November 6, 2012 / 11:52 AM / 5 years ago

TEXT-S&P summary: Severn Trent PLC

Nov 06 -

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Summary analysis -- Severn Trent PLC ------------------------------ 06-Nov-2012

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CREDIT RATING: BBB-/Stable/A-3 Country: United Kingdom

Primary SIC: Water Supply

Mult. CUSIP6: 81814P

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Credit Rating History:

Local currency Foreign currency

28-Jan-2010 BBB-/A-3 BBB-/A-3

02-Jul-2009 A-/A-2 A-/A-2

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Issues:

Rating Rating Date

EUR1.70 bil med-term note Prog 12/18/2002: sr

unsecd BBB+ 28-Jan-2010

(Gtd: Severn Trent PLC

Gtd: Severn Trent Water Ltd.)

EUR4.00 bil med-term note Prog 12/18/2002: sr

unsecd BBB- 28-Jan-2010

(Gtd: Severn Trent PLC)

¿4.5 bil 1.83% med-term nts ser 61 due

11/19/2014 BBB- 28-Jan-2010

¿3 bil 1.625% med-term nts ser 73 due

06/29/2015 BBB- 25-Mar-2010

¿75 mil var rate med-term nts due 07/04/2022 BBB- 09-Jul-2012

¿500 mil RCF bank ln BBB- 03-Oct-2012

(Gtd: Severn Trent PLC)

EUR1.70 bil med-term note Prog 12/18/2002: S-T

debt A-2 02-Jul-2009

(Gtd: Severn Trent PLC

Gtd: Severn Trent Water Ltd.)

EUR4.00 bil med-term note Prog 12/18/2002: S-T

debt A-3 28-Jan-2010

(Gtd: Severn Trent PLC)

EURO CP prog auth amt EUR750 mil A-3 28-Jan-2010

Rationale

Standard & Poor’s Ratings Services’ ratings on Severn Trent PLC (SVT; BBB-/Stable/A-2) and its core subsidiary, regulated U.K. water and sewerage company Severn Trent Water Ltd. (STW; BBB+/Stable/A-2), reflect our assessment of the consolidated group’s “excellent” business risk profile and “significant” financial risk profile. The ratings are supported by our view of the group’s strategic focus on the U.K. water sector--one that we consider as having low operating risks and very limited competition. Further support for the ratings comes from the stable and predictable cash flows generated by the broadly credit supportive regulatory framework over five-year periods; relatively low balance sheet gearing compared to peers; and a “strong” liquidity position, with significant pre-funding of capital expenditures (capex).

These rating strengths are in part offset by a weakening in cash flow-based credit measures following the start of the current five-year regulatory period on April 1, 2010, which illustrates the issue of regulatory reset risk. Additional constraints include a large capex program that, when combined with dividend payments, we think will result in negative discretionary cash flows during the current regulatory period (2010-2015); and the contribution of about 5% of group operating profits from non-regulated activities, which we consider to be more exposed to the economic cycle than the regulated water activities.

Although we rate the company on a consolidated basis, the long-term rating on the holding company (SVT) is two notches lower than that on the operating subsidiary (STW) because STW benefits from regulatory protection. In our view, debtholders at the holding company level are more exposed to nonpayment risk because they have only secondary access, through dividends, to regulated operating cash flows (for more information see “UK Regulatory Ring-Fencing For Utility Holding Companies: Standard & Poor’s Approach,” published July 8, 2003, on RatingsDirect).

S&P base-case operating scenario

In our base-case operating scenario, we anticipate that SVT’s consolidated operating profit before exceptional items will gradually increase, reflecting the average 0.6% decline in real revenues approved by the regulator, offset by positive Retail Price Index (RPI) inflation that we anticipate will range between 2%-3%. We anticipate that operating margins will erode slightly, as infrastructure renewals expenditure (IRE) increases, and the non-regulated business only gradually recovers from current cyclical lows. We anticipate that the EBITDA margin will remain above 40%, but we consider this below the peer group average, reflecting the meaningful contribution from non-regulated activities that have lower margins than the regulated business, in our view.

