TEXT-S&P cuts Zagrebacki Holding rating to 'B+', outlook is negative

Tue Nov 27, 2012 11:42am EST

Overview
     -- Because of high personnel and fuel costs, which are not fully covered 
by tariff adjustments, diversified municipal services provider Zagrebacki 
Holding is demonstrating weaker performance and liquidity than we envisaged in 
our previous base-case scenario.
     -- In our view, Zagrebacki Holding has not made sufficient progress in 
finding a solution to sustainably strengthening its liquidity position.
     -- We are lowering our stand-alone credit profile (SACP) on Zagrebacki 
Holding to 'ccc+' from 'b-'.
     -- As a result, we are lowering our issuer credit rating on Zagrebacki 
Holding to 'B+' from 'BB-'.
     -- The negative outlook reflects our expectation that the company's weak 
profitability and liquidity position, with high exposure to refinancing risks, 
may increase pressure on its SACP. It also reflects the negative outlook of 
the City of Zagreb.

Rating Action
On Nov. 27, 2012, Standard & Poor's Ratings Services lowered its long-term 
issuer credit rating on Croatia-based Zagrebacki Holding d.o.o. to 'B+' from 
'BB-'. The outlook is negative.

Rationale
The rating on Croatia-based Zagrebacki Holding reflects our assessment of the 
likelihood that its 100% owner, the City of Zagreb (BBB-/Negative/--), would 
provide timely and sufficient extraordinary support in the event of financial 
distress as "high" and our assessment of the company's stand-alone credit 
profile (SACP) at 'ccc+'.

In accordance with our criteria for rating government-related entities, our 
view of a "high" likelihood of extraordinary government support is based on 
our assessment of Zagrebacki Holding's:

     -- "Very important" role in providing essential municipal services, such 
as transport, gas supply, water supply, and waste collection, as well as its 
role as the city's financial vehicle in the context of strict legal limits 
imposed on municipal borrowing in Croatia. In the event of a default, we 
believe the failure to roll over debts coming due would result in Zagrebacki 
Holding scaling down its activity.
     -- "Strong" link with Zagreb. The city council has a strong influence on 
Zagrebacki Holding's strategy and we believe the city's 100% ownership is 
unchallenged in the medium term. We also assume that a default of the company 
would affect the city's reputation in the market. However, the city's ability 
to provide timely support to the company has weakened as it has maintained a 
low cash position and high payables since 2009, and, in spite of significant 
ongoing support from the city, Zagrebacki Holding significantly increased its 
stock of short-term debt in 2010-2011.

Because of our view of the "high" likelihood of extraordinary support from 
Zagreb, the rating on Zagrebacki Holding is three notches higher than its 
SACP, which we now assess at 'ccc+'.

Our view of the SACP is based on the combination of Zagrebacki Holding's 
"highly leveraged" financial profile with "weak" stand-alone liquidity 
arrangements and unpredictable financial policy and "weak" business profile.

The SACP is underpinned by Zagrebacki Holding's monopoly position as a 
provider of public services as well as its strong ongoing support from the 
owner via operating and capital subsidies, guarantees on some debt (which are 
repaid indirectly from the city's budget), and asset transfers. Overall, 
through the purchase of services and subsidies, Zagreb contributed about 33% 
of Zagrebacki Holding's operating revenues in 2011. The city council decides 
the makeup of the holding's management board, most tariffs for regulated 
businesses, and its investment plan.

Nevertheless, as a result of recent changes in national legislation, the 
company may be forced to divest one of its lucrative water supply and sewage 
businesses, which may affect the company's role in the provision of public 
services as well as put additional pressure on its profitability.

Since 2008, Zagrebacki Holding has had no long-term financial strategy. It 
remains subject to the city's politically motivated decisions on mandates and 
sources of income.

Zagrebacki Holding has recently applied some cost-cutting measures, which, 
together with raised tariffs on public transport and water supply as well as 
fewer people eligible for free public transport, may reduce its net loss in 
2012-2014 in line with our base-case scenario. Nevertheless, the company will 
continue to generate losses. Its debt burden will stay high over this period 
with debt-to-EBITDA projected to average a high 7.0x-8.0x and FFO to debt 
staying at a low 8.0%-9.5%.

