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Rating Action:

Moody's affirms Portsmouth Water's rating and changes outlook to negative

19 Dec 2017

London, 19 December 2017 -- Moody's Investors Service (Moody's) has today affirmed the Baa1 corporate family rating of the smallest UK water only company, Portsmouth Water Limited (Portsmouth Water) and changed the outlook on the rating to negative from stable.

This action follows publication, on 13th December, by the Water Services Regulation Authority (Ofwat), the economic regulator for water companies in England and Wales, of its final methodology for the 2019 price review (PR19), including guidance on allowed cost of capital for the period from April 2020 to March 2025 (AMP7).

RATINGS RATIONALE

RATIONALE FOR NEGATIVE OUTLOOK

The outlook change to negative reflects Portsmouth Water's exposure to the likely cut in allowed returns from 2020, as guided by the regulator in its final PR19 methodology. Specifically, it reflects the heightened risk that the company may not be able to maintain a financial profile in line with existing Moody's guidance for its current rating levels, which may tighten as the PR19 process evolves. It also takes into account its (1) relatively high embedded cost of debt; and (2) inflexible and long-dated funding structure.

Ofwat published its final methodology for PR19, setting out requirements and expectations for companies' business plans and the regulator's assessment of these. Compared with the regulator's July draft consultation, the final methodology includes small changes to the total expenditure incentive regime as well as outcome delivery targets, but overall efficiency requirements will likely remain challenging. The regulator is proposing to reward companies whose business plans it assesses as exceptional or enhanced, but the monetary adjustment will provide limited relief against the low headline return.

As part of its methodology, Ofwat provided guidance on the allowed cost of capital for AMP7. Given the continuing low yield environment, a cut in allowed returns is to be expected and the regulator has guided to a reduction to 2.3% (real, assuming Retail Prices Index, or RPI, inflation) from currently 3.6% for the regulated water and wastewater wholesale activities. The regulator's proposal to link revenue and asset inflation to a measure of the Consumer Prices Index, adjusted for housing costs (CPIH) will increase the overall allowed return, albeit at the expense of future growth in the regulatory capital value (RCV). Nevertheless, the allowed cost of capital will still fall by around 0.8%, assuming a 100bps wedge between RPI and CPIH.

Portsmouth Water's funding, which consists of a single GBP99.6 million index-linked loan maturing in 2032, is both relatively expensive vs current market rates and long-dated. Consequently, the company is relatively exposed to any divergence between its borrowing costs and those allowed by the regulator, particularly given that its effective real interest rate of 3.6% remains well above the sector average of 2.1%. Given its small size and limited refinancing or new funding needs, Portsmouth Water is not able to benefit from the currently low interest rates. Therefore, the company's debt will not refresh as quickly as assumed by Ofwat when setting allowances for the cost of debt and its effective cost of debt will remain misaligned with that assumed by the regulator.

RATIONALE FOR RATING AFFIRMATION

Affirmation of the ratings reflects that while Portsmouth Water's credit quality will be pressured by the proposed cut in allowed returns, the PR19 process is in the early stages and the reduction may be less than currently proposed and/or mitigated by other aspects of Ofwat's final determination. Moody's also takes into account that (1) Portsmouth Water's gearing as at March 2017, as measured and adjusted by Moody's was 68.1% Net Debt/RCV which is well below the current rating guidance and below industry average; (2) the company has limited dividends pressure which gives it some financial flexibility.

Moody's notes the regulator's duties, in particular to ensure that efficient companies can finance their functions but also Ofwat's focus on a notional capital structure, with notional gearing proposed at 60% of the RCV, to set the allowed return.

Affirmation of the rating also reflects Portsmouth's sound business risk profile as a monopoly provider of essential water services and the stable cash flows generated under a transparent and well-established regulatory regime.

WHAT COULD CHANGE THE RATING UP/DOWN

The outlook could be stabilised if Moody's concludes that the risk exposure of Portsmouth Water's capital structure remains manageable and does not impair the company's financial flexibility in comparison with industry peers. Taking into account the company's ownership, Portsmouth Water benefits from limited dividends pressure, as well as historically good operational performance.

Conversely, the rating could be downgraded if Portsmouth Water's final price determination is particularly challenging and despite measures available to management, the company is unable to meet our guidance for the Baa1 rating, namely Adjusted Interest Cover Ratio (AICR) of 1.4x and Net Debt/RCV of below 86%. Furthermore, downward pressure could result from (1) unexpected, severe deterioration in operating performance that results in the company remaining persistently in breach of its distribution lock-up triggers; and/or (2) a material change in the regulatory framework for the UK water sector leading to a significant increase in Portsmouth Water's business risk.

The principal methodology used in this rating was Regulated Water Utilities published in December 2015. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

Portsmouth Water Limited is the smallest of the six water only companies in England and Wales by RCV (following the acquisition of Dee Valley Water by Severn Trent) and has the lowest average customer bills of all the water service providers in the sector. The company supplies around 713,000 domestic and commercial customers across 312,000 properties and an area of 868 square kilometres in Hampshire and West Sussex. It serves Gosport, Fareham, Portsmouth, Havant, Chichester and Bognor Regis, as well as some surrounding rural areas.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Velina Karadzhova
Analyst
Infrastructure Finance Group
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Neil Griffiths-Lambeth
Associate Managing Director
Infrastructure Finance Group
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Releasing Office:
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

No Related Data.
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