National Grid Plc (NGG) Ratings Reaffirmed by Fitch Following Recent Review

Fitch Ratings has affirmed National Grid plc's (NYSE: NGG) Long-term Issuer Default Rating (IDR) at 'BBB' and its subsidiaries, National Grid Electricity Transmission plc (NGET), National Grid Gas plc (NGG), and National Grid Gas Holdings (NGGH, NGG's parent), at IDR 'A-'. The Outlooks are Stable. A full list of rating actions is available at the end of this commentary.

The affirmation reflects the regulated nature of NG's businesses, reinforced by the consistently solid performance of NGET and NGG under the RIIO regulatory framework. The ratings are further supported by conservative financial profiles, albeit with limited headroom under their gearing ratios in our view.

KEY RATING DRIVERS
Low Business Risk
NG and its regulated subsidiaries enjoy a strong and predictable cash flow profile, reflecting low regulatory and business risk. In the financial year to 31 March 2015, 95% of group's operating profit came from regulated activities in the UK and the US. The regulatory frameworks are well-established, mature and transparent. The group benefits from significant geographical and business diversification.

Disposal of UK Gas Distribution
In a move to rebalance its asset portfolio to higher growth, NG announced its intention to sell a majority stake in the currently wholly-owned four UK gas distribution networks (GDNs). All of the net proceeds from the transaction will be returned to shareholders, which may be in the form of a special dividend and or share buy backs. At this stage in the process, details remain unknown, including the exact stake to be sold, transaction structure, the amount of debt to be de-consolidated, minority dividend inflow and the amount of share buy backs.

We expect the disposal to be broadly neutral for NG's financial profile. The overall impact would come from the de-consolidation of GDNs, minority dividend stream and returning the sale proceeds to shareholders. Fitch assumes that the group would reasonably shrink the number of shares to close the dividend funding gap and keep a sustainable dividend burden.

In Fitch's view the business risk impact of the sale would be modestly negative as deconsolidation would lead to higher cash flow contribution from slightly higher-risk US operations. National Grid North America (NGNA) would provide 39% of NG's operating profit to the pro forma entity as opposed to 30% in FY16.

Greater Focus on the US
With the disposal of GDNs, the relative importance of the US businesses for NG would increase. We may tighten guideline ratios for the group's 'BBB' IDR to reflect an increase in business risk.

While we acknowledge that the US businesses are offering higher growth prospects, we are also wary of the moderately higher business risk. This is primarily due to the differences in regulation. In the UK, RIIO framework provides cash flow visibility over an eight-year regulatory period with most of the regulatory variables adjusted for automatically. In the US new rate cases need to be filed regularly to ensure that all regulated assets are earning allowed regulatory returns and all of the operating expenses are recovered through customer bills. Regular re-filings carry associated execution and equity return reset risk.

US Rate Filings Credit-Positive
In late 2015 - early 2016 NG filed three major rate cases in New York and Massachusetts. These include Massachusetts Electric Distribution, KEDNY (Brooklyn Union Gas Company) and KEDLI (KeySpan Gas East Company), which contribute around 11%, 14% and 12% to the total US rate base respectively.

These companies underperformed against allowed return on equity (ROE) in the last few years. New filings are credit-positive for NG. Although they may not lead to higher allowed ROEs, they would allow appropriate cost recovery and rate base recognition (including prior years' true ups) and hence improve the networks' ability to achieve allowed ROEs.

The US businesses target consistent delivery of 95% of allowed returns on equity (ROE), similar to the long-term level demonstrated by best-in-class US utilities. In 2014 US assets achieved an 8.4% ROE versus the 9.7% allowed level, which amounts to 87% of allowed returns. The group estimates a weaker performance at 8.0% ROE for 2015. A full-year impact of the new rate cases would only flow through in 2017 due to lengthy re-filing procedures.

