Fitch Ratings yesterday downgraded Empresas Publicas de Medellin E.S.P.’s (EPM) foreign and local currency issuer default ratings (IDRs) to ‘BB+’ from ‘BBB-‘ and maintained the Negative Rating Watch. Additionally, the company’s senior unsecured debt ratings have been downgraded to ‘BB+’ from ‘BBB-‘ with a Negative Rating Watch. Fitch has maintained the Negative Rating Watch on the stand-alone credit profile (SCP) of ‘bbb-‘, which assumes the company is not owned by the Municipality of Medellin and will not receive state support should the need arise.
EPM’s ratings reflect strong ownership and control by its owner, the City of Medellin (‘BB+’/Stable), which was downgraded to ‘BB+’/Stable from ‘BBB-‘/Negative. The company’s business risk is low resulting from its diversification and characteristics as a utility service provider. The company’s ratings also reflect its somewhat aggressive growth strategy and solid credit protection measures supported by moderate projected leverage, healthy interest coverage and an adequate liquidity position.
This article is edited from Fitch’s press release regarding its downgrade of EPM
EPM’s Negative Watch reflects continued uncertainty regarding the closure of Ituango’s blocked Auxiliary Diversion System since April 28, 2018, and final cost over-runs of its Ituango project. The possibility of major flooding downstream from the project exists until the diversion tunnel is closed. While the likelihood of this is remote, the environmental, financial and reputational damage to the company could be significant. Fitch’s expectation is that 300MW of the project will be online by mid-2022. The resolution of the Rating Watch may extend longer than six months given these uncertainties.
Key Rating Drivers
Strong Linkage with Parent:
EPM consistently contributes significant cash flows in the form of dividends to its parent, the City of Medellin (BB+/Stable). These distributions comprised over 22% of the city’s total revenues in 2020 and have exceeded government revenues by 20% four out of the last five years. Under Fitch’s criteria, a government-related entity (GRE) that sustainably generates more than 10% of the government’s revenues is considered a strong linkage factor that would lead to an equalization of the ratings.
Fitch continues to maintain the Rating Watch Negative until further confirmation that the diversion and auxiliary tunnels are appropriately plugged. The tunnels are expected to be secured between December 2021 and March 2022, just prior to the entry of the first 300MW unit. As of March 2021, the company reported 92.5% progress on pre-plug 2 of the right deviation tunnel. Despite an additional delay announced in June 2020 due to the coronavirus, Fitch’s base case is that two 300MW units will come online per year between 2022-2025. Fitch expects that once complete, Ituango will add over $800 million USD to the company’s generation revenue and become part of the country’s base load installed capacity.
Insurance Payments Support Capex:
Fitch’s base case assumes that EPM will receive insurance payments of over USD800 million between 2021-2024 for its Ituango project at a rate of roughly USD200 million per year. Insurance payments will be made in instalments as both entities review damages and costs. The payments are a credit positive and relieve pressure of EPM selling assets to offset the estimated incremental project cost of USD1.6 billion. EPM received the first payment of USD150 million from Mapfre Seguros Generales de Colombia S.A. in 2019 and USD200 million in 2020. Payments are contingent on a suspension of the arbitration process against the insurers, which was temporarily suspended in June 2021.
Fitch estimates EPM’s consolidated gross leverage, defined as total debt to EBITDA, will average 3.3x between 2021-2024. Leveraged peaked at 4.7x in 2020 as poor demand affected the company’s distribution businesses, low hydrology impacted generation and Ituango incurred additional cost overruns. Fitch expects leverage to fall to 3.8x in 2021 as conditions normalize and to drop to 2.8x by 2024 due to tariff increases at the company’s distribution businesses and a number of Ituango’s generation units coming online, the first of which is expected in mid-2022.
Moderate Regulatory Risk Exposure:
Fitch believes EPM’s exposure to regulatory risk is low. The bulk of EPM’s consolidated revenues is generated by regulated tariffs or medium-term contracts. The latter exposes the company to potentially sustained low electricity prices. Historically, Colombian regulatory entities have ruled independently from the central government and have provided a fair and balanced framework for both companies and consumers. EPM’s diversified business profile further mitigates the company’s regulatory risk, as a simultaneous tariff decrease across all businesses is unlikely.
Assumption of CaribeMar Assets:
Fitch views EPM’s assumption in September 2020 of CaribeMar, a coastal electricity distribution company renamed to Afinia, as positive for the business and credit neutral. Fitch estimates that once the Afinia business is stabilized in 2023, it will add approximately USD1.2 billion in revenue and USD165 million in EBITDA. Fitch estimates capital expenditures of COP4 trillion, or USD1 billion between 2021-2024. This investment will be necessary to lower high energy losses, which stood at an estimated 27.6% in 2020 with the goal to lower this amount to below 22% by 2024.
