Corporate

Europe

Eurozone Sovereign/Corporate Links 2012 Update

Sovereign Downgrades Have Spread, but Corporate Insulation Continues
Special Report Eurozone Crisis Storm Abated, Not Cleared
Corporate Insulation Holding Up: Corporate funding has held up well in the face of a continued fragile environment in the eurozone. While the corporate rating trend has been negative overall, the scale of movements has been consistent with a normal recessionary period, and has not been driven by any material linkage to the regions sovereign ratings. No Euro Break-up, No Corporate Crisis: We continue to expect that the absence of transfer and convertibility risk inside the eurozone will limit the magnitude of the effect of further major sovereign debt deterioration on corporate ratings, relative to the effect of sovereign downgrades typically seen in non-eurozone countries. Extended Guidance to Address Utilities: In both of our highly adverse scenario analyses, corporate sectors generally have held up, consistent with our guidance on relative insulation with one notable exception. Utilities, highly rated in normal times, performed particularly badly in each of our hypothetical eurozone default and eurozone shock cases, albeit that the assumptions used in these cases were especially harsh on that sector. Sovereign Downgrades Circle Widened: Additionally, since our last report on sovereign/corporate interaction in April 2011, Greece, Portugal, Italy, Spain, Belgium, Cyprus and Slovenia have all been downgraded, while Frances Rating Outlook has moved to Negative. Sovereign Downgrades Scale Increased: Both Italy and Spain the countries with the most significant corporate debt issuance are at least three notches, or a full category, lower than they were in April 2011 when our initial guidance was published. The momentum of individual downgrades has been reinforced by the challenges involved in solving the regional dimension of the problems. Extended Guidance for A Category: As a result, and to address a potential cliff effect in existing guidance, Fitch has extended its broad guidance on the level of constraint a euro-zone sovereign rating exercises upon local corporates. The level of ratings constraint under an aggressively deteriorating euro-zone sovereign varying from potentially none to a soft cap - is summarised in the table below, subject to the additional factors outlined in this paper.
Figure 1

Related Research
Scenario: Euro-zone Default Stress for Corporate (July 2011) Corporates and the Eurozone Crisis - A Q&A on Events So Far (January 2012) Scenario: Eurozone Corporate Shock Case FAQ (March 2012)

Implications of Sharp Deterioration in Eurozone Sovereign Ratings

Sovereign FC IDR A+ ABBB BB+ BBB+ BCCC RD
Source: Fitch

Analysts
Richard Hunter +44 20 3530 1102 richard.hunter@fitchratings.com John Hatton +44 20 3530 1061 john.hatton@fitchratings.com Erwin Van Lumich +34 93 323 8403 erwin.vanlumich@fitchratings.com

Likely Maximum Foreign Currency IDR for Corporates Which are Primarily Domestic Level of Diversification Globally Diversified Potentially no impact Potentially no impact A+ Potentially no impact A Potentially no impact BBB Potentially no impact BBB Potentially no impact BB+ Potentially no impact BB Potentially no impact BB Potentially no impact BB Potentially no impact

www.fitchratings.com

7 March 2012

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Cliff effect at A/BBB levels removed Utilities noted as more vulnerable in stress cases

Revised Guidance
Our guidance now includes constraints for primarily domestic businesses in a eurozone country that is undergoing pressure on its credit profile, and with its sovereign rating in the A category. Ratings of internationally diversified businesses will continue to operate without any mechanical linkage to their sovereign. Such businesses will not be immune to downgrades, depending on the severity of the economic challenges they face from a weakening economy in various markets, but there will still be no lockstep downgrade relationship that forces corporate ratings in failing countries to be downgraded in line their respective home sovereign ratings.

What Has Changed in Our Guidance

The pace and wider scale of sovereign rating deterioration led us during 2011 and early 2012 to review our corporate portfolio against a series of crisis cases a sovereign default case analysis in July 2011 and a shock case analysis in March 2012. Both exercises confirmed our main premise that corporate ratings could remain above sovereign ratings, even for primarily domestic issuers, in a crisis case. However, in both exercises, we identified a cliff effect when sovereigns fell below the A category. In theory, under prior guidance a sovereign could fall to BBB-, the lowest level of investment grade, with no impact on a primarily domestic corporate rated A+. The next downgrade for the sovereign, however, would result in a four notch downgrade for the same A+ rated, primarily domestic corporate. While unlikely to occur in practice, we wanted to adjust our external guidance to reflect a more moderate transition path for such changes.
Current rating case and real-life access to capital still support utility premium Extreme assumptions used in shock and default cases Harsher on utilities reflecting greater interaction with public authorities Stronger rebasing for utilities if sovereigns restructure Unsecured utility bonds now capped at issuer rating in periphery; can still exceed sovereign rating