Solid Regulatory Performance in UK
Both NGET and NGG have delivered significant outperformance against the regulatory allowances during the first two years of RIIO. In FY14/15, NGET achieved ROE of 14% versus the base return of 10.2% (nominal, pre-tax, adjusted for the timing of spend and sharing). UK gas transmission and UK gas distribution achieved ROEs of 14.2% and 12.9% versus the base returns of 10% and 9.9%, respectively.

The total expenditure (totex) incentive mechanism was the major source of outperformance for electricity transmission and gas distribution. As for gas transmission, the outperformance was driven by other revenue incentives and legacy incentives. FY 15/16 performance is expected to be similar for NGET and slightly weaker for NGG due to the cessation of the permit scheme and reduction in legacy price control incentives.

Overall during the eight-year price control we expect both NGET and NGG to deliver 7% totex outperformance (including GDNs). Excluding GDNs, our expectation for NGG is lower, at 5.5%.

As for output performance, NGET performed well and NGG performed adequately on most regulatory outputs. GDNs' performance compared unfavourably with the rest of the UK GDNs universe. NG's GDNs outperformed on gas leakages and stakeholder engagement, but underperformed on repair risk performance, unplanned interruptions and customer satisfaction. We expect at least satisfactory output performance during the remainder of the price control for both NGET and NGG.

Strong PMICR, Tight Gearing
We forecast NGET's net debt/regulatory asset value (RAV) to average at 68% and post maintenance interest cover ratio (PMICR) at 2.1x during the eight-year price control. While PMICR compares favourably with our guideline of 1.7x (mostly due to a large proportion of index-linked debt), the gearing ratio is in line with our negative guideline of 67.5%. However, we draw comfort from the group's commitment to observe the regulatory gearing ratio of 60% in the long term and to reduce the amount of dividend up-streamed to the holding company.

For NGG we forecast an average net debt/RAV at 63.5%, which is weak for an 'A-' IDR. We would tolerate a slightly higher gearing as long as PMICR remains strong. We expect an average eight-year PMICR of around 2.6x. A weaker PMICR could put NGG's ratings under pressure.

Financial impact of the sale on NGG could vary significantly, depending on the amount of de-consolidated debt. NGG's ratings could come under pressure if de-consolidated debt falls significantly below the amount suggested by the regulatory gearing of 65% net debt/RAV. We would assess the impact once all the details are available.

NG's Financial Profile Comfortable
We conservatively forecast NG's funds from operations (FFO)-adjusted net leverage at 5.8x on average for the next four years. Fitch also estimates average FFO interest cover at 4.1x. These ratios are well within our guidance for a 'BBB' IDR. The ratios do not reflect the UK GDNs disposal as there are too many uncertain variables associated with the transaction.

NG's dividend policy is to grow dividend at least in line with RPI. Historically the group has been following the RPI increase, which mirrored the pace of RAV growth in the UK. However, we believe that there could be pressure from equity investors to receive returns outpacing the RPI. An upward revision of the dividend policy, not supported by a corresponding increase in earnings, could put pressure on the credit ratios and ratings.

Group Rating Dynamics
NG's IDR of 'BBB' reflects (i) the combination of the business risk of its UK and US operating entities, the majority of which are regulated - although the US regulation offers shorter-term cash flow visibility (ii) the additional debt raised at various intermediate holding-company levels, bringing the group gearing to a higher level than the gearing at individual operating companies; (iii) the significant amount of structural subordination as most of the group's debt is raised at the operating company level.

