Fitch Rates Comision Federal de Electricidad's USD1B Note Issuance 'BBB+'

MONTERREY, Mexico--()--Fitch Ratings has assigned a 'BBB+' Long-Term rating to Comision Federal de Electricidad's (CFE) USD1 billion note issuance due 2026. Proceeds from the issuance are expected to be used for working capital needs.

KEY RATING DRIVERS

CFE's ratings incorporate the company's strong linkage with the Mexican government and the government's implicit support. CFE's Foreign- and Local-Currency Issuer Default Ratings (IDRs) are at the same level as Mexico's sovereign rating. The ratings also reflect CFE's position as the largest electric utility in Mexico and its monopoly on transmission and distribution activities, which makes it strategically important for the country. CFE's ratings also incorporate high debt levels, improvement in unfunded pension liabilities, limited free cash flow generation, and risk of political interference.

Strong Linkage with Government

The relationship between CFE and the government is strong and extends beyond its ownership. CFE is governed by a board of directors, which includes the ministers of energy, finance, economy, and environment and natural resources. The board also includes the undersecretary of the Secretaria de Energia (SENER), four independent members, and the minister of the national executive committee of the only union of electrical workers in Mexico.

The government, through the Comision Reguladora de Energia (CRE), directly sets electricity tariffs to all electricity users, except for those high tension industrial users that decide to participate in the wholesale electricity market and establishes subsidies for specific customers. Tariffs with subsidies, which include agricultural and residential customers, have been partially compensated by government payments during 2016 and it is expected to continue in the next few years. As per the Energy Reform, the Secretaria de Haciendo y Credito Publico (SHCP) should provide to CFE an equal amount that the company achieved in its pension negotiation in May 19, 2016, which resulted in a reduction in the pension liability. CFE's debt is booked as national debt despite not being explicitly guaranteed.

Largest Electricity Generator

CFE will remain Mexico's largest electricity generator in the country. At the end of June 2016, the company had a total installed capacity of 54,981 MW, of which 42,028 MW is directly generated by CFE and 12,953 MW by Independent Power Producers (IPPs). Overall, there are 188 centrals (159 CFE and 29 IPPs) and 613 generation units (532 CFE and 81 IPPs). CFE is 8.4 times (x) larger than the IPP with higher capacity. Approximately 80% of installed capacity of the IPPs is sold to CFE's through agreements that last 25 years, and the rest is sold to industrial users through private agreements. In Fitch's opinion, high investments requirements in this industry results in entry barriers and competing against CFE's infrastructure could be difficult.

Strategically Important for the Country

Fitch believes CFE's scale, its position as sole electricity marketer to unqualified users and its monopoly on transmission and distribution activities make the company strategically important for the country. Fitch views CFE's transmission and distribution business, where it retains a monopoly position, as having lower business risk than the generation business. Qualified users will have access to the wholesale electricity market (WEM), starting with those who consume a minimum peak demand of 3 MWh in 2016, 2 MWh in 2017, and 1 MWh in 2018. New energy reform laws enable CFE to apply certain fees to those private investors (PI) who would participate in the WEM and will have to use CFE's transmission and distribution network. Also, energy reform enables the company to enter into agreements with PI to develop and finance the transmission and distribution infrastructures on its behalf.

Diversification of Operations

Service and customer diversification supports CFE credit profile by reducing concentration risks. Additionally to the sale of electricity, the energy reform allows CFE to sell natural gas to third parties and to generate income through the rent of its transmission and distribution network. Also, the company can market its products to both qualified and unqualified users, new private investors and third parties.

Energy Reform Opens Sector

The energy reform enables PIs participation and IPPs excess capacity to sell electricity, at spot prices or under negotiated contracts, to high tension industrial users. Large industrial users will be able to contract their demand directly with private generators at lower than current rates. Fitch believes CFE would be able to offer electricity at competitive rates through higher generation with natural gas. Thirteen pipelines are expected to start operation in the next three years, and CFE is expected to use them under 25-year agreements.

Fitch expects that transportation, distribution and sale of natural gas could add income and reduce electricity generation cost to CFE. Also, in order to improve generation unit costs, CFE is transforming seven thermoelectric plants to combined cycle plants with the purpose of reducing the use of heavy fuel oil in the generation of electricity and increasing the use of natural gas. From 2013 - 2015, CFE reduced heavy fuel oil consumption by 38.8% and increased natural gas consumption in the generation of electricity. Electricity generation with the use of natural gas is about 3.6x per MWh cheaper than heavy fuel oil, which improves profitability.

Company's Profitability Affected

Subsidies for residential and agricultural customers, technical losses and exposure to exchange rate volatility affect CFE's profitability. Electrical losses have declined to approximately 12.8% in 2015 from 16.1% in 2010, underpinned by improvement in Mexico's metropolitan area, which used to be operated by Luz y Fuerza del Centro (LyFC). The company's strategy is to reach 10% of electricity losses in 2018. The Energy Reform allows CFE to establish partnerships in transmission and distribution activities to share costs, expenses, investments and to reduce the technical losses through the modernization of the distribution network giving flexibility in funding options for investments.

CFE is exposed to exchange rate volatility. Approximately, 43% of total costs and expenses are denominated in U.S. dollars and in practice 99% of its revenues are denominated in Mexican pesos. However, 70% of revenues have tariffs that are adjusted monthly for fuel prices, which some of them are linked to U.S. dollars. Considering currency swaps, approximately 48% of CFE's total debt is denominated in U.S. dollars. Assuming that 99% of revenues are denominated in Mexican pesos, Fitch estimates that a 10% devaluation of the Mexican peso increases 1.3x the company's leverage.

