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Rating Action:

Moody's changes outlook on South Staffs Water to negative, affirms ratings

03 Sep 2019

London, 03 September 2019 -- Moody's Investors Service ("Moody's") has today changed the outlook to negative from stable on South Staffordshire Water Plc (South Staffs Water), a water-only company operating in the English Midlands and the City of Cambridge. At the same time, the rating agency affirmed the company's Baa2 senior unsecured debt rating.

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

RATINGS RATIONALE

RATIONALE FOR NEGATIVE OUTLOOK

Today's action reflects South Staffs Water's exposure to a likely significant cut in allowed returns from 2020, a material negative revenue adjustment for over-recoveries in the current period as well as challenging cost efficiency targets, as outlined in the industry regulator's draft determination, published on 18 July 2019. It also takes into account Moody's financial ratio guidance for the sector, which was recalibrated in May 2018 to reflect the rating agency's perception of increased regulatory risk. In this context, the negative outlook reflects Moody's view that the company may be unable to maintain credit metrics in line with the guidance for the current Baa2 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.

In addition, the regulator included a true-up adjustment, which will reduce South Staffs Water's revenues in the next regulatory period, primarily due to the company receiving higher actual developer contributions in the current period compared with previous regulatory assumption. The overall revenue cut, which also includes other minor adjustments, amounts to ca. GBP14.3 million over the period, whereas the company expected a small GBP1.5 million revenue uplift.

Reflecting the draft determination, Moody's expects South Staffs Water's Adjusted Interest Coverage Ratio (AICR) to be just under 1.3x on average over the next five-year period, or closer to 1.2x when taking into account a further 37bps cut in the allowed return as highlighted by the regulator. These ratio levels would be below the rating agency's 1.5x guidance for South Staffs Water's Baa2 rating, with the impact of the revenue claw-back accounting for a close to 0.3x fall in the AICR.

South Staffs Water's AICR is also under pressure due to its embedded cost of debt being significantly above the regulators allowance, albeit its debt mostly being inflation linked, and the relatively long debt tenor. Moody's, however, takes into account that the risk is partially mitigated by the company maintaining material gearing headroom.

Finally, South Staffs Water faces a total cost efficiency challenge of 10.5%, just marginally below the sector average of 11%. Key differences between the company's plan and the regulator's efficient cost assessment are around base operating and maintenance costs, where the company's proposal remains 7.5% above the regulatory efficient cost assessment versus 4% for the sector as a whole, as well as enhancement expenditure, where South Staffs Water's proposed costs remain ca. 28% too high. While a cut in enhancement expenditure may allow the company to adjust certain growth-related projects, South Staffs Water will have to redirect funds for investment necessary to enable it to meet challenging performance targets from other sources.

RATIONALE FOR RATING AFFIRMATION

The affirmation of South Staffs Water's Baa2 rating reflects, as positives, (1) the company's low business risk profile as the monopoly provider of essential water services, with stable and predictable cash flows generated under a transparent and well-established regulatory regime; (2) strong operational performance, which if sustained, will result in regulatory outperformance for the current regulatory period 2015-20; and (3) a conservative gearing target of net debt to regulatory capital value (RCV) in the region of 66%.

At the same time, South Staffs Water's rating is constrained by (1) the company being part of the wider South Staffordshire Plc group, with additional debt situated at the holding company; and (2) the company's relatively small size, which leaves it more exposed to material negative events such as cost shocks.

South Staffs Water has a highly-covenanted financing structure with a range of creditor protections. Moody's does not, however, consider that the financing terms provide as much credit enhancement as those in comparable highly covenanted transactions. In particular, the structure does not include specific requirements to maintain additional liquidity reserves nor does it provide any security for creditors.

WHAT COULD CHANGE THE RATING UP/DOWN

The outlook could be stabilised if Moody's concludes that South Staffs 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 cost 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 South Staffs 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 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.

South Staffordshire Water Plc is the fourth-largest of six water-only companies (WoCs) in England and Wales by RCV, with reported RCV (including Cambridge Water) of around GBP380 million as at March 2019. The company provides water services to a population of nearly 1.3 million within an area of 1,500 square kilometres in the English Midlands and around 319,000 people in the city of Cambridge and the surrounding area.

For the year ended 31 March 2019, South Staffs Water reported revenues of GBP124 million and operating profit of GBP31 million. The company is owned by South Staffordshire Plc, which is in turn owned 55.1% by long-term pension funds and institutional investors, advised and managed by Arjun Infrastructure Partners, and 44.9% controlled by Mitsubishi Corporation (A2 stable), through a direct 25% ownership stake and a 19% stake held by Mistsubishi UFJ Lease & Finance Company but managed by Mitsubishi Corporation.

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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