Liquidity
We view Zagrebacki Holding's liquidity as "less-than-adequate" under our 
criteria, based on what we view as the company's "weak" stand-alone liquidity 
position, combined with our opinion that the City of Zagreb has the ability 
and willingness to provide sufficient liquidity support to the company in a 
timely manner. We also note the fact that the city continues to transfer funds 
earmarked for the repayment of a portion of the company's debt.

Throughout 2012, the holding's free cash and available credit facilities was 
about Croatian kuna (HRK) 180 million (EUR24 million), well below its debt 
service within the next year of about HRK1.3 billion (or HRK1.1 billion, 
excluding debt repaid from the city's budget).

Based on our forecast, the holding's sources of liquidity (cash, committed 
credit lines, and funds from operations) will cover only 50% of the uses of 
liquidity--such as capital investments and principal repayment--over the next 
year. We expect that beyond the investment in the water and sewage networks, 
the holding's capital expenditures will be close to minimal.

The company's debt repayment profile has weakened significantly since 2009, 
with a short-term portion of the debt raised to 19% of total debt outstanding 
by year-end 2011.

By Croatian law, a public sector company is not allowed to raise long-term 
borrowings unless it has a corresponding investment program approved--which 
the company has failed to do so far. Under such circumstances, the company is 
to refinance its long-term debts coming due with short-term bank loans, 
raising the company's annual funding needs and pressuring its liquidity 
position.

Moreover, since 2010 the company has occasionally delayed payments to 
suppliers and operating-lease payments. We don't consider this a default, but 
rather a sign of a strained liquidity position.

The company can use about HRK120 million (EUR17 million) of an arranged, 
earmarked credit facility from the European Bank for Reconstruction and 
Development (AAA/Stable/A-1+) for the final stage of its water and sewage 
network upgrade project and is expected to successfully roll over its 
short-term bank loans of HRK640 million coming due in December 2012 and July 
2013.

The company owns significant real-estate assets, which it initially planned to 
start selling in 2008, using the proceeds to repay debt. However, the 
inability of the company's supervisors to approve its investment program, 
combined with reduced prices in the residential property market, has led to a 
delay of sales by more than 40 months.

Outlook
The negative outlook reflects our expectation that Zagrebacki Holding's SACP 
may deteriorate further as a result of unfavorable organizational changes, an 
inability to contain expenditures, or rising refinancing risks. It also 
reflects the negative outlook on the City of Zagreb.

Our base-case scenario for the SACP (which is consistent with the 'ccc+' 
level) assumes that in 2012-2013 the holding will benefit from higher tariffs 
on its (primarily transport) services, continue to reduce personnel costs, and 
successfully extend short-term credit lines from local banks and leasing 
obligations.

We could take a negative rating action on Zagrebacki Holding within the next 
12 months, if as a result of the divestiture of its water supply and sewage 
branch and insufficient consolidation measures, the company fails to improve 
its profitability or it takes materially more short-term debt than envisaged 
in our base-case scenario, or its access to external liquidity deteriorates.

We could also consider negative rating action if we took a negative rating 
action on Zagreb, or if we revised downward our view of the likelihood of the 
city providing timely and sufficient extraordinary support to the company in 
case of financial distress.

We could revise the outlook to stable as a result of a similar rating action 
on the city, confirmation of a "high" probability of extraordinary support, 
and stabilization of the holding's SACP in line with our base-case scenario.

Related Criteria And Research
     -- Methodology For Rating International Local And Regional Governments, 
Sept. 20, 2010
     -- Rating Government-Related Entities: Methodology And Assumptions, Dec. 
9, 2010
     -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
Ratings List
Downgraded
                                        To                 From
Zagrebacki Holding d.o.o.
 Issuer Credit Rating                   B+/Negative/--     BB-/Negative/--
 Senior Unsecured                       B+                 BB-



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