In accordance with our criteria for government-related entities (GREs), we base our view of the “extremely high” likelihood of extraordinary government support on the following characteristics of K-Water:
-- Its “very important” role for the government of Korea given its essential public policy function to develop and manage Korea’s water resources; and
-- Its “integral” link with Korea’s government because of the government’s full ownership, tight supervision, and strong financial support. The government drives the company’s business and investment strategy, determines key budgetary decisions, and maintains tight control to ensure implementation of the company’s policy role. The Ministry of Land, Transport and Maritime Affairs supervises the GRE.
Standard & Poor’s raised its company’s long-term foreign and local currency ratings on the company to ‘A+’ from ‘A’ on Sept. 17, 2012, after raising its long-term foreign and local currency credit ratings on the Republic of Korea to ‘A+’ and ‘AA-', respectively, from ‘A’ and ‘A+'. Strong ties between K-Water and the government make the ratings on the sovereign a key driver for the ratings on K-Water.
Our stand-alone credit profile (SACP) of ‘bb’ for K-Water reflects our view that a substantial increase in debt to fund capital spending for the Four Major Rivers Restoration Project weighs on the company’s financial risk profile.
The Four Major Rivers Restoration Project is a government-led project to improve water security, flood control, and ecosystem vitality in four major rivers in Korea. K-Water expects to make Korean won (KRW) 8 trillion in capital expenditures on this project from 2009 to 2012. Though Korea’s government subsidizes interest payments on debt for the project and grants K-Water development rights for property surrounding the rivers to help recover project costs, the company’s investment in the project is primarily debt financed, and cash flow from property development remains uncertain. The company’s “strong” business risk profile partially mitigates its deteriorating financial risk profile. K-Water implements government policies related to development and management of water resources in Korea. In particular, the company is solely responsible for wholesale water supply and multipurpose dam construction in Korea. K-Water’s considerable capital requirements to implement its policy role have led to strong ongoing government financial and regulatory support. The government subsidizes a large portion of K-Water’s expenses for multipurpose dam construction, and the company receives perpetual rights to operate dams after construction is completed.
On the other hand, tight government regulation of water rates constrains the company’s profitability. Korean government concerns about inflation have led it to freeze water rates since 2008. We believe K-Water will have difficulty winning government approval to hike rates in 2012, because Korea is due to hold a presidential election during the year. Assuming that a rate increase will not go ahead and that the Four Major Rivers Restoration Project will not generate cash inflow apart from government financial support on financing costs in 2012, we believe the ratio of the company’s adjusted funds from operations (FFO) to debt is likely to fall below 5% over the next few quarters, compared with 13% on average over the past three years. We could lower the SACP if K-Water expands further into noncore businesses such as property development.
We assess K-Water’s liquidity to be adequate. We expect the company’s sources of liquidity to exceed 1.2x uses over the next 12 months. We estimate the company will have KRW2.9 trillion in liquidity, comprising cash, short-term investments, committed credit facilities, FFO, and government financial support. We estimate that the company will use about KRW2.3 trillion on committed capital expenditures, debt maturities, and working capital needs. Furthermore, K-Water has good access to the local capital market and supportive relationships with banks owing to its position as an important GRE in Korea.
The stable outlook reflects our expectations that K-Water’s very important roles in supplying Korea with water and constructing multipurpose dams will attract continued government support for the entity. We would lower the ratings if the company’s policy role or its link to the government were to weaken-- such as if the government reduced its stake in the company--or if the SACP for the company were to deteriorate to below ‘bb-'. Such deterioration in the SACP could occur if the company maintains higher than budgeted capital spending, including for the Four Major Rivers Restoration Project, and embarks on new noncore projects over the next few years while EBITDA margins remain below 35%.
Conversely, we could raise the ratings on K-Water if the likelihood of extraordinary government support were to increase.