Our assessment of EDP's "aggressive" financial risk profile reflects its high debt burden and maturities in a challenging funding environment, and our view of its weak credit metrics and high shareholder returns. Mitigating these weaknesses is the fresh financial support of China Three Gorges Corp. (CTG; A/Stable/--), EDP's new largest shareholder, which strengthens EDP's liquidity position and its deleveraging moves.
S&P base-case operating scenario
The relative stability of EDP's earnings in the first half of 2012, with EBITDA down 0.8% year-on-year, support our expectation that its operating performance in 2012 will remain resilient to challenging economic and regulatory conditions in its core Portuguese and Spanish markets. In our base-case scenario, we forecast a low single-digit EBIDTA growth in full-year 2012.
In particular, we expect capacity additions in wind globally, in hydropower in Portugal, and the commissioning of Pecem in Brazil to more than compensate for the contraction of liberalized activities under recessionary conditions, and the unfavorable foreign exchange effect and tariff freeze in the group's Brazilian operations. We also expect distribution earnings to increase slightly thanks to a tariff increase driven by Portugal's five-year credit default swap (CDS) average spread that should more than compensate for the cut in remuneration for Spanish assets decided by the government in March.
Beyond 2012, we expect the plants--essentially low-cost hydro plants-- leaving CMECs "Custos para a Manutencao do Equilibrio Contratual" to grow EDP's liberalized Iberian business, despite market conditions that we think could remain depressed. We anticipate that the coming on stream of new hydropower and wind capacity will result in EBITDA growth in the low-to-medium single digits despite the implementation of new adverse regulatory changes, notably in Spain following the electricity reform announced in September.
S&P base-case cash flow and capital-structure scenario
EDP's ratio of Standard & Poor's-adjusted funds from operations (FFO) to debt deteriorated further to 12.9% on June 30, 2012, on a rolling 12-month basis, from 15% on the same date the previous year, owing to mounting regulatory receivables, higher operating leases, and eroding cash flow generation. That said, we anticipate a turnaround in credit metrics in the next 12 months. In our base-case scenario, we anticipate that EDP will post neutral discretionary cash flow and an increase in its adjusted FFO-to-debt ratio to 16%-17% in 2013.
We anticipate that EDP's adjusted debt will decrease as a result of the sale for about EUR0.8 billion of minority stakes in wind farms to CTG and the disposal of transportation assets for about EUR260 million. We believe that lower capital expenditure, lower accumulation of regulatory receivables in Portugal and Spain, part of which in addition could be securitized, as well as a possible scrip option for future dividends could contribute further to the deleveraging of EDP.
Beyond 12 months, we think EDP's credit metrics will strengthen further, though mildly, on the back of positive additional disposals to CTG, and a possible reduction in tariff deficits in Spain and Portugal.
The short-term rating on EDP is 'B'. We assess EDP's liquidity as "adequate," as defined in our criteria.
Projected sources of funds exceed projected uses by more than 1.2x over the next 12 months.
We factor into our liquidity assessment for the next 12 months, based on our estimates, the following sources at end-June 2012:
-- About EUR1.4 billion in available cash plus the proceeds of the EUR750 million bond issued in September;
-- About EUR1.85 billion on available committed credit lines maturing beyond 12 months, including EUR1 billion recently granted by China Development Bank (AA-/Stable/A-1+) and EUR0.7 billion under a revolving syndicated line expiring in November 2015;
-- About EUR1.1 billion of asset disposals, including minority stakes to be acquired by CTG and the transmission assets of Naturgas; and
-- Our forecast of FFO of about EUR2.8 billion over the next 12 months.
Against these sources, we factor in the following liquidity uses:
-- Short-term debt of about EUR3 billion;
-- Our estimate of EUR1.9 billion in capital expenditures;
-- Dividend payments of about EUR800 million; and
-- Working capital needs of EUR300 million.
EDP has substantial debt of about EUR4 billion maturing in the next 12 months. The huge appetite for EDP's bond issued in September, the first bond issued by a Portuguese company in more than 18 months, is a positive development although we cannot exclude that markets could close again in the future. However, we expect China Development Bank to grant EDP a second credit facility for EUR1 billion, as part of the strategic agreement with CTG. Additional credit lines with Chinese banks under the umbrella of CTG for up to EUR2 billion could further support EDP's liquidity position. Furthermore, we believe EDP has the flexibility to cut capital expenditures, since its amount of committed projects decreases significantly over 2014-2015. We also believe that EDP's new shareholder structure gives it higher flexibility on dividends than before the privatization.
