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April 10 (The following statement was released by the rating agency)
Fitch Ratings has affirmed Kemble Water Finance Limited's (Kemble Water) Issuer Default Rating (IDR) at 'BB-' with a Stable Outlook and senior secured rating at 'BB'. The agency has also affirmed Thames Water (Kemble) Finance PLC's (TWKF) GBP400m senior secured bond issue at 'BB', which is guaranteed by Kemble Water.
Kemble Water is a holding company of Thames Water Utilities Limited (Thames Water), the regulated monopoly provider for water and wastewater services in London and the surrounding areas.
The affirmation takes into account the pressure on credit metrics stemming from Ofwat's (the regulator for the UK water sector) risk and reward guidance for the price review covering April 2015 to March 2020. The ratings also reflect Thames Water's operating and regulatory performance. The company has scope to improve customer service, reduce sewer flooding incidents, move asset serviceability for sewerage infrastructure back to stable and become more efficient in terms of operating expenditure.
KEY RATING DRIVERS
Material Reduction of Earnings in the Sector
The regulator has guided towards a cost of capital of 3.85% for the regulated companies, lower than Fitch expected. Companies will be able to earn additional returns from incentives. However, earnings visibility regarding outcome delivery incentives may be limited and their scope to outperform total expenditure will depend on the level at which the regulator sets cost targets and the resulting efficiency challenge for individual companies, relative to their current cost performance.
Ofwat appears to have done a lot of modelling regarding the hypothetically possible return on regulatory equity for the regulated companies, but has put limited emphasis on the timing and visibility of these returns. As the price control process moves forward, Fitch will re-assess companies' scope to outperform, consider funding mechanisms associated with incentives and establish forecasts with detailed sensitivities.
Financial Profile Remains Within Guidance
Fitch's preliminary forecasts for the next price control period indicate that Kemble Water can maintain gearing below 90% pension-adjusted net debt/economic regulatory asset value, post-maintenance interest cover at around 1.05x and dividend cover at around 2.2x. To establish the rating case forecast Fitch used the cost of capital of 3.85%, factored in the revenue adjustments related to the last price control period included in Thames Water's business plan and no outperformance. The forecast credit metrics continue to be in line with guidance for Kemble Water's 'BB-' rating.
Upstream Cash Flow Tightens
The GBP750m of incremental debt at the holding level represents around 5% of RAV and incurs an annual finance charge of around GBP60m. The re-based dividend stream from Thames Water expected for the next price control period will still allow servicing of the debt. This is based on the assumption that Thames Water will maintain its current financial structure.
If management decided to reduce gearing at Thames Water by retaining dividends, this would likely have a negative impact on Kemble Water's ratings. Similarly, if Fitch concluded after the price control process that business risk in the sector had increased or Thames Water was expected to underperform price control assumptions, a downgrade of Kemble Water would be likely considering that currently forecasted dividend cover only has little headroom in comparison with the established guideline.
Meeting Regulatory Targets
In the financial year to March 2013 (FY13) Thames Water reported marginal asset serviceability for sewerage infrastructure and the number of sewer flooding incidents exceeded the target. The company met leakage targets for the seventh consecutive year.
Customer Satisfaction Lagging Behind
In terms of the service incentive mechanism, which measures customer satisfaction in the water sector, the company scored 63 points out of 100 for FY13, ranking low compared with peers. In comparison, peers made some progress in improving scores during FY13. The bad debt charge remained at a high level. Hence, there is more work to be done to improve these factors.
LIQUIDITY & DEBT STRUCTURE
Reliance on Upstream Cash Flow
Kemble Water mainly relies on dividends for debt service. As of December 2013, Kemble Water held GBP10.8m in cash and cash equivalents and had access to a committed GBP75m revolving credit facility to bridge short-term liquidity needs. Compared with Kemble Water's annual finance charge of around GBP60m, Fitch deems available back-up liquidity as adequate.
Positive: Future developments that could lead to positive rating action are deemed to be unlikely at this stage due to the challenges posed by the upcoming price control.
Negative: Future developments that could lead to negative rating action include:
- Decrease of dividend cover at Kemble Water below 2x, increase of gearing above 95% and/or decrease of post-maintenance and post-tax interest cover below 1.05x (as per Fitch's forecasts).
- Possibility of a dividend lock-up at Thames Water.
- Deterioration of operational and regulatory performance at Thames Water.
- Increasing business risk in the sector following conclusion of the price control process.
- Retention of dividends at the Thames Water level in order to reduce leverage.