The Hong Kong and China Gas Co. Ltd. Downgraded To 'A' On Sluggish Financial Improvement; Outlook Stable

  • We expect The Hong Kong and China Gas Co. Ltd.'s (HKCG) ratio of funds from operation (FFO) to debt to stay below 40% in 2019-2020 due to the company's sizable capital spending and dividend payouts, and a consistently negative discretionary cash flow.
  • HKCG's increasing exposure to mainland China utilities and commitments to new energy business entails greater volatility in its business risk and financial performance.
  • On April 3, 2019, S&P Global Ratings lowered its long-term issuer credit rating on HKCG to 'A' from 'A+'. We also lowered our issue ratings on all outstanding notes guaranteed by HKCG by one notch: HKCG (Finance) Ltd.'s senior unsecured notes to 'A' from 'A+', and Towngas (Finance) Ltd.'s subordinated perpetual securities to 'BBB+' from 'A-'.
  • The stable rating outlook reflects our expectation that HKCG's FFO-to-debt ratio will remain above 30% and the company will not significantly increase its exposure to mainland utilities and new energy business in the next 24 months.
HONG KONG (S&P Global Ratings) April 3, 2019--S&P Global Ratings today took 
the rating actions listed above.

We lowered the rating on HKCG because we expect the company's leverage to only 
marginal improve and stay below 40% over 2019-2020. This ratio is the 
threshold for maintaining its rating at 'A+'. 

Meanwhile, we anticipate HKCG's China exposure in terms of reported EBITDA 
will rise further to near 58%-60% over the next two years, from about 55% at 
end-2018. In our view, the company's high capital spending and committed 
dividend payments will continue to overtake its growing operating cash flow, 
leading to consistently negative discretionary cash flow. HKCG is a Hong 
Kong-based gas investor and operator with major business exposure in both 
mainland China and Hong Kong. 

In our view, HKCG's increasing cash flow is partly offset by its rising debt 
for growing its mainland gas utilities and unregulated new energy business in 
China. During 2018, the company's reported EBITDA was Hong Kong dollar (HK$) 
11.57 billion, compared with HK$10.63 billion in 2017. The group's net debt 
rose HK$2.6 billion to HK$29.2 billion as of end 2018. We estimate its 
FFO-to-debt was 33%-35% for 2018, an improvement of about 2 percentage points 
from 2017.

The improvement in leverage was primarily driven by growth momentum of HKCG's 
gas sales in China, as seen in most of its peers. In 2018, the group 
(including subsidiaries and joint venture associates) sold about 23 billion 
cubic meters of natural gas in China, up 18% over 2017. The increase was 
mainly contributed by a surge in volume from commercial and industrial (C&I) 
users. We expect HKCG's gas business in China will continue to benefit from 
increasing gas consumption, reaching mid-teen total volume growth in 2019. 

Nonetheless, HKCG's city-gas business in China exposes the group to higher 
pass-through uncertainties compared with its gas distribution in Hong Kong. 
Due to delay in passing through higher costs since last June, the company's 
dollar margin contracted to Chinese renminbi (RMB) 0.6/cubic meter (cbm) in 
2018, from RMB0.63/cbm in 2017. Given a slowing economy and the government's 
initiatives to support the general C&I sector, we expect HKCG's dollar margin 
could remain under pressure in next 12-24 months. 

We believe HKCG's new energy segment in China may take longer than the 
management expects to contribute meaningful cash flow and returns. In the past 
five years, HKCG's EBITDA from this segment increased HK$100 million-HK$200 
million annually but its accumulated capital spending on this segment has been 
HK$6 billion-HK$7 billion by 2018, with HK$1 billion-HK$2 billion fresh 
capital pouring in every year. Slow contribution of the new energy segment 
reflects its high execution risks, low margin in the start-up stage, and 
volatile market risks, compared to it's the utilities business. 

In our view, HKCG's discretionary cash flow will remain constrained by its 
high capital expenditure and significant dividend distribution. We believe the 
company's capital investment will stay relatively high at HK$5.5 
billion–HK$6.0 billion annually in the next one to two years, including gas 
sales and storage facilities, distributed energy, and new energy projects in 
China. We believe HKCG will maintain its high dividend payout ratio of 55%-60% 
per year. Furthermore, the company issued one bonus share for every 10 shares 
in the past 10 years, suggesting a 10% growth of total dividend distribution 
per year (assuming a stable dividend per share).

We believe Towngas China Co. Ltd. (TCCL), the subsidiary of HKCG, is 
unaffected by the rating action on HKCG because HKCG has sufficient buffer in 
credit capacity and is committed to provide extraordinary support to TCCL if 
needed. We continue to assess TCCL as a strategically important entity within 
the HKCG group. Our rating on TCCL is therefore three notches higher than its 
stand-alone credit profile (SACP) of 'bb+'.

The stable outlook reflects our view that HKCG's FFO-to-debt ratio will stay 
above 30% and the company will not significantly increase exposure to mainland 
China utilities and new energy business in the next 24 months. We expect the 
group to continue to benefit from its strong and stable Hong Kong core gas 
business, grow its city-gas business in China, and slowly recover its cash to 
leverage ratios over the next two years.

We may lower the rating on HKCG if:
  • HKCG's overall business mix becomes less stable. This could happen if: (1) the company's exposure to mainland China materially increases; or (2) it has significant expansion and profit contribution from new energy business relative to the utilities business; or
  • Its FFO-to-debt ratio deteriorates below 30% on a sustainable basis, which could be a result of aggressive debt-funded capital spending.
In our view, an upgrade is less likely over the next 24 months, given HKCG's 
sizable debt portfolio, driven by its ongoing capital expenditure and dividend 
payments.

We may raise the rating on HKCG if its core FFO-to-debt ratio approaches 40%, 
and discretionary cash flow turns positive on sustainable basis, without 
significant increase of EBITDA contribution from mainland China.
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