Fitch Affirms Italy's Terna at 'BBB+'; Outlook Stable
(The following statement was released by the rating agency) Fitch Ratings-Milan-March 13: Fitch Ratings has affirmed Terna SpA's Long-Term Issuer Default Rating (IDR) at 'BBB+' with Stable Outlook. A full list of rating actions is detailed below. The rating affirmation factors in Terna's monopolistic position, a transparent and fair regulatory environment in Italy, the strong record of delivery on targets but also large and increasing planned capex, rising leverage and some regulatory reset risk during the business plan horizon over 2020-2024. The Stable Outlook takes into account funds from operations (FFO)-adjusted net leverage that is on average consistent with our rating sensitivities, but shows a small breach towards the end of the business plan (6.9x in 2022-2024 versus negative sensitivity of 6.7x). We believe that this is mitigated by the conservative assumptions used for our rating case and sufficiently offset by a solid net debt / regulatory asset base (RAB) that is always below 60%. Key Rating Drivers Rising Capex Planned: The updated business plan includes net investments for a cumulative EUR7.3 billion, up from EUR6.2 billion in 2019-2023 and almost double compared with that of the plan 2017-2021. Of this, EUR4.2 billion is related to development, with the remainder for asset renewal and grid resiliency and adequacy. Development includes large projects, like the link of Sardinia to Corsica and Italy, and the debottlenecking of critical zones. As a result, the RAB should grow at a CAGR of around 5% to almost EUR20 billion at end-2024 from around EUR15.5 billion at end-2019. Energy Transition Drives Capex: The continuous increase in capex should be seen in conjunction with Italy's ambitious targets related to the sector's transition to greener energy, with a target renewables penetration of 55% on electricity consumption in 2030 (from 35% in 2018) and 30% in total consumption (from 18%). Renewables plants are also concentrated in the south (more than 60%), while demand comes mainly from the north of the country, requiring additional transmission capacity. We expect annual capex to peak at EUR1.5 billion-EUR1.7 billion in the next decade. Regulatory Stability: Electricity transmission in Italy is in the fifth regulatory period, which spans across 2016-2023 and has been divided in two semi-periods, the current one covering 2020-2023. The regulator, Autorità di Regolazione per Energia Reti e Ambiente (ARERA), has a long record of transparency and fairness, and the current semi-period shows total continuity with the previous one, with fair remuneration of capex and operating expenditure and no volume risk. Constructive Methodology by ARERA: We believe that ARERA is conscious of the capex needs across the network and does not want to make investments unattractive. The inclusion of work-in-progress in the RAB, with an annual benefit that we estimate at around EUR50 million on average for Terna, and output-based incentives for a maximum achievable of EUR300 million in 2019-2023, are examples of ARERA's constructive approach, in our view. We include around 70%-75% of the total achievable output-based incentives in our rating case. Rate of Return Reset an Uncertainty: The main regulatory items to be updated are the allowed weighted average cost of capital (WACC) at the beginning of 2022 and the new regulatory period at the beginning of 2024. A key risk for the WACC is represented by a downward trend in the spread between Italy and Germany 10-year treasury bonds. We conservatively assume a lower allowed return for 2022-2024 at 5.3%, down from the 5.6% applied in 2019-2021. The current financial markets volatility, with a widening spread between Italian and German treasury bonds, would be positive for the rate reset, but the observation period will only start in October 2020. Regulated Business Remains Core: Terna's business model is largely focused on regulated transmission activity in Italy. The weight of unregulated activities, which are always related to the core business and largely asset-light, and international activities (transmission business in Brazil, Uruguay, Peru) is around 5% of EBITDA and expected to show only a slight increase to 6%-7% in our rating case. We expect management's focus to remain on the core business, which is positive for the rating. Negative Free Cash Flows: Terna has a solid EBITDA margin and sound operating cash flow generation, which also benefits from a cost of debt lower than 1.4%. However, the large capex plan will result in consistently negative free cash flows (FCF), which will become even larger towards the end of the plan at EUR0.8 billion-EUR0.9 billion per year (average was negative for only EUR0.1 billion in 2015-2019), a worsening trend, which is becoming common across EU peers as the energy transition unfolds. High Leverage: We expect Terna to show fairly low FFO-adjusted net leverage of 6.0x in 2019-2020, increasing from 2021 to an average of 6.9x in 2022-2024, with a small breach of our negative sensitivity. We see this as consistent with our Stable Outlook, since we expect net debt / RAB to always remain below 60% and see some upside to our conservative rating case. 2019 Results in