July 26 (SeeNews) - S&P Global Ratings said on Wednesday it has affirmed its 'BB-' long-term corporate credit rating on Croatia's Zagrebacki Holding, with a stable outlook.
"The affirmation reflects our base-case forecast that S&P Global Ratings' adjusted debt to EBITDA will remain stable at about 5.2x-5.4x as we do not expect deleveraging or significant amounts of new debt issuances," the ratings agency said in a statement.
S&P noted that ZGH is 100% owned by the City of Zagreb, and that the utility company has a very high likelihood of receiving extraordinary government support in the event of financial distress.
It added that the stable outlook also reflects the outlook on Zagreb, itself mirroring that on Croatia.
The ratings agency also said:
"ZGH recently redeemed its euro-denominated Eurobond and issued a second tranche of domestic bonds worth Croatian kuna (HRK) 500 million by year-end 2017. We continue to view ZGH's financial risk profile as aggressive. Although we forecast funds from operations (FFO) to debt to gradually improve to 15% in 2019, we think challenges in the gas segments will persist and performance volatility will limit any significant upside in our core metrics. We expect FFO to debt to remain in the lower end of the range of our financial risk assessment. We forecast increasing capital expenditure (capex), at an average of HRK680 million between 2017 and 2019, which we understand that the company plans to fund through cash, EU grants (HRK180 million), and subsidies from the City of Zagreb. We also forecast a moderate increase in debt to fund capex and liquidity needs. However, this does not worsen our debt to EBITDA and FFO to debt metrics.
We understand that there have been conversations between the city and ZGH to remove the transport company from the Holding, however, there is still no clear timeline. The transport company, which accounts for about 20% of consolidated revenues, is loss-making and has a history of regularly receiving subsidies in excess of its turnover. In 2016, the transport company had revenues of HRK484 million and received a subsidy of about HRK500 million. Subsidies for the transport company will increase by an additional HRK100 million in 2017.
In addition to the water company, the generally weak profitability of the transport segment will drag on the financials of ZGH as a whole. If the transport company were to be transferred out of the Holding, the impact would likely be beneficial for ZGH as it could increase its net income by roughly 5x. That said, we will need to review the likelihood that the City of Zagreb will provide extraordinary state support due to the essential, and therefore heavily subsidized, service provided by the transport company.
ZGH's weak business risk profile reflects the relatively unpredictable cash flows arising from the frequent change in tariffs, and generally weak operating efficiency in companies that are large contributors to revenue. This in turn affects profitability and volatility, which we view as high for ZGH. Although ZGH benefits from leading market positions in many of the services it provides within Zagreb, this is to some extent offset by its lack of insulation from political decisions and external factors. There have been frequent changes in water tariffs over the years, for instance, which limits tariff visibility, and hence predictability (the water supply company accounts for about 10% of turnover). Even with gas distribution, which is regulated by the Croatian Regulatory Energy agency (HERA is considered to act independently and transparently), the business environment remains challenging since HERA decreased tariff items by approximately 38% relative to 2015 prices. This has affected the bottom line of its two gas subsidiaries (distribution and supply) which contribute approximately 25% of revenues and EBITDA.
The business risk profile benefits from the fact that ZGH provides diversified services in one of the richest regions of Croatia. Management is also increasingly focusing on restructuring measures to tighten cost controls and capture efficiency gains through workforce education, gradual staff reduction, and digitalization. However, the potential contribution toward the bottom line remains limited in the context of the subsidies the city needs to provide to ZGH.
Our base case assumes:
- Croatia's real GDP forecast at 2.8% in 2017, 2.6% in 2018, and 2.5% in 2019.
- We assume that the transport company will remain in ZGH and will continue to receive subsidies from the City of Zagreb in the amount of HRK500 million.
- The transport company and all other non-affiliates equate to approximately 48% of consolidated revenues. We forecast EBITDA margins at 15% for the transport company and nonaffiliate companies.
- We expect continued headwinds in the gas sector, with no rebound in tariff prices, forecasting 46% EBITDA margins for the gas distribution company and 6% for the gas supply company over our forecast time horizon.
- The water treatment and distribution company is relatively stable and we expect stable EBITDA margins at 38% going forward.
- We forecast a capex increase to an average of HRK680 million in 2017-2020 from HRK250 million in 2016.
- However, with EBITDA values forecast at about HRK840 million and the receipt of additional EU and Croatian funds, we do not see any liquidity constraints.
- We assume that in a possible downside scenario, with substantially lower turnover and EBITDA, ZGH would also adjust its capital program, with the transport company still receiving subsidies from the city.
Based on these assumptions, we arrive at the following credit measures:
- Debt to EBITDA of 5.2x-5.5x between 2017 and 2019;
- FFO to debt of 13.8% on average between 2017 and 2019; and
- Broadly neutral free operating cash flows to debt.
The long-term rating on ZGH is derived from its stand-alone credit profile (SACP) of 'b', reflecting its weak business risk profile and aggressive financial risk profile. ZGH benefits from a two-notch uplift as we think that ZGH has a very high likelihood of receiving extraordinary government support based on its:
- Very important role. ZGH contains all the municipal companies which provide the necessary services for the proper functioning of the city. These services range from transportation, gas distribution, water supply, and waste collection, to name a few. As such, ZGH also acts as the channel through which the city can implement its investment program, particularly when considering that the city faces strict legal restrictions regarding how much debt it can take.
- Very strong link with the city of Zagreb. ZGH has independent management teams for each company which are, in turn, supervised by the board. However, Mr. Milan Bandic, the Mayor of Zagreb, still wields considerable influence on the strategy of ZGH as exemplified by the fact that he nominated key board members. We do not see the link between the city and ZGH diminishing in the future. In the short-to-medium term, ZGH can only thrive through its long-term contractual relations with the city and the subsidies it provides, which create a quasi-monopoly position in the provision of essential public services. We will review the likelihood of extraordinary state support if Zagreb takes over the transport function, which we view as providing an essential service for the city.
The stable outlook reflects the outlook on the City of Zagreb, itself mirroring that on Croatia. We believe that FFO to debt will remain at about 13%-15% and that liquidity will remain adequate, even without any changes to the ownership of transport company ZET.
An upgrade of ZGH over the next two years could occur through a noticeably better performance in the FFO to debt metric (above 20%); a change in the structure of the company and its operating efficiency, resulting in a better competitive position; or an upgrade of Zagreb by two notches. However, we view all of these scenarios as unlikely. We do not disregard the possibility that the transport company could be moved out of ZGH before year-end 2019, resulting in much stronger metrics. We could downgrade ZGH following a downgrade of the City of Zagreb or as a result of FFO to debt falling below 12%. We would also view any accumulation of debt to offset negative liquidity pressures as negative for the creditworthiness of ZGH. In our view, this is the most likely downside scenario as ZGH currently has an ambitious capex program and is facing challenges in the business environment which could possibly further compress EBITDA."