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Research Update: Meridian Energy Outlook Revised To Stable From Negative On Smelter Extension; 'BBB+/A-2' Ratings Affirmed

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Research Update: Meridian Energy Outlook Revised To Stable From Negative On Smelter Extension; 'BBB+/A-2' Ratings Affirmed

Rating Action Overview

  • Rio Tinto PLC's announced continuation of its New Zealand Aluminum Smelter (NZAS) until at least Dec. 31, 2024, provides certainty to the country's electricity market over the medium term at least.
  • New Zealand-based Meridian Energy Ltd.'s (Meridian) earnings were materially exposed to the exit of NZAS due to its substantial lower South Island generation. The extension of NZAS's operations relieves pressure on Meridian allowing time for the sector to expand alternative demand avenues and to lift existing transmission constraints previously anticipated to strand generation.
  • On Feb. 24, 2021, S&P Global Ratings revised its outlook on Meridian to stable from negative. At the same time, we affirmed our 'BBB+' long term issuer credit rating and 'A-2' short-term issuer credit rating on the company.
  • The stable outlook reflects the certainty provided to Meridian under expected status quo operating conditions. As such, we anticipate Meridian to operate with debt to EBITDA of 2.4x-2.8x over the next two to three years subject to the finalization of capex plans and shareholder distributions.

Rating Action Rationale

We revised the outlook on Meridian to stable to reflect our view that Rio Tinto's decision to continue operations at its NZAS smelter until at least Dec. 31, 2024, eases previously forecast pressure on earnings and energy margins. In July 2020, Rio Tinto announced its NZAS smelter would exit New Zealand in August 2021. We anticipated this to exert significant pressure on Meridians earnings and energy margins. NZAS consumes 40% of Meridian's electricity generation and if it were to have left existing transmission constraints would have impeded the movement of excess power northward. The decision to stay relieves this pressure.

Meridian and New Zealand's electricity sector now has certainty and time to address lower South land transmission constraints.  The agreement reached between Rio Tinto and the company provides price certainty for 572 megawatts (MW) and underpins demand in the lower South Island until at least June 30, 2022. The agreement also provides certainty for a minimum of 400MW until Dec. 31, 2024, with Rio Tinto having the right to relinquish 172MW with six-months notice from Jan. 1, 2022. This provides the sector with time to overcome existing transmission constraints in the lower South Island. Works to address these constraints are currently underway and scheduled for completion in mid calendar 2022. This will allow the export of all excess power if NZAS was to relinquish 172MW under the new agreement, cushioning the impact on lower South Island wholesale prices.

We expect Meridian's debt-to-EBITDA metrics to trend at around 2.4x-2.8x over the next two to three years and remain within our tolerances for the 'BBB+' rating. This compares to our previous forecast of 2.2x-3.4x under an August 2021 smelter exit scenario. Our forecast anticipates drier hydrological conditions in fiscal 2021 followed by a reversion to mean hydrology from fiscal 2022 onward. The extent of moderation or appreciation in wholesale prices in addition to final capital expenditure (capex) plans and distributions will determine whether Meridian's credit metrics will perform at the upper or lower end of our forecast.

Meridian is proceeding with its Harapaki windfarm with debt funding to drive the weakening in Meridian's metrics from fiscal 2022.  We note that this project has now received the Meridian board's approval. The current consent requires work to be substantially underway by at least September 2023. We anticipate total project cost of around NZ$395 million based on the current windfarm scale. Dependent on project timelines and commissioning, we anticipate some benefit to flow from late fiscal 2024 with full benefit in fiscal 2025. We anticipate that Meridian will maintain adequate liquidity through its growth capex phase and put in place appropriate additional bank facilities to support this.

Management to exercise a degree of dividend flexibility throughout the peak capex phase of Harapaki. We believe that management will maintain its ordinary distribution policy of 75%-90% of free operating cash flow (FOCF) over time during the construction of Harapaki. Throughout this period we also anticipate that management may exercise some flexibility in relation to ad hoc special dividends. If undertaken this would offset some of the moderation in ordinary dividends due to peak capex providing a degree of stability in dividend cents per share. We have incorporated special dividends into our forecasts over the next few years to reflect this expectation.

Outlook

The stable outlook reflects the certainty provided to Meridian under expected status quo operating conditions. Meridian's cost competitive position in New Zealand's generation-dispatch merit order and appropriate risk management strategy support the ratings. Under mean hydrological conditions and forecast growth capex we anticipate Meridian will sustain debt to EBITDA of about 2.4x-2.8x over the next two to three years. We also expect the company to prudently manage any domestic and offshore growth opportunities, and adequately balance these against distributions.

