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Rating Action:

Moody's confirms Affinity Water's ratings; negative outlook

26 Mar 2020

London, 26 March 2020 -- Moody's Investors Service (Moody's) has today confirmed the Baa1 corporate family rating (CFR) of Affinity Water Limited (Affinity Water) as well as the A3 senior secured debt rating of Class A notes and Baa3 subordinated rating of Class B notes issued by its finance subsidiaries and guaranteed by Affinity Water. The rating outlook is negative.

A full list of affected ratings is attached towards the end of this press release.

This rating action concludes the rating review initiated on 20 December 2019, following publication by the Water Services Regulation Authority (Ofwat), the economic regulator for water companies in England and Wales, of its final determination for the five-year regulatory period commencing April 2020 (AMP7).

RATINGS RATIONALE

Today's rating confirmation reflects Moody's view that, going into AMP7, Affinity Water has the capacity to maintain financial ratios in line with guidance for its current ratings and that any underperformance against regulatory assumptions may be mitigated by management action to defend credit quality. At the same time, the negative outlook reflects the risk that if operating performance cannot be improved or otherwise offset by credit-strengthening measures, Affinity Water's Adjusted Interest Coverage Ratio (AICR), would likely fall below the 1.3x minimum guidance for its Baa1 rating.

The rating confirmation positively reflects the company's low business risk profile as a monopoly provider of water services operating under a well-established, transparent and predictable regulatory framework and the benefit to creditors from the bond covenant and security package. However, at the start of the new regulatory period, Affinity Water faces (1) a significant cut in allowed wholesale returns to ca. 2.4% real in cash terms, compared with 3.6% in the current period; and (2) challenging performance targets. Compared with the regulator's draft determination, Ofwat's final determination has reduced the company's exposure to the risk of cost overruns, but not eliminated the risk of performance penalties.

On 16 December 2019, Ofwat published its final determination for AMP7. As previously flagged by the regulator, the determination includes a significant cut in allowed cash returns to ca. 2.42% for the wholesale activities at the start of the new period, which incorporates the regulator's decision to link half of the regulatory assets as at 31 March 2013 to the Consumer Prices Index adjusted for housing costs (CPIH), with the rest remaining linked to the Retail Prices Index (RPI). As the share of regulatory assets linked to CPIH grows over time, Moody's estimates that Affinity Water will have an average allowed cash return of around 2.5% over AMP7. On an RPI-stripped basis, for comparison with the current period, allowed returns will fall to 1.92% (1.96% including retail margin) from 3.6% (3.74% including the retail margin), a nearly 50% cut. Affinity Water has a lower embedded cost of debt than some of its peers, but the material cut in allowed returns coupled with the company's continuing high gearing will pressure interest coverage metrics.

Ofwat's allowances for base operating and maintenance expenditure, excluding enhancement projects but including retail costs, were GBP1.2 billion, broadly in line with the company's request in its August 2019 draft determination response. For enhancement expenditure, Affinity Water was also granted an allowance roughly in line with the amount requested in its August 2019 draft determination response, including a separate GBP83 million of spending related to strategic water resources development.

However, the company continues to be exposed to stringent operational targets, despite Ofwat lowering the level of stretch on a number of performance commitments. Moody's estimates that Affinity Water could face net performance penalties of around GBP24 million over the AMP7 period, if it performed in line with its business plan. These penalties would largely be linked to leakage, supply interruptions and mains bursts, as well as penalties on the new customer satisfaction measures, given its historically weak performance in that area. While penalties will be paid with a two-year lag and may thus only bite in the later part of the period, the majority of penalties would still affect cash flows during the AMP7 period. In addition, the calibration of targets and incentive rates means that severe weather events could carry disproportionate downside risk.

Moody's base case scenario, reflecting the final determination, results in Affinity Water exhibiting an AICR within the range of 1.2-1.4x, and gearing at just under 80% over the AMP7 period. These ratios position the company weakly against its current Baa1 rating and if Affinity Water incurs the penalties estimated by Moody's then the AICR could fall persistently below the 1.3x guidance for the current rating. However, total expenditure allowances in line with the company's ask may allow Affinity Water to invest in performance improvements that could help avoid significant penalties.

Finally, Affinity Water's current Baa1 CFR takes into account the benefit to creditors from the company's covenant and security package. Key creditor protections include (1) a cash trapping mechanism, designed to maintain and restore credit quality by preventing distributions and retaining cash in the company if certain financial ratios are breached; (2) liquidity facilities (and/or cash reserves) equal to 12 months of debt service; (3) a first-ranking fixed charge over Affinity Water's shares, plus first-ranking fixed and floating charges over all of the company's assets, rights and undertakings; (4) the agreement by financial creditors to give up their individual rights to petition for insolvency proceedings and (5) restrictions on debt maturity concentration.

RATING OUTLOOK

The negative outlook reflects the risk that Affinity Water's metrics could fall outside of the minimum guidance for the current rating (outlined below), if it is not able to avoid or otherwise offset performance penalties over the AMP7 period. The outlook could be stabilised, if ongoing investments will lead to improved operational performance or the company can mitigate weaker ongoing cash flows by credit-strengthening measures.

WHAT COULD CHANGE THE RATING

Given the current negative outlook and the challenges presented by the final determination Moody's currently does not envisage any upward rating pressure.

The ratings could be downgraded if Affinity Water was likely to exhibit gearing, measured by net debt to RCV, persistently above 80%, and an AICR persistently below 1.3x.

In addition, downward rating pressure could result from 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 are not offset by other credit-strengthening measures; or the company facing unforeseen funding difficulties.

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

LIST OF AFFECTED RATINGS

Confirmations

..Issuer: Affinity Water Finance (2004) Plc

....BACKED Senior Secured Regular Bond/Debenture, Ratings Confirmed at A3

..Issuer: Affinity Water Finance Plc

....BACKED Subordinate Regular Bond/Debenture, Ratings Confirmed at Baa3

....BACKED Senior Secured Regular Bond/Debenture , Ratings Confirmed at A3

..Issuer: Affinity Water Limited

....LT Corporate Family Rating, Rating Confirmed at Baa1

Outlook Actions:

..Issuer: Affinity Water Finance (2004) Plc

....Outlook, Changed To Negative From Rating Under Review

..Issuer: Affinity Water Finance Plc

....Outlook, Changed To Negative From Rating Under Review

..Issuer: Affinity Water Limited

....Outlook, Changed To Negative From Rating Under Review

Affinity Water Limited is the largest of the six water-only companies (WoCs) in England and Wales in terms of customers served. It is the second largest by RCV (after South East Water Limited), with an RCV of GBP1.2 billion as at March 2019. For the 12 months ended 31 March 2019, Affinity Water reported revenue of GBP312 million and operating profit of GBP59 million. The company supplied water to around 1.3 million household customers and over 66,000 local businesses (equivalent to a population of over 3.6 million people) across parts of Bedfordshire, Berkshire, Buckinghamshire, Essex, Hertfordshire, Surrey, Kent and London.

Since May 2018, Affinity Water's ultimate shareholders are Allianz Capital Partners (36.6% share), HICL Infrastructure (36.5%) and DIF Infrastructure (26.9%).

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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