Line with Expectations: Preliminary results in 2019 indicate solid operating performance with Terna's EBITDA up 5.5% yoy. EBITDA benefitted from an increase in revenues from regulated activities in Italy and a growing contribution from international and non-regulated businesses. This operating performance led to solid FFO generation of EUR1,264 million, neutral working capital flows and accelerated capex. FFO adjusted net leverage of 6.0x in 2019 is close to our positive sensitivity and broadly in line with 2018's, comparing favourably with our conservative forecast of 6.3x. Derivation Summary Terna has a robust business profile with negligible price and volume risks similar to its most direct local peer, Snam S.p.A. (BBB+/Stable), which shares the same regulator, country of operation and reference shareholder, CDP RETI S.p.A. (BBB/Negative). Snam has a slightly higher international exposure, which however is to developed countries and provides some diversification. Overall Fitch has the same rating sensitivities for both of them. Italgas SpA (BBB+/Stable) is an Italian gas distributor with tighter Fitch sensitivities for the same rating (6.5x) due to its smaller size and higher cash flow volatility underscored by renewal risk pertaining to local gas distribution tenders. Red Electrica Corporacion S.A. (A-/Stable) has higher business risk, due to its less mature system and diversification into less solid businesses, but its rating is higher due to a more conservative financial profile. Redes Energeticas Nacionales, SGPA, S.A. has a lower rating (BBB/Stable), due to higher business risk and leverage. Key Assumptions - EBITDA broadly aligned with management expectations, with main differences being WACC of 5.3% for 2022-2024 and slightly lower contribution from non-regulated and international activities - Tax rate of 29% over the rating horizon of 2020-2024 - Cost of new debt at around 1.5% p.a. over the rating horizon - Cumulative net capex of EUR7.3 billion; no MA activity, no disposals over the next four years - Broadly neutral working capital trend (cumulative cash flow generation below EUR100 million) - Dividends in line with management policy, with slightly higher pay-out in the outer years of the business plan RATING SENSITIVITIES Developments That May, Individually or Collectively, Lead to Positive Rating Action An upgrade is unlikely, as we expect FFO adjusted net leverage to be close to our negative sensitivity. However, future developments that could lead to a positive rating action include: FFO-adjusted net leverage declining below 6.0x on a sustained basis and net debt / RAB below 58% Developments That May, Individually or Collectively, Lead to Negative Rating Action Deterioration of FFO-adjusted net leverage above 6.7x, FFO interest coverage below 4.0x, net debt/RAB approaching 65% over a sustained period, for instance as a result of worse-than- expected FCF or debt-funded acquisitions Growing exposure to unregulated activities or regulated activities under less predictable regulatory frameworks Liquidity and Debt Structure Healthy Liquidity: At 30 September 2019, Terna's cash and cash equivalents amounted to EUR2.4billion and undrawn committed lines of EUR2.7 billion. This is compared with short-term debt maturities of around EUR757 million, with estimated negative FCF of around EUR250 million in 2020 after acquisitions and divestures. Since end-2018, Terna has successfully tapped the debt capital market three times, including two new green bonds, with an average tenor of six years for a cumulative amount of EUR1.25billion. Debt is raised at the level of the parent Terna. At end- September 2019, total outstanding debt was EUR9.99 billion with an average maturity of around five years. ESG Considerations ESG issues are credit neutral or have only a minimal credit impact on the entity(ies), either due to their nature or the way in which they are being managed by the entity(ies). For more information on Fitch's ESG Relevance Scores, visit Link Terna S.p.A.; Long Term Issuer Default Rating; Affirmed; BBB+; RO:Sta ; Short Term Issuer Default Rating; Affirmed; F2 ----senior unsecured; Long Term Rating; Affirmed; BBB+ Contacts: Primary Rating Analyst Antonio Totaro, Senior Director +39 02 879087 297 Fitch Italia Società Italiana per il rating, S.p.A. Via Morigi, 6 Ingresso Via Privata Maria Teresa, 8 Milan 20123 Secondary Rating Analyst Carlos Baeta, Analyst +44 20 3530 2616 Committee Chairperson Josef Pospisil, CFA Managing Director +44 20 3530 1287 Media Relations: Adrian Simpson, London, Tel: +44 20 3530 1010, Email: email@example.com; Stefano Bravi, Milan, Tel: +39 02 879087 281, Email: firstname.lastname@example.org. Additional information is available on Link Applicable Criteria Corporate Rating Criteria (pub. 19 Feb 2019) Link Corporates Notching and Recovery Ratings Criteria (pub. 14 Oct 2019) Link Parent and Subsidiary Rating Linkage (pub. 27 Sep 2019) Link Sector Navigators (pub. 23 Mar 2018) Link Short-Term Ratings Criteria (pub. 06 Mar 2020) Link Additional Disclosures Dodd-Frank Rating Information Disclosure Form Link Solicitation Status Link Endorsement Policy Link ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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