Downside scenario

All else being equal, a downgrade would require Meridian's debt to EBITDA to approach and sustain at 3.0x. This is most likely to occur if Meridian was to undertake material debt-funded capex not balanced by moderation of distributions, beyond that incorporated into our current expectations.

The rating would also come under pressure if the government reduced its ownership to a minority stake or circumstances lead us to review the level of government support.

Upside scenario

In our opinion, upside potential is minimal because we expect Meridian to actively manage its growth and balance sheet to maintain some rating headroom to withstand any hydrological risk. However, a debt to EBITDA of less than 2.0x and polices and commitment by Meridian to maintain metrics at such a level would indicate upward rating momentum.

Company Description

Meridian is the largest generation company in New Zealand, producing approximately 31% of the country's electricity. Similar to Mercury NZ Ltd. and in contrast to Genesis Energy and Contact Energy, all of Meridian's generation comes from renewable sources. The company has a broad spread of hydro stations with seven distinct facilities and five wind farms across New Zealand.

With about 11% of the retail market, Meridian is New Zealand's fourth-largest electricity retailer. The company has about 291,000 customers, including those under its Powershop brand. Meridian's largest customer is the Tiwai Point New Zealand Aluminum Smelter (NZAS, ultimately owned by Rio Tinto), which covers about 40% of Meridian's generation output under a price guarantee contract. The smelter accounts for approximately 12% of total national generation output and is under a strategic review by its majority owner, Rio Tinto PLC.

Our Base-Case Scenario

Assumptions
  • EBITDA margins of 23%-25% in line with historical trends in fiscal 2021 and dependent on prevailing market conditions thereafter.
  • Below average hydrological conditions in fiscal 2021 offset by elevated generation prices; Average hydrological conditions thereafter.
  • Flat demand growth over fiscal 2021.
  • Continued operation of NZAS until at least December 2024.
  • Stay-in-business capex of around NZ$55 million to NZ$65 million over the forecast period.
  • Harapaki windfarm capex of around NZ$350 million to NZ$400 million spread over fiscals 2022, 2023, and 2024.
  • All in cost of debt of around 5.2%-5.5% over the next few years.
  • Underlying returns to shareholders within company guidance of between 75% and 90% of FOCF. In addition we anticipate management will prudently manage the payment of any special dividends from fiscal 2021 onward, balancing this against its capex pipeline.
Key metrics

Meridian Energy--Key Metrics*
--Fiscal year ended June 30--
(Mil. NZD) 2019a 2020a 2021e 2022f 2023f
EBITDA 825.5 838 700-750 630-700 630-700
EBITDA margin (%) 24.6 25.5 23-25 23-25 23-25
Capital expenditure 69 63 70-90 130-150 270-320
Debt to EBITDA (x) 1.7 1.8 2.0-2.2 2.4-2.6 2.6-2.8
FFO to debt (%) 44 39.4 38-40 31-33 27-29
*All figures adjusted by S&P Global Ratings. a--Actual. e--Estimate. f--Forecast.

Ratings Score Snapshot

Issuer Credit Rating: BBB+/Stable/A-2

Business risk: Satisfactory

  • Country risk: Low Risk
  • Industry risk: Moderately High Risk
  • Competitive position: Satisfactory

Financial risk: Intermediate

  • Cash flow/Leverage: Intermediate (Standard volatility table)

Anchor: bbb

Modifiers

  • Diversification/Portfolio effect: Neutral (no impact)
  • Capital structure: Neutral (no impact)
  • Liquidity: Adeqaute (no impact)
  • Financial policy: Neutral (no impact)
  • Management and governance: Satisfactory (no impact)
  • Comparable rating analysis: Neutral (no impact)

Stand-alone credit profile: bbb

  • Sovereign rating: AAA
  • Likelihood of government support: Moderate (+1 notch from SACP)

Related Criteria

Ratings List

Ratings Affirmed

Meridian Energy Ltd.

Senior Unsecured BBB+
Commercial Paper A-2

Meridian Finco Pty Ltd.

Senior Unsecured BBB+
Ratings Affirmed; CreditWatch/Outlook Action
To From

Meridian Energy Ltd.

Issuer Credit Rating BBB+/Stable/A-2 BBB+/Negative/A-2

Meridian Finco Pty Ltd.

Issuer Credit Rating BBB+/Stable/-- BBB+/Negative/--

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Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. All ratings affected by this rating action can be found on S&P Global Ratings' public website at www.standardandpoors.com. Use the Ratings search box located in the left column.

Primary Credit Analyst:Alexander Dunn, Melbourne + 61 (3) 96312120;
alexander.dunn@spglobal.com
Secondary Contact:Parvathy Iyer, Melbourne + 61 3 9631 2034;
parvathy.iyer@spglobal.com

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