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Utility Eskom downgraded to 'CCC+' on ongoing liquidity concerns and insufficient government support; Outlook Negative

28 February 2018 S&P Global Ratings

• or default in the next six months despite securing South African rand (ZAR) 30 billion in short-term funding from local and international funders so far this year. • We now believe there is a lower likelihood that Eskom would receive extraordinary support from the government, reflecting our view that government support for the utility over the past few months has been insufficient given that the utility's liquidity concerns persist. • We are therefore downgrading Eskom to 'CCC+' and 'zaB' from 'B-' and 'zaBB-'. • The negative outlook points to uncertainty regarding the extent and timeliness of government support for Eskom over the coming six months, considering the magnitude of the utility's funding deficit and refinancing risks.

Rating action

On Feb. 27, 2018, S&P Global Ratings lowered its long-term foreign and local currency issuer credit ratings on South Africa-owned utility ESKOM Holdings SOC Ltd. to 'CCC+' from 'B-'. The outlook is negative.

At the same time, we lowered our long-term South Africa national scale rating on Eskom to 'zaB' from 'zaBB-', and affirmed our 'zaB' short-term national scale rating.

Rationale

The downgrade reflects our view that the possibility of a distressed exchange or default in the next six months continues to hang over Eskom despite the utility having secured South African rand (ZAR) 30 billion (around $2.5 billion) in shortterm funding commitments from local and international funders over January-February of this year. The rating action also incorporates our view that the support provided by the government to Eskom over the past few months has been insufficient. This has led us to reassess the likelihood of extraordinary government support for Eskom to high from very high.

We note that Eskom has so far this year secured an additional gross ZAR30 billion in short-term funding, of which only ZAR20 billion will be available beyond March 1, 2018. These recently concluded facilities are in the form of short-term bridging finance.

Despite the near-term improvement in cash balances, Eskom has monthly debt service of ZAR2 billion-ZAR6 billion over the six months ending Aug. 31, 2018, excluding refinancing of its short-term bridge funding and recurring negative free cash flow. Furthermore, the 5.2% sub-inflation tariff increase awarded by the regulator (NERSA) in fiscal year 2019 (ending March 31, 2019), against a budgeted 10.5% increase, is likely to exacerbate negative cash flow generation and weigh on already low investor sentiment. We therefore anticipate pronounced pressure on Eskom's fiscal 2019 financing plans, which include capital expenditures (capex) of around ZAR55 billion and negative free cash flow, as well as refinancing ZAR20 billion in bridge financing due Aug. 31, 2018, and about ZAR20 billion in scheduled debt maturities. Consequently, Eskom remains at risk of facing a distressed exchange situation or default in the next six months.

We acknowledge that Eskom is addressing its structural and liquidity challenges, including reducing its fiscal 2018 funding requirements by ZAR14 billion to ZAR54 billion, with the debt issuance reduction compensated by lower capex and operational cash outflows. However, given that the company has already rationalized its capital and operating expenditures significantly, we see limited additional scope for cost cuts in fiscal 2019.

Furthermore, the qualified opinion issued to ESKOM on its fiscal 2017 financial statements triggered a covenant in its ZAR15 billion facility from the Development Bank of Southern Africa (DBSA). While the DBSA has provided a contingent waiver (predicated on actions to be taken to ensure Eskom receives an unqualified audit opinion for its fiscal 2018 financial statements), if the fiscal 2018 financial statements are qualified, a covenant waiver breach could occur on or before June 30, 2018. Moreover, despite the bridging finance recently committed by local and international market participants, we think market sentiment of international and domestic investors is weak, implying that Eskom's ability to attract senior unsecured debt funding in line with its requirements presents a significant challenge. These factors underpin our 'ccc-' assessment of Eskom's stand-alone credit profile (SACP).

Although the South African government has taken measures to help Eskom, we think that government support to the utility over the past few months has been insufficient. Nevertheless, of the government's actions to support Eskom, we note:

• had been allegedly implicated in impropriety, and undertaking to appoint permanent executives in key positions by March 2018; and
• Provision of explicit assistance in securing short-term bridging funding commitments of ZAR30 billion from market participants (including a guarantee).

