches. The size of the bond is sufficient to repay such outstandings, repay other short term borrowings, and provide some funding for business needs. Nevertheless, HEP will still need to access the bank and debt markets in short to medium-term to fund its ongoing sizeable capital expenditure programme and meet on going debt repayments.

The weaker financial performance up to June 2012 was ultimately caused by drought conditions which resulted in significantly lower profitability and cash flow given that the half of HEP's installed capacity is hydro power plants. Nevertheless, given expected improved precipitation and the greater covenant headroom in other debt documentation, Moody's expects that HEP will be in compliance with financial covenants in remaining debt documentation as at 31 December 2012 following the anticipated loan repayments.

Given its 100% ownership by the Government of Croatia, HEP falls within the scope of Moody's rating methodology for government-related issuers (GRIs). In accordance with the methodology, HEP's Ba2 corporate family rating incorporates a two-notch uplift for potential government support to its standalone credit quality, which is expressed as a baseline credit assessment (BCA) of b1.

Moody's downgraded HEP's ratings to Ba2 on 21 September 2012 and maintained the negative outlook. This reflected the significant pressure on HEP's liquidity as a result of (1) a high proportion of the company's total debt burden being short term in nature; (2) the demanding maturity profile of its long-term debt; (3) its need for significant new financing to cover its sizeable investment programme; and (4) the negative outlook on the Government of Croatia's Baa3 rating.

The b1 BCA (downgraded from ba3 on 21 September 2012) reflects the fact that HEP has utilised all of the headroom under its committed credit lines during 2012. HEP's cash flow generation has been weakened by the drought in Croatia, which has significantly limited the company's utilisation of its hydro-based generation facilities. In order to cover the domestic demand for electricity, HEP had to increase its production from thermal power sources and increase imports of electricity, which significantly increased its costs in the first half of 2012 and stretched its liquidity. Hydrological conditions have been improving since the beginning of September.

WHAT COULD CHANGE THE RATING UP/DOWN

The negative outlook on HEP's Ba2 ratings reflects the company's limited visibility with regard to the funding of ongoing business needs and exposure to short-term debt funding. Furthermore, any downgrade in the rating of Croatia would likely result in a downgrade in the rating of HEP. Given the negative outlook on the ratings, Moody's sees limited potential for a rating upgrade over the next 12-18 months. HEP's ratings could be downgraded if the company fails to refinance those loans with waived covenant breaches. In addition, the rating could come under downward pressure if HEP's credit profile weakens through either (1) continued overreliance on debt markets, or a weaker financial profile such that the company's funds from operations (FFO) interest coverage ratio falls below 4.0x; and its FFO/debt ratio declines below 20%."