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- 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.