Stable Cash Flow Profile:
EPM has a stable and predictable cash flow profile supported by regulated businesses in investment grade markets. Fitch estimates 79% of EPM’s 1Q21 EBITDA was derived from its energy business, where its generation segment comprised 34%; 38% was distribution; and the gas and transmission segments combined for 7%. EPM’s distribution business operates in highly regulated markets, mostly concentrated in Colombia, where it is the largest distributor in the country, with a market share of 25%. Fitch estimates that 21% of the company’s EBITDA comes from its water and waste management services.
Interference Weakens Corporate Governance:
Fitch views EPM’s corporate governance as weak due to the strong influence exerted by the company’s owner, the City of Medellin. This follows a lawsuit against the Ituango project insurers and contractors and the contemplated change of the company’s social objective in 2020, which prompted the resignation of all eight independent board members. EPM has an ESG Relevance Score of ‘4’, which reflects the company’s recent instability in board membership and indicates that the score has a negative impact on the company’s credit profile.
EPM’s ratings are linked to those of its owner, the Municipality of Medellin (BB+/Stable), due to the latter’s strong ownership and control over the company. The company’s low business-risk profile is commensurate with that of Grupo Energia Bogota S.A. E.S.P.’s (GEB, BBB/Stable), Enel Americas S.A. (A-/Stable), AES Gener (BBB-/Stable) and Promigas (BBB-/Stable).
Fitch projects EPM’s total leverage to average 3.3x over the rating horizon and 3.0x on a net basis. This is slightly above AES Gener’s expected average gross and net leverage of 3.1x and 2.3x and below Promigas’, which is expected to be 3.6x and 3.3x, respectively. In 2024, Fitch expects gross and net leverage to be 2.8x and 2.5x, respectively, reflecting advances in the Ituango project, a recovery in EPM’s electricity distribution businesses and the normalization of operations at newly-acquired Afinia.
- Ituango units come online at a rate of two per year from 2022-2025;
- Total Ituango cost of USD3.9 billion, a USD1.8 billion increase from original budget;
- Ituango’s medium-term commercial obligations are covered with electricity purchases, existing hydroelectric asset base and thermal generation;
- No Dividends from UNE expected over the rating horizon;
- Dividend payout of 55% of previous year’s net income;
- No divestments in 2021 or the rating horizon;
- Total Insurance payments in excess of USD800 million from 2021 through 2024;
- Capex for Electricarbe to be financed predominately through debt up to USD800 million;
- Medium-term electricity spot prices of COP155/KWh.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
- Although unlikely in the near term, Fitch may consider a positive rating action if there is a positive rating action on the company’s owner, the City of Medellin;
- Fitch may consider a resolution of the Rating Watch Negative once the company has secured the second deviation tunnel at its Ituango project, which Fitch expects by early 2022. In such a case, the rating Outlook for the City of Medellin would likely apply.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
- A negative rating action on the City of Medellin’s ratings;
- The materialization of significant cost overruns and contingencies at the Ituango project that weaken the company’s liquidity.
Best & Worst Case Rating Scenario
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
Liquidity & Debt Structure
Strong Liquidity: Fitch expects the company’s USD750 million 2020 bond issuance to provide the near-term liquidity for general corporate purposes and to fund the company’s capex program in 2021. Approximately 66% of the company’s EBITDA is from regulated businesses with highly stable cash flow generation. EPM held approximately COP5.3 trillion of cash and equivalents as of 1Q 2021. Fitch expects the company will have COP2.3 trillion of cash on hand at the end of 2021 as it continues work on the Ituango project and makes network improvements at its newly-acquired distribution business, Afinia. Fitch estimates the company has in excess of USD500 million in available committed credit lines.
Currently, the company’s dividend policy is expected to remain in place despite the cash flow impact derived from Ituango’s delay. Historically, EPM has transferred on average between 45% and 55% of its net income to the city of Medellin in the form of dividends. EPM’s transfers to Medellin have historically represented approximately 20% to 30% of the city’s investment budget. Although not likely in the near term, an increase in the company’s dividend distribution policy could pressure its FCF generation, which is already expected to continue to be negative in the near term as the company continues to execute its investment plan.
EPM is a leading electricity generator in Colombia and exhibits a diversified international portfolio of utility businesses that include electric generation, transmission and distribution, water and sewage services, natural gas distribution, and garbage collection and disposal services.