In our opinion, SVT’s operational performance measures, as monitored by the regulator, are satisfactory overall, although we continue to observe some areas of weakness. For example, in the recently introduced Service Mechanism(SIM), SVT ranked only 15th out of 21 companies in 2011/2012, while serviceability for underground water assets remained “marginal” for the third consecutive year. For these reasons, SVT has decided to allocate an additional GBP150 million of capital investment over the remainder of the current price control, to improve customer service and network performance.

As with other companies in the sector, SVT has found that the costs associated with the transfer of private drains and sewers (PDaS) have, to date, been below its expectations. While costs are likely to rise from the low level of GBP12.5 million in 2011/2012 as customer awareness of the transfer of responsibility grows, SVT assumes that total costs over AMP5 will be GBP90-GBP138 million, compared to the previous estimate of GBP101-178 million. Consequently, the operating cost component of this amount might be below the threshold required for an IDoK (Interim Determination of ‘K’, a mechanism to re-open a price control) and in our base case, we assume no cost recovery due to PDaS in AMP5.

S&P base-case cash flow and capital-structure scenario

In our base-case cash flow scenario, SVT will maintain a stable adjusted FFO-to debt ratio of just more than 10% until 2015, which compares with our guidance for the ratings of about 9%-10%. We also anticipate that adjusted FFO interest cover will be stable, at about 3x.

In July 2012, SVT paid a GBP150 million special dividend to its shareholders, effectively removing the headroom that previously existed in its ratings. Prior to the capital return, we anticipated that SVT could maintain an FFO-to-debt ratio of about 11.5% on average to 2015, which fell only slightly short of our guidance of 12% for a higher rating.

We anticipate that, following the capital return, SVT’s gearing--as measured by its debt-to-Regulated Capital Value (RCV) ratio--will be stable at 60%-62%, which we consider well positioned at the current rating level.

Liquidity

The short-term rating is ‘A-2’ on STW and ‘A-3’ on SVT. We assess SVT‘sliquidity as “strong” under our criteria and calculate that liquidity sources should exceed liquidity needs by about 1.7x over the next 12 months.

As of June 30, 2012, we estimate liquidity sources of about GBP1.35 billion.

These include:

-- Unrestricted cash and equivalents of about GBP367 million.

-- An available GBP500 million under an undrawn revolving credit facility that expires in October 2016.

-- FFO of about GBP480 million.

We estimate that SVT’s liquidity needs over the next 12 months to be about GBP800 million, comprising:

-- Short-term debt of GBP30.2 million.

-- Capex of about GBP450 million.

-- Dividend payments of about GBP320 million, which include the special dividend of GBP150 million that was paid on July 28, 2012.

Outlook

The stable outlook reflects our view of the relatively predictable performanceof the SVT’s low-risk, regulated U.K. water and wastewater operations. We anticipate that STW will continue to manage its business efficiently; maintain a stable financial profile through the remainder of the 2010-2015 regulatory period; and continue to improve its operational in those areas of current weakness, notably customer service and network performance.

Following the recent GBP150 million capital return to shareholders, we consider that SVT has reduced the headroom in its ratings, but that ratios will remain comfortably within our guidance. Specifically, we anticipate that adjusted FFO-to-debt and FFO interest cover will remain above 9%-10% and 2.5x, respectively.

We consider an upgrade to be less likely following the recent capital return. Nevertheless, we would consider an upgrade if the consolidated group’s adjusted FFO-to-debt ratio were to exceed 12% on a sustainable basis, while maintaining FFO interest coverage of more than 3.0x.

Related Criteria And Research

All articles listed below are available on RatingsDirect on the Global Credit Portal.

-- Enhanced Competition Could Alter Standard & Poor’s Assessment Of The U.K. Water Sector, Dec. 12, 2008

-- Corporate Ratings Criteria 2008, April 15, 2008

-- U.K. Regulatory Ring-Fencing Risk For Utility Holding Companies: Standard & Poor’s Approach, July 8, 2003

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