EDP's senior unsecured debt is rated 'BB+', in line with the corporate credit rating. The recovery rating is '3', indicating our expectation of meaningful (50%-70%) recovery in the event of a payment default.
Our recovery estimate reflects our view of EDP's significant stressed enterprise value at our hypothetical point of default in 2016, the absence of prior ranking secured debt in the capital structure (except for a modest EUR767 million of project-finance loans), and Portugal's insolvency regime, which we view as relatively favorable for creditors (see "Debt Recovery For Creditors And the Law of Insolvency In Portugal," published Dec. 14, 2007). The recovery rating is constrained by the unsecured nature of the debt and relatively weak credit protection provided by the documentation.
Importantly, the recovery ratings are capped at '3', although debt coverage exceeds the 50%-70% range. This is because our criteria state that the recovery rating on unsecured debt issued by corporate entities rated 'BB-' or higher is capped at '3' to account for the risk that recovery prospects may be impaired by the issuance of additional priority or pari passu debt before default (see "Criteria Guidelines For Recovery Ratings On Global Industrials Issuers' Speculative-Grade Debt," published on Aug. 10, 2009).
EDP's corporate structure is fairly complex. However, the majority of debt is issued by EDP (approximately 12% of total debt) or its finance vehicle EDP Finance B.V. (EDP BV; about 75%). EDP BV's debt issues include a EUR10 billion European medium-term note (EMTN) program, which benefits from a "keep-well" agreement from EDP. The keep-well agreement and the documentation for the EMTN program indicate that the notes rank pari passu with EDP's other bank debt and loans, and cross-default provisions are in place. All debt issued in Brazil (7%) is completely ring-fenced and is nonrecourse to EDP.
In the event of a default, we believe EDP would be reorganized rather than liquidated, given its strong market position. Our hypothetical default scenario contemplates a default in 2016, owing to a sustained period of operating underperformance, generally poor economic conditions in Portugal and Spain, and excessive financial leverage, resulting in incapacity to refinance maturing debt.
We used discrete asset valuation methodology to calculate EDP's stressed enterprise value, applying severe stresses. Under our assumptions, we calculate a stressed enterprise value at the point of default of about EUR18.42 billion.
The negative outlook on the long-term rating on EDP mirrors that on the long-term rating on Portugal. Under our criteria for rating nonsovereign entities higher than their related sovereign in the eurozone, the rating on EDP is capped at one notch above the sovereign credit rating on Portugal.
A downgrade of Portugal to 'BB-', 'B+', or 'B' would automatically trigger a downgrade of EDP of the same magnitude, unless:
-- We revised our assessment of EDP's exposure to Portugal to "moderate" from "high," which we consider unlikely in the foreseeable future unless EDP's new large shareholder fundamentally changes EDP's business parameters. This could exceptionally prompt us to consider a two-notch differential with the sovereign rating; or
-- We believed EDP would receive extraordinary support from CTG or related Chinese banks if it faced refinancing stress. However, CTG currently only holds a minority stake in EDP and has only a short record as EDP's owner.
We could also lower our rating on EDP if it faced unexpected and far-reaching regulatory changes that in our view undermine its business risk or financial risk profiles.
We consider that ratings upside is remote at this stage. All else being equal, an upgrade of EDP would hinge on an upgrade of Portugal.
Related Criteria And Research
-- Portugal's Ratings Lowered To 'BB/B'; Recovery Rating Of 4 Assigned; Outlook Negative, Jan. 13, 2012
-- Credit FAQ Discusses The Potential Effects Of Portugal's Ratings And Privatization On Portuguese Utilities EDP And REN, Dec. 22, 2011
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- General Criteria: Nonsovereign Ratings That Exceed EMU Sovereign Ratings: Methodology And Assumptions, June 14, 2011
-- Use Of CreditWatch And Outlooks, Sept. 14, 2009
-- Criteria Guidelines For Recovery Ratings On Global Industrials Issuers' Speculative-Grade Debt, Aug. 10, 2009
-- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009