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S&P affirms Croatia's HEP at 'BB+', outlook stable

Author Iskra Pavlova
S&P affirms Croatia's HEP at 'BB+', outlook stable gary yim/Shutterstock.com

ZAGREB (Croatia), November 26 (SeeNews) - S&P Global Ratings said on Tuesday it has affirmed its 'BB+' long-term issuer credit rating on Croatia's Hrvatska Elektroprivreda (HEP) after the state-owned power utility improved its ability to manage exposure to historically very volatile hydrological conditions and commodity price fluctuations.

"We expect HEP to continue posting solid credit metrics, with funds from operations (FFO) to debt above 60% in the next 12 months and above 45% in the next two to three years. We are therefore revising our view of HEP's stand-alone credit profile (SACP) to 'bb+' from 'bb'," S&P said in a statement.

Still, the rating agency has affirmed its 'BB+' rating on HEP, because it expects that the company will post negative free operating cash flow (FOCF) due to large capital expenditure (capex) in networks and renewables and retain a degree of earnings volatility.

The rating outlook remains stable, reflecting that on Croatia, as well as the expectations that HEP will hardly improve further its SACP in the short term.

S&P also said in the statement:

"Hydrological conditions are an important part of HEP's credit story  Because more than 50% of HEP's power generation is derived from its 2,163 megawatt (MW) installed hydro capacity, HEP's hydropower generation can range roughly between 4 terawatt hours (TWh) to 8TWh of power generated per year. For example, during the 2011-2012 draught, HEP's FFO to debt declined to about 20% and debt to EBITDA increased beyond 3.0x, from 50% and 1.6x, respectively, in the previous year.

HEP's gradual but clear transformation to reduce earnings volatility has protected its credit metrics over the last seven-year cycle.   HEP has restructured its operations to ensure a long-term efficient and flexible cost structure on a consolidated group level. In addition, HEP mitigates commodity risk (fuel, carbon dioxide, and electricity procured) by hedging about 60% of its needs each year. Also, more stable regulated business still represents about 50% of the earnings profile. In our opinion, these factors have contributed to protect HEP's credit metrics over the last full seven-years-cycle, in which hydrology showed both poor and favorable conditions in Croatia.

We expect less volatility in HEP's earnings from hydrological conditions or commodity prices, and therefore we see improvement in its SACP.   We believe that HEP will continue being subject to some volatility, which is characteristic of hydropower generation; however, we expect such volatility to be more contained than in the past. Specifically, we expect HEP's FFO to debt to remain above 45% and debt to EBITDA below 3.0x even in the event of less favorable hydrological conditions over the next 12 months. As a result, we are revising up our SACP assessment on HEP to 'bb+' from 'bb'.

Croatian government support provides a solid rating headroom.   The company's SACP is already very close to the 'BBB-' sovereign rating on Croatia. Our expectation that the Croatian government would be highly likely to provide extraordinary support to HEP if necessary remains unchanged and provides a solid rating headroom even if HEP's stand-alone performance deteriorates, which we currently do not expect. We believe that HEP plays an important role for the country's economy and is essential for achieving the government's climate goals, which we understand will be published soon and will likely include renewable targets toward 2030 and 2050. In our opinion, a crucial component of the Croatian government's support is HEP's relatively supportive dividend policy, which is flexible and allows the utility to accumulate and reinvest earnings in favorable years and help maintain credit metrics in less favorable years.

Increasing investments will support HEP's business but result in negative discretionary cash flow (DCF).   We forecast HEP's capex will increase to about Croatian kuna (HRK)3.6 billion in 2019, about 50% higher than in 2018, mainly owing to additional investments in its transmission grid and renewables. We believe that this will result in negative DCF; however, we expect HEP to be able to fund the largest of these investments with its own cash. As a consequence, we see HEP's FFO to debt declining to about 70% in 2020 from 100% in 2019, which remains well above our trigger for the current SACP category.

We see HEP's investments in regulated activities, which represent most of HEP's capex investment, as supportive to HEP's business and a key supporting element of business risk.  Over the next two years, HEP will continue investing across the whole chain of the electric business with the aim of guaranteeing security of supply in Croatia. Out of total capex, we expect about 50% to be deployed in grid expansion and replacement at HEP's transmission subsidiary, Hrvatski operator prijenosnog sustava d.o.o. (HOPS), and and distribution subsidiary, HEP Operator distribucijskog sustava d.o.o. (HEP ODS). In addition, we expect an increasing amount of HEP's capex to be used for expanding its generation capacities and in particular renewable projects.

Renewable investments are gaining relevance in HEP's agenda.   HEP will allocate about HRK310 million in 2019 to finalize its recently acquired Korlat wind farm project. We assume Korlat will start operating in 2020 and generate close to 100 MWh in 2020 and up to 177 MWh over the medium term. We believe that HEP has less experience in this field, which could expose the company to capex execution risks. In addition, HEP is in the approval phase for incorporating two new generation facilities at its Senj hydro power plant, which will add a total of 412 MW to HEP's generation capacity over the medium term. We believe that the upcoming Croatian National Energy Plan could provide some additional low risk opportunities to HEP, because we understand that such projects could benefit from government subsidies that would ensure a level of profitability, and that HEP would be entitled to participate in such tenders.

The stable outlook on HEP mirrors that on Croatia, and reflects our assumption that HEP will continue to enjoy a high likelihood of extraordinary government support.

It also captures our expectation that HEP will continue posting sound financial performance. We expect that the company will post FFO to debt above 60% over the next 12 months.

In addition, although HEP will continue to be exposed to hydrological conditions, large working capital fluctuations, and commodity price swings, we expect that FFO to debt will not deteriorate below 45% and debt to EBITDA will not deteriorate above 3.0x, thanks to a more flexible cost structure and hedging policies. We also expect that FOCF will be materially negative in 2019-2020 due to large capex investment in networks and renewables.

Rating downside is limited. Assuming no change in our expectation of a high likelihood of state support, we could downgrade HEP if its financial performance deteriorates enough to lead us to revise our assessment of its SACP to 'b+', which is, however, far from our base-case scenario. A downgrade could also stem from a two-notch sovereign downgrade, which is also not our base-case scenario, given our stable outlook on the sovereign. A one-notch downgrade of Croatia would not result in a downgrade of HEP if the company's stand-alone fundamentals remain unchanged.

We could revise down our view of HEP's SACP to 'bb' from 'bb+' if the company were to post FFO to debt below 45% or debt to EBITDA above 3.0x, for example, because of poor hydrological conditions that came at the same time as a significant market share loss in Croatia.

If we took a positive rating action on Croatia, it would result in a similar rating action on HEP.

We could also upgrade HEP following further improvement of its stand-alone credit quality, although we consider this as unlikely in the short term. This is because of the company's massive capex plans, exposure to hydro conditions, and commodity price volatility. Although volatility has decreased in recent years, we believe it will still be an inherent characteristic of HEP's business over the next 12-24 months."

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