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Rating Action:

Moody's changes outlook for Sutton and East Surrey Water plc to negative; affirms rating

20 Aug 2019

London, 20 August 2019 -- Moody's Investors Service ("Moody's") has today changed the outlook to negative from stable on Sutton and East Surrey Water plc (SES Water), a water-only company operating in the South East of England. At the same time, the rating agency affirmed the Baa1 underlying senior secured rating on the company's GBP100 million 2.874% Guaranteed Secured Index-Linked Eurobond due 2031.

The rating action follows the July-publication of the draft determination for the next five-year regulatory period commencing in April 2020.

SES Water's bond also benefits from an unconditional and irrevocable guarantee of scheduled principal and interest payment by Assured Guaranty (Europe) plc (previously Financial Security Assurance (U.K.) Limited), pursuant to a financial guarantee insurance policy, and the A2 guaranteed rating remains unaffected by this action and in line with the insurance financial strength rating of Assured Guaranty (Europe) plc.

RATINGS RATIONALE

RATIONALE FOR NEGATIVE OUTLOOK

Today's action reflects (1) SES Water's exposure to a likely significant cut in allowed returns from 2020 and challenging efficiency performance targets, as outlined in the industry regulator's draft determination, published on 18 July 2019; (2) Moody's financial ratio guidance for the sector, which has been recalibrated in May 2018 to reflect the rating agency's perception of increased regulatory risk; and (3) SES Water's financial policy as indicated in its business plan submission in September 2018. Specifically, the negative outlook reflects Moody's view that -- considering the above -- the company may be unable to maintain credit metrics in line with the guidance for the current Baa1 rating.

In its draft determination for the sector, the economic regulator Ofwat, set an allowed cash return of 2.69% (or 2.58%, excluding the retail margin), 21-22 bps below the "early view" guidance it gave in December 2017. However, this figure was based on market data from February 2019. Ofwat noted that large market movements between February and June would support a further reduction of 37 bps. In total, this would translate into a roughly 140 bps cut in cash returns from the 3.74% (or 3.6% excluding the retail margin) allowed in the 2015-20 period.

Reflecting the draft determination, Moody's expects SES Water's Adjusted Interest Coverage Ratio (AICR) to be around 1.4x-1.5x, falling to 1.3x-1.4x when taking into account a further 37bps cut in the allowed return. The latter would be below the rating agency's 1.5x guidance for SES Water's Baa1 rating, but ultimately SES Water's credit profile will depend on the final allowed return and the company's ability to meet performance and efficiency targets.

Companies with debt tenors beyond that assumed by the regulator and/or higher embedded cost of debt as compared to regulatory assumptions are exposed to falling interest rates, as allowed returns converge to market rates faster than they are able to refinance existing debt. While SES Water will be less affected compared with some of its water-only company peers by the expected reduction in allowed returns due to earlier refinancing and lower embedded cost of debt, it still exhibits embedded costs of debt as at March 2019 that are above the regulator's allowance.

In addition, SES Water faces a total cost efficiency challenge of 18%, above the sector average of 11%, with key differences between the company's plan and the regulator's efficient cost assessment around enhancement expenditure as well as retail costs. While a cut in enhancement expenditure may allow the company to adjust certain growth-related projects, the company will have to redirect funds for investment necessary to enable SES Water to meet performance targets from other sources. Furthermore, the pressure on retail cost remains substantial, even though this represents a smaller part of the overall costs.

RATIONALE FOR RATING AFFIRMATION

The affirmation of SES Water's underlying Baa1 rating reflects, as positives, (1) the company's low business risk profile as the monopoly provider of essential water and sewerage services in the South East of England, with stable and predictable cash flows generated under a transparent and well-established regulatory regime; (2) historically good operational performance; and (3) partial risk mitigation from the structural enhancements included in its bond covenant and security package. The rating affirmation also takes into account management's efforts to reduce gearing to below 60% ahead of the start of the AMP7 regulatory period in April 2021 to improve its financial flexibility.

At the same time, SES Water's credit quality remains constrained by (1) decreasing financial flexibility as a result of declining allowed returns; (2) increasing efficiency and operational challenges for the next regulatory period; and (3) the high leverage allowed under the company's debt documentation.

WHAT COULD CHANGE THE RATING UP/DOWN

The outlook could be stabilised if Moody's concludes that SES Water's risk exposure to the lower return environment is adequately mitigated by a combination of a favourable final price determination outcome, cost savings measures to meet the significant efficiency challenges, and further balance sheet strengthening.

Conversely, the rating could be downgraded if, taking into account such measures as management may implement, it appears that SES Water will likely have insufficient financial flexibility to accommodate the expected reduction in allowed returns at PR19. In particular, downward pressure could result from (1) net debt to regulatory capital value (RCV) likely to be above 80%, and adjusted interest coverage persistently below 1.5x; and/or (2) a significant increase in business risk for the sector as a result of legal and/or regulatory changes leading to a reduction in the stability and predictability of regulatory earnings, which is not offset by other credit-strengthening measures.

The principal methodology used in this rating was Regulated Water Utilities published in June 2018. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

Sutton and East Surrey Water plc is one of the six water-only companies in England and Wales and the monopoly provider of essential water services to a population of about 707,000 in its franchise area of around 835 square km in the South East of England. Since 2013, SES Water has been jointly owned by Sumitomo Corporation (Baa1 stable) and Osaka Gas Co., Ltd. with each holding a 50% stake. In the year ending 31 March 2019, SES Water generated revenues of GBP66.8 million, with an operating profit of GBP20.1 million. SES Water is the third smallest water-only company by RCV, which was around GBP260 million as of YE March 2019.

REGULATORY DISCLOSURES

For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security 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.

Stefanie Voelz
VP - Senior Credit Officer
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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