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ESKOM HOLDINGS SOC LIMITED - Rating Update

Release Date: 20/03/2015 15:30
Code(s): EL31 EL30 ES18 EL29 ES15 ES23 ES42 EL037 EL15 EL28 EL36 ES26 ES33     PDF:  
Wrap Text
Rating Update

ESKOM HOLDINGS SOC Ltd

20 March 2015

RATING UPDATE


Research Update:
South African Power Utility ESKOM Holdings SOC
Downgraded To 'BB+' Following Management
Suspensions; Outlook Negative

Overview
The recent announcement of ESKOM Holdings SOC Ltd.'s board regarding the suspension
of the company's CEO and three senior executives has led us to have less confidence in the
company's corporate governance arrangements as well as in its stand-alone credit profile
(SACP).
We continue to assume there is an extremely high likelihood that ESKOM would receive
extraordinary state support if needed, which currently leads us to add six notches of uplift to
our assessment of the company's SACP.
Consequently, we are lowering our long-term ratings on ESKOM to 'BB+' from 'BBB-' and
national scale ratings to 'zaA/zaA-2' from 'zaAA-/zaA-1'.
The negative outlook reflects our opinion that material execution risk remains associated
with the government's support plan, and that ESKOM's operating performance has not yet
stabilized due to rising costs and the very tight generation capacity margin in South Africa.

Rating Action
On March 19, 2015, Standard & Poor's Ratings Services lowered its long-term local and
foreign currency ratings on South Africa power utility ESKOM Holdings SOC Ltd. to 'BB+'
from 'BBB-'. The outlook is negative.
At the same time, we lowered our long- and short-term South Africa national scale ratings to
'zaA/zaA-2' from 'zaAA-/zaA-1'.

Rationale
The downgrade reflects our reassessment of ESKOM's management and governance
to "weak" from "fair." Also, we have revised down our assessment of ESKOM's stand-alone
credit profile (SACP) to 'ccc+' from 'b-', leading us to lower the long-term rating to 'BB+' from
'BBB-'.
Our view of ESKOM's "weak" business risk profile factors in our assessment of a "weak"
regulatory advantage under the framework supervised by the national energy regulator of
South Africa. The business risk profile also reflects our opinion of important execution and
operational risks associated with ESKOM's very large capital expenditures program, which
has been subject to successive delays at a time when South Africa's reserve margin remains
stretched.

Our assessment of ESKOM's "highly leveraged" financial risk profile incorporates our
opinion that the company's stand-alone credit metrics will remain weak over the medium
term, due to continued delays in implementing tariffs that reflect its real-time costs,
investment needs, and the rising debt associated with its large capital expenditures. We
apply our standard volatility table to ESKOM, as per our corporate methodology criteria,
because we assess its regulatory advantage as "weak."
Our revised view of ESKOM's management and governance as "weak" is based on the
following observations:
The recent announcement of ESKOM's board regarding the suspension of the company's
CEO and three senior executives, pending an inquiry, leads us to question the corporate
governance arrangements at the company.
We think the suspension of such senior members of the executive introduces a gap in the
leadership at the company at an important time, given that the entity still has material
operational and liquidity management issues to overcome.
ESKOM has a track record of high turnover at the senior executive level, with a number of
changes in CEOs and CFOs in recent years.
The suspension also leads us to question the timing of the delivery of new power plants and
the cost of project completion.
The pending inquiry is expected to last three months, and the results if they reveal further
cost overruns, delays in the delivery of power, or cash flow weaknesses--could lead to a
further deterioration in the company's credit quality.
However, we could reassess our view of ESKOM's management and governance if the
company implements practices to counteract management's shortcomings.
We consider ESKOM to be a government-related entity (GRE). Under our criteria for GREs,
we believe there is an "extremely high" likelihood that the Republic of South Africa would
provide timely and sufficient extraordinary support to ESKOM in the event of financial
distress. This is based on our view of ESKOM's: "Very important" role for South Africa, since
it is the nation's dominant electricity provider. The government considers ESKOM to be a
strategic asset and, in our view, privatization is unlikely in the medium term.
ESKOM provides an essential commodity to municipalities and large industrial customers;
and "Integral" link to the South African government, reflecting its full ownership by the
government and the explicit government support.
Also, ESKOM obtained a dividend waiver from the government during the build program.
Moreover, the South African government has a strong track record of providing extraordinary
support to critical GREs, including ESKOM, which has received capital injections and large
guarantees from the government in the past.
Our assessment of an "extremely high" likelihood of government support leads us to apply
six notches of uplift to the SACP, resulting in our 'BB+' long-term rating on ESKOM.