We recognize that the government's support in obtaining the aforementioned bridge funding commitments played a key role in enabling the publication of Eskom's (reviewed, unqualified) interim financial statements on Jan. 30, 2018, ahead of the Johannesburg Securities Exchange (JSE) deadline of Jan. 31, 2018. Had this funding not been secured, Eskom's reviewed interim financial statements for the six months ended Sep. 30, 2017, would most likely have contained a going-concern qualification. Also, in the event that the publication of the financial statements had been delayed beyond Jan. 31, 2018, the JSE would have had the right to suspend trading in Eskom's domestic bonds.

Still, in our view, the government support made available in recent months provided insufficient evidence of the government's ability and willingness to address severe and imminent liquidity stresses in a timely or sustainable manner. Despite recent events indicating that the government would adopt a more constructive attitude toward supporting its state-owned enterprises, including statements by the President in his State of the Nation address, the support framework set forth in the budget speech on Feb. 21, 2018, fell short of our expectations. In our view, the budget does not adequately address the amount and timing of financial support given Eskom's imminent forthcoming liquidity requirements, and focused instead on previouslyannounced planned strategic asset sale initiatives, extensions to the guarantee framework, and changes to management structure.

Furthermore, current levels of government support follow diminished issuances in the local bond and commercial paper markets after negative news concerning financial impropriety in South African state-owned enterprises came to light in the State of Capture report in October 2016, which was followed by resignations and suspensions of members of Eskom's senior executive team. Despite these circumstances, during 2017 the government and national treasury did not provide meaningful additional support beyond planned issuances under the government-guarantee framework (GSF). While Eskom's total utilization of GSF guarantees appears to be broadly on track, we note that only ZAR72 billion of the ZAR350 billion remains unutilized, of which ZAR59 billion is currently under negotiation.

We believe that, cumulatively, the government has provided an insufficient response to both the closure of local bond markets to Eskom in 2017, and, more recently, the utility's acute liquidity challenges so far this year. Although we still believe that Eskom will benefit from considerable government support, the circumstances under which such support will be forthcoming have become less predictable, as has the amount, nature, and timeliness.

Our 'ccc-' assessment of Eskom's SACP is based on our view of the utility's weak liquidity, taking into account continuing and sizable negative free cash flow, combined with the company's unsustainable capital structure (without government support).

Liquidity

Our assessment of Eskom's liquidity as weak reflects the pressure Eskom faces, since its revenues are insufficient to compensate for higher costs, significant capex commitments, and the difficult operating environment which has constrained growth in electricity demand. In addition, we think the company has a relatively high dependence on what we consider to be uncommitted sources of funding. For example, as of Jan. 30, 2018, the company was still negotiating approximately 46% of its ZAR55 billion of funding requirements for fiscal year ending March 31, 2018. We forecast that Eskom's liquidity sources will cover its uses by materially less than 1.0x over the 12 months started Dec. 31, 2017.

In addition, we consider that prospects for liquidity improvements continue to be slim given the current depressed local issuance activity, and recent approval by the regulator of sub-inflation tariff increases, which exacerbate the level of negative cashflow generation.

We calculate that Eskom had the following liquidity sources as of Dec. 31, 2018, and over the subsequent 12 months, assuming that the ZAR30 billion committed bridge funding is raised and repaid (ie, not refinanced) within the coming 12 months:

• Cash and marketable securities of about ZAR4.4 billion at the company level
• Revolving credit lines of about ZAR3.2 billion; and
• Cash funds from operations of ZAR8 billion-ZAR9 billion.

We calculate the following liquidity uses for the same period:

• Capex of about ZAR45 billion-ZAR55 billion in the next 12 months; and
• Principal debt maturities of ZAR18 billion-ZAR20 billion.

Outlook

The negative outlook on Eskom reflects uncertainty regarding the government's commitment and ability to provide timely support to cover any of the company's funding shortfalls over the coming six months, and the risk of further deterioration of the company's SACP.

Downside scenario

We could lower our long-term rating on Eskom by one or more notches if we consider that the likelihood of extraordinary government support has weakened further. We may conclude that the likelihood of government support has reduced if we see further weakness in the predictability and level of such support. This may be indicated by a further deterioration of Eskom's financial position without offsetting measures taken by the government. Such a scenario could occur, for example, if we were to consider default or distressed exchange conditions were to become inevitable over a less than three months horizon while the government was not providing any additional support to the entity.

We could also lower the long-term rating by one notch if we downgrade the sovereign, all other factors remaining unchanged.

Upside scenario

We would consider revising the outlook to stable if pressure on Eskom's liquidity eased sustainably, and the government provides additional funding to offset the company's large negative free cash flow.

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