TEXT-S&P revises FirstGroup otlk to neg; affirms 'BBB-/A-3' rtgs

Aug 17 -

Overview

-- On Aug. 15, 2012, FirstGroup PLC was awarded the contract to operate the Intercity West Coast rail franchise in the U.K.

-- This new contract will, in our view, increase leverage and consequently weaken the U.K.-based transport operator's financial risk profile.

-- We are therefore revising our outlook on FirstGroup to negative from stable and affirming our 'BBB-/A-3' corporate credit ratings on the group.

-- The negative outlook reflects our view of the risk that credit metrics may not recover to a level that we consider commensurate with the 'BBB-' rating within the next two years.

Rating Action

On Aug. 17, 2012, Standard & Poor's Ratings Services revised to negative from stable its outlook on U.K.-based transport operator FirstGroup PLC. At the same time, we affirmed our 'BBB-' long-term and 'A-3' short-term corporate credit ratings on the group.

Rationale

The rating actions follow the award, by the U.K. Department for Transport, of the Intercity West Coast rail franchise. This contract will start on Dec. 9, 2012, and run for 13 years and 4 months. The franchise links major urban areas in the U.K., including London, the West Midlands, Greater Manchester, Liverpool, and Glasgow. It currently generates revenues of about GBP900 million per year. FirstGroup expects revenue growth of about 10% per year and an operating margin of about 5% over the life of the franchise.

Following the award of the West Coast rail franchise, we have revised downward our assessment of FirstGroup's financial risk profile to "significant" from "intermediate." This reflects our forecast that FirstGroup's financial metrics will weaken from 2013.

Our assessment of FirstGroup's credit profile incorporates our projection that, with the award of the West Coast rail franchise, revenues will increase by about 7% in 2013 and fall by about 5% in 2014. (The latter reflects the fact that the First Great Western and First Capital Connect franchises reach their term in March and September 2013, respectively.) It also takes into account our projection that FirstGroup's profitability margin will decline to about 10% in 2013, from about 11% in 2012, and remain flat in 2014.

In assessing FirstGroup's financial risk profile, we add to its reported debt the net present value of operating lease commitments, which we consider to be debt-like. We estimate the operating lease commitments associated with the West Coast rail franchise to be in excess of GBP1 billion at the start of the contract. We anticipate that these new commitments will lead to a significant increase in FirstGroup's adjusted debt and negatively impact the group's credit metrics. We project that FirstGroup's Standard & Poor's-adjusted funds from operations (FFO) to debt will weaken to about 22%-23% in 2013 and 2014, from about 29% in 2012.

We also estimate that the underlying adjusted credit metrics, treating FirstGroup's ring-fenced U.K. rail franchises as investments, will also be weak in the near term. On that basis, we forecast that adjusted FFO to debt will be close to 20% in 2013 and about 22%-23% in 2014 if we include in debt the contingent liabilities associated with the West Coast franchise and other U.K. rail franchises. This is below the level we consider commensurate with the 'BBB-' rating. Our forecast credit metrics reflect our expectation that FirstGroup is unlikely to receive any significant dividends from the West Coast train operating company in 2013 and 2014. However, we anticipate the franchise will make a greater contribution in terms of dividend payments in the medium term, which could support an improvement in credit metrics.

We continue to assess FirstGroup's business risk profile as "satisfactory" under our criteria. This reflects the additional diversification offered by the new long-term contract. That said, FirstGroup is exposed to operational underperformance of the franchise, which could for instance occur if passenger demand does not increase as much as the group anticipates, and could see margins tighten below its expectations.

FirstGroup faces fixed franchise payment commitments, which give a net present value for the franchise term of GBP5.5 billion. Although the new franchise does not benefit from any revenue support, we understand that there is a GDP-based mechanism that offers some protection from day one. We note that the group is planning to make operating investments of GBP350 million in the first five years of the franchise, and will be able to adjust its investment plan if passenger demand does not meet its expectations.

Our base-case credit scenario does not consider the effect of FirstGroup securing other rail franchises. We will evaluate any such effect once we have visibility on additional contracts secured by FirstGroup, and when details of the terms of the contracts are available.