TEXT-S&P puts Drax Power 'BB+' rating on watch negative
Overview -- U.K.-based power generator Drax Power Ltd. plans to convert three of its six generation units to biomass within five years to reduce its dependence on coal. -- Drax plans to fund part of the required capital investment of GBP650 million-GBP700 million--the majority of which it will spend in 2012-2014--with about GBP200 million of term debt. We believe this will cause Drax's Standard & Poor's-adjusted credit metrics to weaken. -- We are therefore placing our 'BB+' long-term corporate credit rating and 'BBB-' senior secured debt rating on Drax on CreditWatch negative. -- The CreditWatch placement reflects the likelihood of us lowering our long-term corporate credit and senior secured debt ratings by one notch if the debt financing closes in accordance with Drax's current plans. Rating Action On Nov. 13, 2012, Standard & Poor's Ratings Services placed the 'BB+' long-term corporate credit rating on U.K.-based power generator Drax Power Ltd. (Drax) on CreditWatch negative. At the same time, we placed on CreditWatch negative our 'BBB-' issue rating on Drax's senior secured credit facility. The recovery rating on this debt is unchanged at '2', indicating our expectation of substantial (70%-90%) recovery in the event of a payment default. Rationale The CreditWatch placement follows Drax's announcement, on Oct. 25, 2012, that it will fund part of the GBP650 million-GBP700 million capital investment--the majority of which is required over 2012-2014--to convert three of its six generation units to biomass with GBP190 million of equity and about GBP200 million of term debt. In our view, Drax's Standard & Poor's-adjusted credit metrics will weaken as a result of the debt issuance. In addition, we believe that the increase in financial risk as a result of the debt issuance may not be offset by a commensurate reduction in business risk in the near term. This is because we consider that biomass conversion on the scale that Drax plans entails significant execution risk. The ratings on Drax continue to reflect our assessment of the company's "weak" business risk profile and "intermediate" financial risk profile. The "weak" business risk profile reflects: -- Drax's inherently risky merchant business model and resulting exposure to wholesale electricity prices; -- Its single asset base and primary focus on coal, which is subject to increasing regulatory and environmental constraints; -- Its exposure to coal and carbon costs, and therefore the dark green spread (the difference between the power price and the prices of coal and carbon); and -- Execution risk associated with the company's biomass expansion strategy. These weaknesses are partly offset by: -- Drax's important position in the U.K. power markets, accounting for about 7% of generation capacity; -- Its well-maintained, efficient, and flexible power turbines; -- Its good operational track record; and -- Its increasing proportion of biomass-fired generation capacity, which will benefit from regulatory support. We view the U.K. government's recent confirmation of regulatory support for biomass conversion as a positive development that allows coal-based generators like Drax to diversify away from coal and increase the proportion of earnings from relatively profitable and stable renewables-based generation. We believe that, in the longer term, a decreasing dependence on coal might help strengthen Drax's business risk profile. In the near term, however, we consider that there are a range of execution risks associated with biomass conversion, including construction, operational, logistical, and biomass procurement risks. Drax's "intermediate" financial risk profile is supported by strong debt coverage ratios due to a current lack of term debt; positive, albeit volatile, discretionary cash flows; and strong liquidity. Drax's transition to negative discretionary cash flow as it moves into a period of high investment, and the introduction of term debt into the capital structure, will in our opinion weaken the company's adjusted ratios significantly, particularly in 2013. However, we forecast that the ratios will remain commensurate with an "intermediate" financial risk profile over the medium term. The recent equity placement, which raised GBP190 million, will support Drax's strong liquidity position and in our view may help cover any unexpected financial costs. Liquidity We assess Drax's liquidity as "strong" under our criteria, and calculate that liquidity sources should exceed liquidity uses by more than 1.5x to June 2013. As of June 30, 2012, we estimate that liquidity sources include the following: -- Unrestricted cash and equivalents of about GBP245 million; -- Availability of GBP90 million under Drax's GBP100 million revolving credit facility (RCF). The RCF expires in December 2013, but we anticipate that Drax will refinance it by the end of this year; and -- Funds from operations, which in the 12 months to Dec. 31, 2011, were about GBP245 million. We estimate that Drax's liquidity needs over the next 12 months will include the following: -- Capital expenditure of about GBP250 million; -- Borrowings under the RCF of GBP10 million; and -- Dividends, which in the 12 months to Dec. 31, 2011, were about GBP124 million. Our view of "strong" liquidity under our criteria derives further support from our opinion that sources of liquidity will exceed uses even if EBITDA falls by more than 30%. We consider that Drax has a good standing in the capital markets, and that its liquidity management is prudent. Recovery analysis The 'BBB-' issue rating on Drax's GBP310 million senior secured credit facility due April 2014--including a sublimit of GBP100 million for the senior secured RCF--is on CreditWatch negative, in line with the CreditWatch placement on the corporate credit rating. The recovery rating on this credit facility is unchanged at '2', indicating our expectation of substantial (70%-90%) recovery in the event of a payment default. We intend to review our recovery assumptions when Drax finalizes its new debt structure, including the issuance of additional term debt and the refinancing of the existing senior credit facility. As a result of our revised analysis, we are likely to lower the issue rating on the new debt facilities by one notch, in line with any action on the corporate credit rating, and to reflect the higher total amount of debt. For our existing recovery analysis, please see the recovery section of our full analysis on Drax, "Drax Power Ltd.," published June 29, 2012, on RatingsDirect on the Global Credit Portal. CreditWatch We aim to resolve the CreditWatch placement within 90 days. During this period, we will monitor the execution of Drax's funding strategy, including the additional debt issuance that we anticipate Drax will complete by the end of this year. We are likely to lower by one notch the long-term corporate credit rating on Drax, and the issue rating on its senior secured debt, if the company raises about GBP200 million of new term debt. Related Criteria And Research All articles listed below are available on RatingsDirect on the Global Credit Portal, unless otherwise stated. -- Methodology: Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Credit FAQ: How Electricity Market Reform Could Affect The Ratings On U.K. Generators, May 24, 2011 -- Criteria Guidelines For Recovery Ratings On Global Industrial Issuers' Speculative-Grade Debt, Aug. 10, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- 2008 Corporate Criteria: Ratios And Adjustments, April 15, 2008 Ratings List Ratings Affirmed; CreditWatch/Outlook Action To From Drax Power Ltd. Corporate Credit Rating BB+/Watch Neg/-- BB+/Stable/-- Drax Finance Ltd. Senior Secured Debt* BBB-/Watch Neg BBB- Recovery Rating 2 2 *Guaranteed by Drax Power Ltd. Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.
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