In our rating approach for NGET and NGG we recognise the benefit of the regulatory ring-fencing and the parent's commitment to keep the leverage at these entities within the regulatory guidance (60% gearing for NGET and 64% gearing for NGG, incentivised by tax claw backs). However, given the softness of ring-fencing provisions in the UK, we would not widen the rating differential between NG and its rated UK subsidiaries to beyond two notches.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case include:
-RPI at 1.9% in FY15/16, 2.8% in FY 16/17 and 3.1% thereafter
-Reducing allowed cost of debt reflecting low IBOXX index
-Totex for FY15/16-FY20/21 of GBP10bn for NGET and GBP7.9bn for NGG (in 09/10 prices)
-Average NGET's RAV growth of 4.5% per annum for FY15/16-FY20/21, NGG's RAV growth at 1%
-Average totex outperformance versus allowances of 7% for both NGET and NGG during the eight-year price control
-Average cost of debt outperformance of 70 basis points for NGET and 65 basis points for NGG
-NG's average annual EBITDA of GBP5.6bn in FY15/16-FY18/19
-NG's capex of GBP14.3bn in FY15/16-FY18/19, including capex related to NSN link interconnector
-Average annual dividend of GBP1.4bn in FY15/16-FY18/19
-NG's average cost of debt at 5.2% and average cash cost of debt at 4.2% in FY15/16-FY18/19

RATING SENSITIVITIES
Positive: The probability of a positive rating action is low given the large capex programme and tight gearing ratios of the UK networks. However, future developments that may, individually or collectively, lead to a positive rating action include:

NG: An improvement in its consolidated FFO interest coverage to 4.5x or higher and a reduction in FFO consolidated net leverage to below 5.0x, on a sustained basis

NGET: An improvement in PMICR to above 2.3x and a decline in RAV-based net leverage to below 55% on a sustained basis

NGG: An improvement in PMICR to above 2.5x and a decline in RAV-based net leverage to below 50% on a sustained basis

NGGH: A positive rating action on NGG accompanied by no material debt at NGGH

Negative: Future developments that may, individually or collectively, lead to negative rating action include:

NG: A decline in consolidated FFO interest coverage to below 3.5x and an increase in FFO consolidated net leverage to 6.0x or higher on a sustained basis, and/or negative rating action on the rated UK operating companies

NGET: PMICR decreasing to below 1.7x and RAV-based net leverage increasing to over 67.5% on a sustained basis, or a negative rating action on the holding company

NGG: PMICR decreasing to below 1.9x and RAV-based net leverage increasing to over 62% on a sustained basis, or a negative rating action on the holding company

NGGH: A negative rating action on NGG, issue of material quantity of debt by NGGH or a negative rating action on the holding company

LIQUIDITY
Available liquidity at 31 March 2015 included available cash of GBP702m and a total of around GBP3.2bn of undrawn committed facilities. Fitch forecasts negative free cash flow at GBP1.26bn and debt maturities at GBP3bn to March 2016.

In addition to undrawn committed facilities, NGET procured a RPI-linked EIB loan of GBP1.5bn, which was fully undrawn as of end-March 2015. In September 2015, National Grid North America Inc. raised GBP400m of convertible debt at a fixed rate of 0.9% to 2020. The company therefore has sufficient liquidity for the next 12-18 months. It also benefits from ready and diverse access to capital markets.

On average, NG expects to issue GBP2bn-GBP3bn of long-term debt each year to fund the expansion of the business and to refinance maturing debt. Its average debt maturity is 12 years.

FULL LIST OF RATING ACTIONS

NG
Long-term IDR affirmed at 'BBB'; Outlook Stable
Short-term IDR affirmed at 'F2'
Senior unsecured debt affirmed at 'BBB+'

NGET
Long-term IDR affirmed at 'A-'; Outlook Stable
Short-term IDR affirmed at 'F2'
Senior unsecured debt affirmed at 'A'

NGG
Long-term IDR affirmed at 'A-'; Outlook Stable
Short-term IDR affirmed at 'F2'
Senior unsecured debt including for guaranteed bonds due 2018 issued by British Transco Finance Inc affirmed at 'A',
Commercial paper affirmed at 'F2'

NGGH
Long-term IDR affirmed at 'A-'; Outlook Stable

NGG Finance plc
Subordinated hybrid debt affirmed at 'BBB-'

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