Following a strong showing in its year-end results last week, Fitch Ratings has upgraded South Africa-based Transnet’s long-term foreign currency Issuer Default Rating (IDR) to BBB from BB+ and its long-term local currency IDR to BBB from BBB-.

The ratings agency further upgraded the parastatal’s outlook to stable.

Fitch said in a statement on Wednesday that the upgrade reflected the ratings agency’s updated view of Transnet's standalone profile as BBB- and a change to a bottom-up ratings approach from a top-down approach within its criteria.

This reflected the expectation that Transnet's future debt would not be guaranteed by the South African government – its 100% parent.

“We, thus, view Transnet's legal links with the sovereign as limited. However, the rating includes a single-notch uplift to reflect the strong strategic and operational links between Transnet and its parent,” the agency noted.

Transnet's credit profile benefited from its monopolistic position in the country's rail, port and pipeline services, with a long-term contract base and business diversification underpinning its strong operating cash flows.

Structural weaknesses in the operating environment – including wage pressures and an evolving regulatory framework – together with expected negative free cash flows and substantial funding needs, owing to large capital expenditure (capex), constrained the ratings.

“The stable outlook incorporates our expectations that Transnet's operations will remain strong, despite possible weakening in commodity export markets, and that management would scale back its capex in case of weaker demand expectations to maintain the company's financial profile in line with stated targets.

“We expect funds from operations net adjusted leverage to slightly exceed four times its current value by the financial year to March 2016, a level still commensurate with the current ratings,” it held.

KEY RATING DRIVERS

The freight rail business contributed R17-billion, or 60%, of total group revenue in the six months ended September 30 and about 52% of total group earnings.

Although the National Ports Authority (NPA) division generated significantly less external revenue, at R4.5-billion, it had a far higher margin of 71%, compared with 41% in freight rail and contributed 26% to group earnings before interest, tax, depreciation and amortistion (Ebitda).

Transnet Port Terminals, the port infrastructure operating division, contributed 10% to group Ebitda, while the pipelines and engineering divisions contributed 9% and 3% respectively.

“Although Transnet's demand drivers are closely linked to overall industrial and economic activity in South Africa and global commodity markets, we take a positive view of its transport mode diversification compared with most rated peers,” said Fitch.

The freight rail business was supported by a long-term contractual framework with top 20 diversified counterparties, including miners, industrial companies and traders.

Export coal and iron-ore – or around 58% of the rail business – were supported by long-term take-or-pay agreements, and in some cases, for 20 years and with five-year review periods.

Coal represented 40% of rail volumes, reflecting South Africa's heavy exposure to coal-fired power generation, which represented 95% of total electricity generated in 2013.

“The concentration on coal is likely to remain a factor for Transnet, as we expect local demand to continue to rise with new coal power stations such as Medupi and Kusile being built in South Africa; however, we view the constraint for its business profile as currently limited,” Fitch stated.

Meanwhile, some 21% of Transnet's external revenue and 35% of its Ebitda as at September 30, related to the NPA and the pipeline segments, which were regulated.

Historical tariff determinations had been significantly below the levels requested by the company, owing to the regulator using a lower valuation of the regulatory asset base.

Fitch said a recent proposed tariff methodology was likely to reduce the discrepancy in tariff decision, but this was yet to be fully established.

Meanwhile, the agency noted that Transnet was in a “heavy investment phase”, which was likely to peak over the next three years.

The updated plan for the next seven years assumed a total of R307.5-billion for expected ramp-up in freight volumes in the long-term and for operational efficiencies.

“The plan carries considerable execution risk as annual capex will likely increase 88% by 2016 from 2013’s R27.5-billion. Although expansionary investments reflect declared customer demand, risk of excess capacity cannot be ruled out for the short- to medium-term amid significantly weaker world commodity markets.

“However, the risks and the associated funding challenge are mitigated by future committed capex being low at around 40% of total and by Transet's ability to scale back capex if required,” said Fitch.

It added that Transnet had strong operational and strategic links with the South African government, which included government-approved business and funding plans, budgets and strategy, tangible support, as well as Transnet's importance to the country's extractive industries and overall economy.

“We view the likelihood of an increase of government guarantees of Transnet's debt, currently at 4%, as low and, therefore, the legal links are unlikely to strengthen. As such, we limit the uplift to Transnet's standalone profile to one notch,” the agency stated.