Liquidity
Our "less than adequate" assessment of ESKOM's liquidity reflects the pressure ESKOM
faces, based on our assumptions of negative working capital, higher capital expenditures,
and the continued challenging operational environment.
In addition, we think that the company has a relatively high dependence on what we
consider to be uncommitted sources of funding to support its debt maturity profile.
In our calculation of the company's liquidity sources, we include sovereign-guaranteed
domestic bond issuances amounting to about South African rand (ZAR) 12 billion-ZAR15
billion from Jan. 21, 2015, to Jan. 21, 2016, along with committed facilities amounting to
ZAR13 billion from development finance institutions (DFIs) and export credit agencies
(ECAs). We note that ESKOM may choose to draw down close to ZAR41 billion under the
ZAR150 billion sovereign-guaranteed domestic medium-term note (DMTN) program over
March 2014-March 2018, of which currently ZAR51 billion are still available for issuance. But
these amounts could change, depending on discussions with the government regarding how
to utilize the remaining ZAR200 billion in government-guaranteed issuances.
However, we assume that ESKOM is unlikely to tap more than ZAR12 billion-ZAR15 billion
under its DMTN program in any given year, based on potential constraints on the domestic
market's capacity to absorb such issuances. We note that ESKOM currently continues to tap
issuances of between ZAR1 billion and ZAR2 billion per month under its commercial paper
(CP) program, and is currently exploring alternative funding sources by way of banks and
capital markets, as well as the announced equity contribution from the government through
the government's asset disposal program. ESKOM's liquidity position could benefit if the
company executes these initiatives successfully. However, we do not include potential future
sources of CP program issuances as liquidity sources, as per our criteria, nor do we include
potential future sovereign-guaranteed issuances (beyond our one-year outlook horizon) or
any other potential issuance. This is because we do not assume that companies are able to
borrow in the future unless such lines are committed. Furthermore, we do not include the
government's expected equity contribution from future asset disposals.
We forecast that ESKOM's sources will cover its liquidity uses by less than 1.2x over the 12
months started Jan. 21, 2015.
We calculate that ESKOM has the following liquidity sources for the 12 months
started Jan. 21, 2015:
 Estimated funds from operations (FFO) of between ZAR18 billion and ZAR22 billion;
Committed lines of ZAR1.4 billion; and · Debt of about ZAR25 billion to be raised from
committed or reliable sources such as DFIs and ECAs, and the domestic bond market.
We calculate the following liquidity uses for the same period:
· Capital expenditures of about ZAR60 billion;
· Negative working capital of about ZAR5 billion-ZAR15 billion; and
· Loans and interest due of about ZAR30 billion.

Outlook
The negative outlook reflects our opinion that considerable execution risk remains
associated with the government's support plan. ESKOM's operating performance has not yet
stabilized due to rising costs combined with a doubtful interim tariff regime reprieve, a very
tight capacity margin in South Africa, and a less than effective executive management team.
Moreover, we think that there is a risk that ESKOM's financing needs may exceed what is
currently covered in the government's additional support package.
To revise the outlook to stable, we would need to believe that ESKOM could sustain
adjusted FFO to debt of at least 5% in the medium term, with no additional strain on liquidity.
ESKOM's management needs to demonstrate a track record of effective control of major
projects and a restored relationship with key stakeholders, such as the ESKOM board and
the South African government.

Downside scenario
We could lower the ratings on ESKOM if we were to revise our SACP assessment
to 'ccc' or lower, or if we saw a reduced likelihood of extraordinary government support for
the company. A deterioration of the SACP could result if we consider that, over the next 12
months, ESKOM may be about to experience a near-term liquidity crisis, violation of financial
covenants, or is likely to consider a distressed exchange offer or redemption. A deterioration
in the SACP could occur, for example, if the regulator does not grant additional tariff
increases during the current regulatory period (MYPD3), as it did for the fiscal year ending
April 2016, that are sufficient to allow Eskom to adequately manage ongoing debt service
requirements. A deterioration in the SACP could also occur, due to other elements, such as
the announced equity contribution from the government's asset disposal program or
conversion of government loans to equity, or if ESKOM's operating performance deteriorated
further because of additional cost overruns or a lack of progress in planned efficiencies,
without offsetting government support. A weakening of the SACP by one notch would, all
else being equal, likely result in a one-notch downgrade of ESKOM to 'BB'. We could also
lower the ratings if we were to revise downward our assessment of the likelihood of
extraordinary support from "extremely high." This could occur if ESKOM develops additional
funding requirements that are not explicitly covered by government support, or if the
announced support program is not implemented on time or in full. All else remaining equal,
this could lead us to downgrade ESKOM by three notches, to 'B+'.

Finally, we could lower the ratings on ESKOM if we lowered the sovereign rating on South
Africa, all else remaining equal. Under our criteria for GREs, a one-notch downgrade of the
sovereign would result in a one-notch downgrade of ESKOM.
Upside scenario
We consider an upgrade unlikely in the foreseeable future given the current
pressures on the SACP. Under our GRE criteria, an upward revision by one notch
in our assessment of ESKOM's SACP would result in an upgrade of ESKOM by one
notch, assuming unchanged government support. However, an upgrade could materialize if
we believed the likelihood of government support had increased to "almost certain," which
would result in us equalizing the ratings on ESKOM with the sovereign rating. That said, we
consider this unlikely in light of the government's finite resources and the actions it has taken
to support ESKOM to date.

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