Ratings On ENN Energy Holdings Ltd. Raised To #BBB+# On Stronger Financial Outlook Stable

Stocks and Financial Services Press Releases Monday April 30, 2018 18:12
HONG KONG--30 Apr--S&P Global Ratings

HONG KONG (S&P Global Ratings) April 30, 2018--S&P Global Ratings said today that it had raised its long-term issuer credit rating on ENN Energy Holdings Ltd. to 'BBB+' from 'BBB'. The outlook on the long-term rating is stable. At the same, we raised the long-term issue rating on the company's senior unsecured notes to 'BBB+' from 'BBB'.

ENN is a China-based major clean energy distributor with total gas sales of 19.6 billion cubic meters (bcm) in 2017.

We raised the ratings on ENN to reflect our view of its solid improvement in financial performance, as supported by its robust growth of gas sales volume, and decent household connection fee income from increasing gas penetration.

We expect ENN's funds from operations (FFO)-to-debt ratio to improve further to 36%-40% in 2018-2019. The ratio was over 33% in 2017, exceeding our upgrade trigger of 32%. China-based ENN is one of the largest city gas companies. It has a national footprint and operates over 172 projects on 25 to 30 years' concession with local governments.

We expect ENN will continue to benefit from China's strong demand for natural gas over the next two years, maintaining annual growth of gas sales volume of 15%-20%. China's ongoing economic growth and accelerated urbanization will boost energy demand. In addition, the central government's initiative to reduce pollution and promote natural gas utilization as a replacement of coal, especially in the rural areas of the northern region, will increase demand. In 2017, ENN's growth was 33.7% from piped gas sales and the company secured 2 million new household connections. In the first quarter of 2018, we expect 20% growth of piped gas sales volume year-on-year.

Furthermore, ENN's rapidly expanding integrated energy business supplemented top-line growth. We expect this segment to contribute up to Chinese renminbi (RMB) 10 billion in revenue by 2020. That said, we believe the gross margin from this segment is lower compared with its core businesses in the near term. Therefore, this segment's impact on the overall cash flow will be limited.

Strong top-line performance from gas sales will also partially temper the pressure on ENN's margin. In 2017, the company's dollar margin from gas sales compressed to 0.63 from 0.73 (excluding value-added tax [VAT]) due to increased gas consumption by power plant customers, and insufficient or less timely pass-through of cost hikes during the gas shortage in the winter. However, its total EBITDA amount still rose 14%. We expect the company's average selling price or margin to be remain largely stable, despite some pressure from the central government's policy goal to lower corporate costs.

We believe gas supply will improve in the coming winter, as ENN and its suppliers seek various channels to ensure stable supply. ENN has signed annual take-or-pay contracts with major suppliers such as CNPC and Sinopec. Moreover, ENN can import liquefied natural gas (LNG), if needed, through the Zhoushan LNG receiving terminal owned by ENN Group, a company controlled by ENN's chairman. The first phase of Zhoushan terminal is targeted to be operational by mid-2018. Upon completion of all phases, the LNG terminal can handle up to 10 million metric tons of LNG per year, or about 14 bcm when converted to gas, which is more than 70% of the company's total gas sales volume in 2017.

In our view, China's evolving regulatory regime should increase regulatory transparency and predictability for the country's gas transmission and distribution businesses. In July 2017, the regulator proposed a cap of 7% investment returns for determining distribution tariffs (excluding connection fees). The implementation depends on the detailed scheme that each provincial government will develop by the end of June 2018.

However, we believe further regulatory clarity on connection fees would provide higher cash flow visibility for utilities. That's because these fees comprise a significant part of the profit and cash flow of most city gas companies. In 2017, ENN had about 45% of its gross profit coming from connection fees. Because of the central government's favorable sentiment toward gas usage and the role of connection fees to fund the significant capital expenditure of operators, we believe the chance of removing connection fees is slim over the next two to three years. However, the regulator may gradually phase out and/or incorporate the fees into the capacity component of tariffs.

We believe financial discipline is key for ENN to maintain its leverage position and credit stability amid elevated capital expenditure due to its expansion of the integrated energy segment. Barring an unexpected sizable investment, its capital expenditure commitment (together with acquisition of new projects) of RMB6 billion is still manageable. The company's robust operating cash flow can continue to support capital expenditure, and its free operating cash flow should remain positive.

Compared with ENN's peers with similar financial risk profiles, we view ENN's credit quality to be stronger and have more headroom. We anticipate the company will slightly deleverage in 2018 after repaying the outstanding US$479 million convertible bonds by exercising the cash settlement option for US$469 million of the total amount and converting the remaining portion into ordinary shares in February 2018.

The stable rating outlook on ENN reflects our expectation that the company will continue to consolidate its financial strength over the next 24 months with a disciplined approach toward large acquisitions. Organic growth and stringent environmental measures should continue to underpin the stable growth of the company's gas sales and new user connections.

We could lower the rating if ENN's financial strength weakens, as indicated by a ratio of FFO to debt dropping below 32% consistently. This could happen due to:
  • Subdued growth as a result of weaker economic conditions in China;
  • Significant delay in cost pass-through because of adverse regulatory changes; or
  • Aggressive expansion either domestically or overseas that significantly increases its debt burden.
We may also see downside pressure if the company's unregulated business grows significantly, leading to higher cash flow volatility and business risks.

While further upside is less likely in the short term, we could raise the rating if ENN's financial strength further improves significantly, such that we expect its ratio of FFO to debt to approach 45%, while free operating cash flows remain positive on a sustainable basis. Such improvement should also be associated with an articulated and supportive financial policy and a track record of financial discipline toward capital expenditure and acquisitions.

Potential further improvement in the regulatory environment, such as better transparency or predictability supported by a solid track record and insulation from political interference, could also lead us to upgrade the company.


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