Potential Impact Would Be Limited to One Sector - Utilities

Our rated portfolio for corporate issuers with a domestic focus revealed very few issuers rated in the high A category and above. All, bar the regions utilities, represented globally diversified businesses. At the same time, our extreme default and shock stresses on the utility portfolio resulted in disproportionately large hypothetical rating revisions for that sector, for three reasons. Utilities start with higher leverage for a given rating level, reflecting the predictability of revenues and the essential nature of the service provided. Institutional threats to predictability have a disproportionate impact. Independent and transparent regulation is seen as key to partially mitigate the credit impact of typically negative free cash flow (FCF) profiles, compared to a corporate universe where investment grade companies mostly run with positive FCF. The sector thus remains vulnerable to political interference on key matters of generation, investment and tariff policy. Utilities have diversified internationally over recent years, but this diversification has been less successful than for other sectors when viewed in terms of creditworthiness as opposed to broader measures of corporate success. In a number of key cases, diversification has also been relatively localised, into other economies facing similar eurozone pressures with a high correlation on sovereign pressures.

The current ratings remain appropriate in a scenario of weakening economic conditions which is our central case. However, the extended guidance better incorporates the gulf between ratings at the current levels and the hypothetical levels should the eurozone enter a more profound sovereign driven series of shocks. More detail on the deterministic assumptions used in constructing our stress cases can be found in the reports linked above. Related Criteria
Rating Corporates Above the Country Ceiling (January 2012)

Fitch notes that the actual effect of sovereign rating pressure on utilities creditworthiness largely depends on the timing and extent of regulatory and fiscal intervention, which is likely to

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vary across the eurozone. On the one hand, our deterministic assumptions were extremely harsh, with significant undermining of the regulatory tariff structures in each scenario, arguably more so than other sectors because of the greater government purview in the utility sector. On the other hand, a number of eurozone countries have taken measures that penalise the utility sector, including a Robin Hood tax in Italy and a deferral of collection of costs related to special regime generation in Portugal, among other initiatives in the region. This has occurred while the respective sovereigns are still rated solid investment-grade, also supporting Fitchs extended notching guidance.

Some Unsecured Utility Bond Ratings Already Affected

A technical rating matter has already reduced some utility bond ratings. While we do not operate individual country ceilings within the eurozone, we have generally regarded the additional notch applied globally to regulated utility debt issuance as inappropriate in jurisdictions where the utility is rated at a higher level or the same level as the sovereign. This reflects an expectation that the higher recoveries typically expected for defaulting utility bonds would be sufficiently less predictable in an environment of sovereign default to remove this premium rating on utility debt. As sovereign ratings in Spain and Italy have moved into the A category, this constraint has led to bond, rather than issuer-level, downgrades for a number of utilities to the level of their respective issuer rating, described in detail here.

Risks Vary Substantially Key Focus on Diversification

Fitch continues to believe that a euro-zone break-up is highly unlikely. The possibility of a single exit or further restructuring of individual euro-zone sovereigns obligations, however, has clearly increased following the evolution of Greeces predicament. Corporates face the following risks from the scenario of a euro-zone sovereign default, without a eurozone exit: local funding and commercial dislocation; strain on public-sector disbursements to vendors; supply-chain failures with the potential for snowball effects; liquidity interruptions to corporate bank and bond funding; in extremis, disruption to payment systems.

Adding an exit from the euro currency bloc to this radically changes the picture. Defaults multiply, and almost all locally-domiciled issuers would be lowered to high speculative grade at best.
State ownership not a cap for corporate ratings May face greater challenges than fully private corporates Rating gaps unlikely to exceed guidance for domestic corporates outlined on page 1 Particular concern focused on directed deposits

Factors Beyond Diversification

Many corporates would suffer economically under an orderly sovereign default, but would avoid their own default provided strong internal liquidity remained available, or the sector (eg, utilities, telecoms, consumer non-durables) remained attractive to international capital providers which could lend without redenomination worries. Rating actions may be limited in scope, and maintained at levels several categories above a defaulting state, provided that organic liquidity for the corporate in question remains strong, and any sovereign debt restructuring remains reasonably orderly. Other factors that might coincide between sovereign and corporate creditworthiness could include, as examples:

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underlying financial performance; issuer-level liquidity, including an assessment of the syndicate of banks providing back-up liquidity; other measures of market access including sharp volatility in equity or credit default swap pricing; any institutional disruption within that jurisdiction short of capital controls (eg, taxation, directed deposits, etc.).

On this latter point, looking at the specific risk of directed deposits, as the government potentially seeks to halt outflows of institutional deposits, Fitch would therefore include a consideration of the spread of risk in cash holdings in its liquidity analysis, potentially applying haircuts to liquidity assumptions should the position of the local banking system so warrant. Fitchs focus on gross debt as well as net debt measures also helps maintain a consistent assessment of risks. Naturally, the combination of some or all of these risk factors is highly likely to also pull down an issuers standalone profile, which may well result in ratings lower than the maximum levels indicated in Figure 1.

State Ownership
Within these factors, Fitch would generally make only a limited distinction based on state ownership of the corporate. This decision reflects a number of factors.

