Fitch Upgrades EP Energy to 'BBB-'; Outlook Stable.
The IDR upgrade mainly reflects rating equalisation with EP Energy's parent, EP Infrastructure (EPIF, BBB-/Stable), following increasing integration of EP Energy within the larger EPIF group. The recent repayment of EP Energy's secured bond with a combination of cash and intragroup debt raised at parent level and a clear commitment expressed by EPIF to further implement an intragroup funding structure has strengthened the ties between the two companies.
KEY RATING DRIVERS
Parental Support Drives Upgrade: Following the refinancing in April 2018 of its EUR598 million bond, partially with an intragroup loan and own cash for EUR348 million, EP Energy has tied its financial structure to its parent's. Moreover the cross default provision included in a recent EPIF bond sets an incentive to financially support EP Energy, its 100%-owned material subsidiary, and adds to the strength of the legal ties between the two entities in line with Fitch's Parent and Subsidiary Rating Linkage criteria.
Operational and strategic ties are deemed strong through the economic relevance of EP Energy's core business for EPIF (contributes over a quarter of the group's EBITDA on a proportionately consolidated basis), EPIF's management control over EP Energy, and operating integration. Fitch believes that the protection granted by the covenanted structure of EP Energy's outstanding secured EUR499 million notes is temporary in light of its upcoming maturity in 2019. Headroom is material within the distribution covenant as well as parental commitment to refinance the entire instrument with intragroup debt at or before maturity.
Secured Bond Rating: EP Energy's EUR499 million notes due in November 2019 are secured with pledges over shares and material assets in certain key operating companies. We continue to apply a one-notch uplift from the IDR for the secured instrument, resulting in today's upgrade to 'BBB' on the back of above-average recovery expectations based on the security package. This is further supported by the regulated and quasi- regulated nature of the heat and electricity distribution, which represents around 70% of EP Energy's cash flow.
Predictable Business: EP Energy's credit profile is supported by low-cost heat supplies, cogeneration power sales and by its position as a regulated regional distribution monopoly. Its business is mostly quasi- or fully regulated and earnings are fairly predictable. On a proportionately consolidated basis, more than 50% and 40% of its EBITDA is generated from partially quasi-regulated heat infrastructure through various regional monopolies and from fully regulated electricity distribution business through Stredoslovenska distribucna, a.s. (SSD) respectively. SSD is a wholly owned subsidiary of Stredoslovenska energetika, a.s.(SSE), which in turn is 49%-owned by EP Energy with management control.
OKTE Gap to be Extinguished: Distribution companies in Slovakia such as SSD have incurred significant working-capital outflows in relation to the two-year timing difference between regulated fees paid to renewables producers and the related compensation recouped from customers (OKTE gap). From 2019, the Slovak government plans to support renewables producers directly. Full reimbursement of the total amount or regulatory receivables resulting from the system time lag is expected by 2020 at the latest. Over time, the OKTE gap is cash-neutral, but it has negatively impacted SSE's financial cost due to the two-year time lag. Fitch forecasts SSE's normalised annual EBITDA of around EUR175 million.
Standalone Net Leverage Increase: In light of the strong link with EPIF, the expected OKTE recovery in the next two years and EP Energy's headroom under the bond covenant, Fitch foresees that EP Energy may set up a more aggressive dividend policy, upstreaming on average around EUR65 million p.a. This would lead to an increase of EP Energy's funds from operations (FFO) adjusted net leverage to just under 4.5x (3.7x in 2017), compared with our prior expectation of 4.0x (in all cases deconsolidating SSE).
Notwithstanding the above in the Fitch rating case, EP Energy continues to generate solid operating cash flow that covers both capex and working capital requirements, resulting in average pre-dividend free cash flow (FCF) of around EUR85 million p.a.
Stronger Parent: EPIF's IDR is supported by the regulated and long-term contracted nature of the group's businesses, which include gas transmission, gas and electricity distribution and gas storage in Slovakia, as well as heat infrastructure in the Czech Republic. The group also benefits from a shareholder agreement between Energeticky a prumyslovy holding, a.s. (EPH) and Macquarie Infrastructure and Real Assets (MIRA), which includes a clause targeting between 4.0x and 5.0x proportionate net-debt-to-EBITDA. In addition, the bond covenants include a restriction on dividend payments at a proportionate net-debt-to-EBITDA ratio of 4.5x.
EP Energy's rating is aligned with that of parent company EPIF. Its rating also reflects the company's medium size, higher leverage than most CEE peers (FFO adjusted net leverage on average at 4.5x - post deconsolidation of SSE) as well as the risk embedded in the company's frequent restructuring. On the other hand more than two thirds of the entire business arises from heat and electricity distribution, providing stable cash flows despite some exposure to power prices through its power generation division.
Fitch's Key Assumptions within our Rating Case for the Issuer
- Average achieved power prices of about EUR32/MWh over 2019-2022
- Trend of slightly increasing heat prices
- Stable EUR/CZK exchange rate of about 25
- Capex of about EUR100 million a year
- Dividend payments to EPIF of EUR65 million p.a. on average during 2018-2022.
Developments That May, Individually or Collectively, Lead to Positive Rating Action
- An improvement of the parent's creditworthiness and rating, assuming unchanged links between EPIF and EP Energy, which would be positive for EP Energy's rating.
Developments That May, Individually or Collectively, Lead to Negative Rating Action
-A rating downgrade of EPIF or weakening of ties between EPIF and EP Energy as a result of, for example, an adverse revision of EP Energy's funding structure.
For the ratings of EPIF, the following sensitivities were outlined by Fitch in its Rating Action Commentary of 2 March 2018:
Developments that May, Individually or Collectively, Lead to Positive Rating Action
- We see limited upside for the current rating given the group's dividend policy and future dividend lock-up; however FFO adjusted net leverage consistently below 5.0x could trigger a positive rating action
- Structural changes in the gas market supporting greater cash flow visibility and reduced counterparty risk (which could also support positive rating action for eustream and SPPD)
Developments that May, Individually or Collectively, Lead to Negative Rating Action
- FFO adjusted net leverage consistently above 5.7x
- Adverse changes in eustream's contract portfolio or a weakening in the unconstrained credit profile of its counterparties
- Adverse changes to gas and electricity regulation in Slovakia or heat market regulation in the Czech Republic
At end-2017, EP Energy had readily available cash and cash equivalents of EUR371 million and an undrawn committed credit facility of EUR100 million. Some EUR269 million of EP Energy's cash was pledged as security for bond holders but is readily available. We expect EP Energy's deconsolidated FCF (post-dividend) to be negative by EUR20 million in 2018 and neutral in 2019, after assuming more than EUR220 million will be up-streamed to EPIF.
The EUR499 million bond, which matures in November 2019, should be refinanced with intragroup loans made available by EPIF, limiting refinancing risk. As at end-2017, EPIF had EUR585 million of cash and cash equivalents and an undrawn committed facility of EUR200 million.