Moody's upgrades Croatia's HEP ratings to Ba1

The change follows Moody's upgrade of the long-term rating of the Government of Croatia to Ba1 from Ba2 and the concurrent change in outlook to stable from positive on November 13, the agency said in a statement earlier this week.

The probability of default rating of HEP was upgraded to Ba1-PD from Ba2-PD, and the senior unsecured debt rating was lifted to Ba1 from Ba2, Moody's said.

Given its 100% ownership by the Government of Croatia and HEP's strategic importance to the country, the company's rating would normally incorporate an uplift from its standalone credit quality expressed as a Baseline Credit Assessment (BCA) of ba1, to reflect the strong likelihood of extraordinary support from the government in case of financial distress.

"However, as the company derives most of its earnings from Croatia, it is exposed to domestic regulatory oversight and local economic conditions, so its rating would not be expected to exceed that of the government," Moody's said.

Moody's also said in a statement:

"The BCA of ba1 is supported by (1) HEP's position as the vertically integrated incumbent in the Croatian electricity market and its leading position as supplier, enjoying around 90% market share; (2) its electricity generation mix, with a high share of low cost and low CO2 hydro and nuclear output; and (3) a strong contribution from lower risk regulated electricity distribution and transmission activities, which in aggregate contribute around half of EBITDA.

HEP's BCA continues to reflect the company's lack of diversification in terms of market presence. Moreover, it takes account of a developing track record in regulation, with a framework that is less transparent and predictable than for Western European peers. Certain smaller business segments, such as district heating and gas retail and distribution, have a history of very low or even negative returns. In recent years, the company has demonstrated a flexible dividend policy, aligned to its net profit, which reflects the supportive stance of the Government.

The BCA also factors that HEP remains exposed to fluctuating hydro levels and hence variable output from its hydro-dominated fleet, which normally generates slightly less than half of its production. As a consequence, the company purchases an additional 20-40% of energy on the market to balance its supply and trading needs. This creates some earnings volatility, as the company's exposure to imports and more expensive input costs of its own thermal fleet increases in dry years.

The BCA additionally reflects Moody's expectation that the company will continue to demonstrate a strong financial profile, building on its solid track record in recent years. The financial profile, as reflected in funds from operations (FFO)/net debt of 216% as of December 2019, is likely to weaken through a larger investment programme than in the recent past, which includes planned new generation capacity and investments to upgrade its ageing asset base and expand its existing networks. Notwithstanding the capital expenditure programme, Moody's expects HEP to retain its robust credit metrics, such as FFO/net debt in the strong double digits in percentage terms over the next few years.

HEP falls under Moody's rating methodology for Government-Related Issuers. The Ba1 rating incorporates (1) HEP's BCA of ba1; (2) its 100% ownership by the Ba1-rated Croatian government; (3) the strong likelihood of extraordinary support in case of financial distress; and (4) high default dependence, reflecting the company's strong domestic focus with around 90% of sales emanating from Croatia.

RATIONALE FOR THE STABLE OUTLOOK

Moody's would not expect HEP's rating to be higher than that of the government. The rating outlook is stable, in line with that of the sovereign and reflects Moody's expectation that HEP will continue to operate with a solid business and financial profile commensurate with the current BCA.

FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS

An upgrade in the rating of the Government of Croatia would likely result in an upgrade of HEP's rating, assuming no major deterioration in the company's business or financial profile in the meantime.

Downward pressure could develop on HEP's rating in the event (1) that the sovereign rating was downgraded; or (2) of a significant deterioration in the company's financial or liquidity profile or business risk characteristics, potentially as a result of a more challenging operating or regulatory environment.

A corporate family rating is an opinion of the HEP group's ability to honor its financial obligations and is assigned to HEP as if it had a single class of debt and a single consolidated legal structure. The Ba1 senior unsecured rating of HEP's outstanding global notes is the same rating level as HEP's CFR, and reflects the absence of structural and contractual subordination of noteholders to the claims of other HEP group lenders."