Fitch Ratings has downgraded Thames Water’s holding company Kemble Water Finance Limited's Long-Term Issuer Default Rating (IDR) and senior secured debt rating to 'CCC' from 'B'. The Recovery Rating remains 'RR4'.
Fitch said the downgrade mainly reflects that Kemble will have to engage with syndicated banks to amend and extend (A & e) the £190 million loan due April 2024 under terms that could be viewed as a distressed debt exchange (DDE), under the ratings agency’s criteria.
The downgrade also reflects rising liquidity pressure due to increased regulatory and political scrutiny of the dividend distribution from Thames Water Utilities Ltd (TWUL) to Kemble. Theratings update says there is limited visibility of the liquidity position beyond end-March 2024 (FY24).
Fitch also sees material challenges beyond the next few months, since the equity contributions from shareholders in the five-year price control period ending March 2025 (AMP7) at the TWUL level remain conditional and there is currently limited visibility on regulatory development and further shareholder support in the next five-year price control period ending March 2030 (AMP8). A strong operational turnaround at TWUL would be needed to improve profitability and the prospects for future dividend distribution to Kemble.
Key rating drivers
Refinancing Risk: Kemble has to refinance a £190 million loan due in April 2024. Appearing before the House of Commons EFRA Committee last week, Thames Water management confirmed its plans to proceed with an A&E of the loan. The A&E could be viewed as a DDE under Fitch’s criteria, a key consideration for the negative rating action.
Liquidity Under Pressure: Increasing regulatory scrutiny from the UK water regulatory authority Ofwat on the dividend distribution to Kemble from TWUL increases the risk to Kemble's primary source of cash flows for debt service. This materially weakens debt market access for the holding company, in Fitch’s view.
With Kemble's cash balance estimated at about £20 million as of the end of November 2023, dividends from TWUL become even more critical. The ratings agency says it notes that TWUL's latest decision to distribute dividends (paid usually every six-months) of £37.5 million in October 2023 has been subject to an information request from Ofwat. Kemble's annual interest burden stands at around £80 million - £85 million in FY24. Fitch says it does not forecast covenant cash-lock up at TWUL in the remainder of AMP7; however, “risk of regulatory cash-lock up is increasing” in Fitch’s view.
Limited Relief from Committed Line: In a scenario of insufficient dividend receipts to cover interest expenses at Kemble, the £150 million working capital facility could be used for Kemble debt service to secured creditors. Nonetheless, Fitch says it believes the use of the committed working capital facility would be seen by existing and potential lenders as a last resort to avoid a payment default of servicing Kemble interest.
Conditional Equity Support Fundamental: Fitch believes shareholder support at TWUL mainly depends on progress on the refocused turnaround plan (approved by TWUL's board in November 2023), together with appropriate risk-and-return balance for AMP8 (Draft Determination due in May/June 2024, final regulatory outcome in December 2024).
Fitch added that it sees “the execution and timing of the uncommitted equity of £750 million in AMP7 as uncertain.” In addition, management has guided for a further £2.5 billion of conditional shareholder equity support during AMP8.
Covenant Forecasts Include Equity: Fitch expects both TWUL and Kemble to comply with their financial covenants in the remainder of AMP7. For the purposes of covenant calculation, management deems it reasonable to include £500 million and £250 million of additional equity receipts at TWUL in FY24, and FY25, respectively. The closing net debt/Regulatory Capital Value (RCV) at Kemble (on a covenant basis) was 86.4% at end September 2023 compared with an event of default of 95%.
TWUL Lock-up a Key Risk: TWUL's risk of regulatory cash lock-up will increase from April 2025, since the revised licence condition will include a monitored credit rating falling to 'BBB'/Negative or below (vs. current condition being at 'BBB-'/Negative or below).
A lock-up event would be followed by a three-month grace period before enforcement, subject to Ofwat's review of financial resilience. Application, exemption, or extension of the grace period are three possible outcomes of Ofwat's review.
Refocused Turnaround Plan: Fitch sees execution risk around TWUL's refocused turnaround plan, which now prioritises a lower number of initiatives. The plan, under the leadership of the new CEO starting in January 2024, aims to strengthen the company's performance in key areas like pollution, leakage, supply interruptions and water quality. Successful delivery of the plan is fundamental to mitigating the impact of higher operating and financing costs and tightening regulation, improving TWUL's creditworthiness and ultimately the dividends stream to Kemble in the medium to long term.
Standalone Assessment under PSL: Fitch rates Kemble on a standalone basis using the stronger subsidiary/weaker parent approach under its Parent and Subsidiary Linkage (PSL) Rating Criteria. This assessment reflects 'insulated' legal ring-fencing as underlined by a well-defined contractual framework, and tight financial controls imposed by Ofwat and designed to support TWUL's financial profile. We view access and control as overall 'porous' as TWUL operates with separate cash management and a mixture of external and intercompany funding.