TEXT-S&P lwrs rtg on Hrvatska Elektroprivreda to 'BB-'

Wed Oct 3, 2012 8:33am EDT

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(The following statement was released by the rating agency)

Oct 03 -

Overview

-- Croatia-based electricity utility Hrvatska Elektroprivreda d.d. (HEP) is facing a challenging operating environment, which we believe could continue to erode profitability and weaken its liquidity position.

-- We expect pressure on liquidity to remain despite the company's plans to issue medium-to-long-term financing to fund its ambitious capital expenditure and to meet its significant upcoming debt maturities.

-- We are lowering HEP's stand-alone credit profile from 'b+' to 'b' to reflect our view of a weakened business risk profile, liquidity position, and management. Consequently, we are lowering our long-term corporate credit rating to 'BB-' from 'BB'.

-- We are placing the ratings on CreditWatch with negative implications, reflecting execution risks attached to the planned new financing, which is dependent on market conditions.

Rating Action

On Oct. 3, 2012, Standard & Poor's Ratings Services lowered its long-term corporate credit and senior secured debt ratings on Hrvatska Elektroprivreda d.d. (HEP), the 100% state-owned, vertically integrated Croatian electricity utility, to 'BB-' from 'BB'. At the same time, we placed the ratings on CreditWatch with negative implications.

Rationale

The downgrade reflects our view that HEP's business prospects have deteriorated; that poor hydrological conditions, rising commodity prices, and an increased share of electricity imports to be procured at volatile market prices likely will lead to persistent cash flow pressures. Negative cash flows have already led to aggressive use of short-term credit lines and deferral of investments. However, we understand that to alleviate its immediate funding needs and extend debt maturities, the company aims to raise medium-to-long-term financing, which we expect to happen in October.

We have revised our assessment of HEP's business risk profile to "fair" from "satisfactory." This reflects the company's inherent earnings volatility in the context of unpredictable, politically determined, regulated tariffs. Although the government raised tariffs by 18.9% in May 2012, we are uncertain as to whether future tariff resets will allow an adequate return on investments and sufficient and timely compensation of cost overrun.

However, the company benefits from some flexibility as most of its new generation projects are non-committed (that is, discretionary at this stage). It is also pursuing a plan to optimize costs, which aims to achieve about Croatian kuna HRK2.0 billion of savings over 2012-2016. Also, we expect the state to potentially support the investments by forgoing dividends, as in the past (excluding a one-off dividend in 2011).

Over the next approximately three to five years we expect HEP to generate consistently negative free operating cash flows (FOCF) (after capital expenditures, net of connection income). This is because HEP has an ambitious capital investment program, planned at HRK19.0 billion for the period between 2012 and 2016, which will result in ongoing funding needs and increase of leverage. What's more, HEP faces HRK1.3 billion of principal repayments in 2013 alone (notwithstanding new loans) and risks related to the annual renewal of its HRK1.0 billion fully used committed credit lines. Even factoring new planned financing, we see little prospect for a sustainable recovery in HEP's liquidity position over the next 12 months. This is why we have revised HEP's financial risk profile to "highly leveraged" from "aggressive."

The 'BB-' rating on HEP is based on the company's stand-alone credit profile (SACP), which we assess at 'b', as well as on our opinion that there is a "high" likelihood that the government of the Republic of Croatia (BBB-/Negative/A-3) would provide timely and sufficient extraordinary support to HEP in the event of financial distress. In accordance with our criteria for government-related entities (GREs), our view of a "high" likelihood of extraordinary government support is based on our assessment of HEP's "very important" role for the energy sector and the broader economy in Croatia; and on its "strong" link with the Croatian government, which is the sole shareholder and is actively involved in defining the company's strategy.

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