Risk of Political Interference

The electricity rate settlement by CRE exposes the company to regulatory risk and political interference. Subsidies to agricultural and residential sectors also expose CFE to unfavourable tariffs, which at times could be set below operating costs. However, for 2016 Mexico's Federal Expenditure Budget establishes a budget allocation of MXN30 billion to partially compensate CFE for the electricity tariffs subsidy. This amount represents approximately 50% of 2015 subsidies.

Fitch believes preferential tariffs for agricultural and residential customers will continue due to their social component and the political cost of eliminating them. The government often sets electricity rates at levels below CFE's operating costs to maintain the affordability of electricity for different residential and agricultural customers, which represented approximately 25% of the company's revenues for the latest-12-months (LTM) ending June 30, 2016.

Improvement in Unfunded Pension Liabilities

In May 19, 2016, the company reviewed the workers contracts conditions with its labor union, where CFE achieved a pension liability reduction of approximately MXN150 billion pesos. The unfunded pension liability as of June 30, 2016, amounted to MXN482.7 billion compared to MXN634.9 billion amounted in March 31, 2016. According to the Energy Reform, the Secretaria de Haciendo y Credito Publico (SHCP) should provide to CFE an equal amount, resulting in a MXN304.4 billion reduction to the unfunded pension liability in total.

Stand-Alone Credit Quality

CFE's stand-alone credit quality is commensurate with a 'BB-' Long-Term Rating if the company was not owned by the Mexican government and if it did not receive financial support from the sovereign. This stand-alone view incorporates the actual regulation from the energy reform and the continuing establishment of subsidies to agricultural and residential sectors due to their social component and the political cost of eliminating them. Fitch believes CFE's exposure to subsidies for agricultural and residential customers will continue due to their social component and the political cost of eliminating them. The stand-alone credit quality is limited by CFE's high leverage, limited free cash flow generation and improvement in unfunded pension liabilities.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for the issuer include:

--Revenue growth of around 1% - 1.5% from 2016 onward;

--EBITDA margin around 27.7%, adding the estimated actuarial cost of labor obligations into EBITDA;

--Capex at around MXN45,000 million per year;

--Cash balance at around MXN35,000 million;

--Capex funded with CFO and debt;

--Debt-to-EBITDA levels around 4.6x.

RATING SENSITIVITIES

Absent an improved operating and financial profile, an upgrade of CFE's ratings could result from an upgrade of the sovereign or increased financial support from the government. Negative rating actions could be triggered by a downgrade of the sovereign's rating, the perception of a lower degree of linkage between CFE and the sovereign as a result of the energy reform in conjunction with a weak operating and financial profile.

LIQUIDITY AND DEBT STRUCTURE

High Leverage with Manageable Debt-Maturity Profile

As of June 30, 2016, total on-balance-sheet debt was MXN421.6 billion and its leverage level was 5.3x compared to 4.9x, 3.6x, and 4.6x in 2015, 2014 and 2013, respectively (adding back the estimated actuarial cost of labor obligations into EBITDA). The leverage decrease is a combination of higher debt and higher EBITDA generation. CFE's debt maturity profile is manageable, with MXN56.8 billion maturing in the short-term, compared to MXN51.1 billion in cash and MXN24.9 as positive FCF. Free Cash Flow has been limited, on average, during the last five years, mainly due to high capital expenditures. Fitch estimates over the next four years, CFE leverage will be around 4.7x and will generate neutral to negative FCF as a result of lower electricity generation cost and stable debt levels.

Fitch currently rates CFE as follows:

--Long-Term Foreign-Currency Issuer Default Rating (IDR) 'BBB+';

--Long-Term Local-Currency IDR 'BBB+';

--USD3.7 billion senior unsecured notes 'BBB+';

--MXN10 billion unsecured Certificados Bursatiles Issuances 'BBB+';

--National Long-Term Rating 'AAA(mex)';

--MXN87.8 billion unsecured Certificados Bursatiles 'AAA(mex)';

--National Short-Term Rating 'F1+(mex)';

--Short-term Certificados Bursatiles Program 'F1+(mex)'.

Date of Relevant Committee: June 30, 2016

Additional information is available on www.fitchratings.com

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
https://www.fitchratings.com/site/re/869362

National Scale Ratings Criteria (pub. 30 Oct 2013)
https://www.fitchratings.com/site/re/720082

Additional Disclosures

Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1012627

Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Contacts

Fitch Ratings
Primary Analyst:
Alberto De Los Santos, +52-81-8399-9100
Associate Director
Fitch Mexico S.A. de C.V.
Prol. Alfonso Reyes 2612
Monterrey, N.L., Mexico
or
Secondary Analyst:
Lucas Aristizabal, +1-312-368-3260
Director
or
Committee Chairperson:
Sergio Rodriguez, CFA, +52-81-8399-9100
Senior Director
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526
New York
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst:
Alberto De Los Santos, +52-81-8399-9100
Associate Director
Fitch Mexico S.A. de C.V.
Prol. Alfonso Reyes 2612
Monterrey, N.L., Mexico
or
Secondary Analyst:
Lucas Aristizabal, +1-312-368-3260
Director
or
Committee Chairperson:
Sergio Rodriguez, CFA, +52-81-8399-9100
Senior Director
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526
New York
elizabeth.fogerty@fitchratings.com