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Rating Action:

Moody's confirms Portsmouth Water's Baa1 rating; negative outlook

25 Mar 2020

London, 25 March 2020 -- Moody's Investors Service (Moody's) has today confirmed the Baa1 long term corporate family rating of Portsmouth Water Limited (Portsmouth Water). The outlook has been revised to negative from ratings under review.

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 forthcoming regulatory period (AMP7).

RATINGS RATIONALE

Today's rating confirmation reflects (1) Portsmouth Water's low business risk profile as a monopoly provider of water services under a well-established and transparent regulatory framework; (2) its solid and cost-efficient performance track record, underpinned by cost allowances for the next regulatory period that significantly exceed the company's request; and (3) low financial leverage, expected to average around 55% of net debt to regulatory capital value (RCV) over the coming five years, which is underpinned by equity contributions from the company's owners to support material investments and offsets some of the pressure of the low allowed returns.

However, Moody's also considers the risks associated with a significant investment project to build the Havant Thicket Winter Storage Reservoir (HTWSR) over a ten-year period and some uncertainty around the ongoing procurement and permitting process, which is reflected in the negative outlook. The size and scale of the project will require significant management attention and produce a new challenge, particularly in the context of Portsmouth Water's limited scale. The procurement of construction contractors and environmental and planning approval processes have only started and are expected to continue into 2021/22, which creates uncertainties around the project's cost and timeline, although the separate regulatory approach towards HTWSR provides some mitigation for changes or delays outside of management's control.

Today's rating action also takes into account the regulatory final determination for the AMP7 period and the significant cut in allowed wholesale returns to ca. 2.61% real in cash terms from 2020, which incorporates the regulator's decision to link half of the regulatory assets as at 31 March 2020 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 Portsmouth Water will have an average allowed cash return of around 2.75% over AMP7. On an RPI-stripped basis, for comparison with the current period, allowed returns will fall to 2.11% (2.21% including retail margin) from 3.75% for wholesale activities (or 3.89% including the retail margin), a nearly 45% cut. Portsmouth Water will benefit from a small company premium but the still significant cut in allowed returns will pressure interest cover metrics. This is because the company has an inflexible capital structure with essentially one long-dated and expensive piece of debt.

Under a separate ten-year price control for HTWSR, the company has also been allowed a CPIH-based return that is in line with the industry's WACC, i.e. not including the small company premium applied to Portsmouth Water's core business. The HTWSR return will be subject to a re-opener at the five-year mark.

Unlike most of its peers, Portsmouth Water received a total expenditure allowance that is above what it asked for. At around 8% this is, by far, the largest excess allowance and indicative of the company's cost efficiency compared with peers. The excess will likely allow Portsmouth Water to significantly outperform its cost allowances and offset the pressure from lower returns as well as an additional negative revenue adjustment associated with its performance over the current period, ending March 2020, as well as excess revenues collected over that time.

In addition, following the industry-wide softening of some performance targets and incentive rates, the company may also be able to earn net performance rewards over the AMP7 period.

Moody's base case scenario, reflecting the final determination, results in Portsmouth Water exhibiting an Adjusted Interest Coverage Ratio (AICR) in the range of 1.5-1.6x, or around 1.3-1.4x on the core business alone, excluding the implied return for HTWSR. Gearing is forecast to remain broadly around 55%, providing a buffer against the weakening interest cover but also the risks associated with the uncertainty related to the HTWSR procurement and permitting process. Moody's views the company's forecast metrics as overall supportive of the current Baa1 rating.

This view also reflects Portsmouth Water's smaller size, which leaves it more exposed to cost shocks, and its long-dated and relatively inflexible financing structure, albeit somewhat mitigated by the structural enhancements included in the company's bond covenant and security package. Key supporting features include (1) a cash trapping mechanism, which is designed to help maintain and restore credit quality by preventing distributions and retaining cash within the company in downside scenarios; (2) liquidity facilities (and/or cash reserves) equal to six months' of debt service; (3) a first-ranking fixed charge over the shares in the company, plus first-ranking and floating charges over all the assets, rights and undertakings of Portsmouth Water; and (4) a mandatory sinking fund arrangement to reduce refinancing risk.

RATING OUTLOOK

The rating outlook is negative, reflecting the uncertainties around the procurement and permitting process for HTWSR and ongoing negotiations around the associated bulk supply contract. The outlook could be stabilised if these are successfully concluded and the risk allocation of the various arrangements does not put undue strain on Portsmouth Water's credit quality and the company is otherwise generally performing in line with its business plan.

WHAT COULD CHANGE THE RATING

Given the negative outlook and the general challenges of the final determination as well as sizeable investment programme, Moody's does not currently envisage any upward rating pressure.

The ratings could be downgraded if HTWSR procurement and approval proceedings result in significant changes, delays or other risks for the company, which are not appropriately mitigated by regulatory or contractual arrangements or other balance sheet strengthening measures. In addition, the rating could be downgraded if Portsmouth Water was likely to exhibit gearing, measured by net debt to RCV, above 80%, and an AICR persistently below 1.5x. Moody's notes, however, that significant gearing headroom may allow the company to sustain an AICR slightly below this level.

Finally, downward rating pressure could also arise 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 is not offset by other credit-strengthening measures, of the company facing unforeseen funding difficulties.

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.

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 plc by Severn Trent Water Limited) and has the lowest average customer bills of all the water service providers in the sector. The company supplies around 320,000 homes and businesses in 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.

In the year to March 2019, Portsmouth Water had an RCV of GBP150.1 million, reported revenues of around GBP42.2 million and operating profit of GBP7.9 million.

Since March 2018, Portsmouth Water is wholly owned by funds managed by Ancala Partners LLP, an independent infrastructure investment manager.

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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