Generally no Uplift for State Ownership

As free-market economies, in the European Union, only a handful of the ratings assigned by Fitch to state-owned corporations include any uplift for state support (an approach which has differed from that of other rating agencies), reflecting the institutional framework and prevailing approaches to financing of state-owned corporations applied in most parts of the bloc, and state-aid rules that make it harder for states to overtly support national enterprises. Fitch also expects the governance approach of states to their state-owned corporates within the European Union to be marginally more sophisticated than in the majority of emerging markets, where constraint by a state rating more frequently applies. This does not imply that separation to a theoretical standalone level is likely. State-owned corporations will naturally be subject to the same additional risk factors identified above, plus additional threats from intervention linked to the heavier input of state authorities in the entitys financial policies. Additionally, it is very rare for state-owned corporations to be rated above their sovereign. This distinction can be introduced when it becomes evident that a sovereign (a) is becoming distressed and (b) full contagion to state-owned corporations may nonetheless be avoided. Outside the eurozone, this distinction would typically be limited to a zero-to-three notch range. A higher range is likely inside the eurozone, but will be limited in line with the broad guidance above.

The Hand of the State Larger But Not Yet Omnipotent

Some evidence of states racking up tax or other charges for corporates Harshest measures not anticipated other than in our extreme stress cases

In Fitchs original February 2010 comment, we broadly discounted ad hoc taxation efforts. In the meantime, there has been more evidence, in Greece, Hungary, Portugal, Italy and even the UK, of efforts by governments to levy additional one-off taxes and other fiscal transfers. Fitch nonetheless remains of the opinion that, in most sectors, while these pressures can add to the negative pressure on fundamental credit ratios that an individual corporate faces in a declining economy, sovereigns are unlikely to pursue expropriation to a degree that would ultimately provoke a default.

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Entity Analysis
Cash flow diversification is as important as revenue split Most industrial corporates have good levels of international diversification Debt and cash flow location are also key to the case-by-case analysis

A selection of larger Fitch-rated corporates in Greece, Ireland, Italy, Portugal and Spain are listed below. Industrial issuers tend to have higher levels of diversification relative to telecom and utility entities, but the correlation between sector and diversification is not uniform.
Figure 2

Selected Issuers - Revenue Diversification

Entity Greece OTE Ireland Electricity Supply Board Italy Acea SpA Edison SpA Enel SpA Eni SpA Fiat SpA Finmeccanica SpA Telecom Italia SpA Terna SpA Wind Telecomunicazioni SpA Portugal Portugal Telecom EDP Energias de Portugal SA Spain Abengoa Cableuropa SA Enagas SA Gas Natural SDG SA Iberdrola SA Obrascon Huarte Lain SA Red Electrica Corporacion Repsol YPFb Telefonica SA Sector Telecom Utility Utility Utility Utility Oil & Gas Industrial Industrial Telecom Utility Telecom Telecom Utility Infrastructure Cable Utility Utility Utility Industrial Utility Oil & Gas Telecom Current rating BB, Evolving Watch BBB+, Negative Outlook A, Negative Watch BB-, Evolving Watch A-, Stable Outlook A+, Stable Outlook BB, Negative Outlook BBB-, Negative Outlook BBB, Negative Outlook A, Negative Outlook BB, Negative Outlook BBB, Negative Outlook BBB+, Negative Outlook BB, Stable Outlook B, Positive Outlook A+, Stable Outlook A-, Stable Outlook A-, Stable Outlook BB-, Stable Outlook A, Stable Outlook BBB+, Stable Outlook BBB+, Stable Outlook Domestic Revenues

Fitch estimates of approximate average revenues, rounded to nearest 10% b Repsol YPF Excluding contribution from Gas Natural SDG Source: Fitch

In addition to revenue diversification, Fitch also looks closely at the geographical earnings and cash flow profiles of eurozone corporates in determining the links with their respective sovereigns. This is for example highly relevant in the oil & gas sector, where Eni SpA and Repsol YPF generate a much larger proportion of revenues than of operational cash flow from their domestic markets, reflecting generally lower margin downstream activities versus upstream. In the case of Eni, only about 10% of its upstream segments revenues are generated in Italy and this segment is by far the largest contributor to the company's consolidated operational cash flow. These companies are therefore likely to be viewed by Fitch as more geographically diversified than their revenue distribution suggests. For the purpose of assessing the geographical earnings mix of eurozone corporates Fitch also adjusts its analysis for those international activities that are funded on a non-recourse basis and whose cash flows may not be freely available to service parent company debt.

Fast-Moving Situation
Our approach, which results in a potential gap of up to four to five notches between a sovereign and its primarily domestic corporates, is both flexible and consistent with our approach in other markets. The current situation is, however, still subject to change, and rating actions will aim to reflect the information available at that time, which may in turn result in small deviations from the expectations outlined above. The most significant risks of material changes to the above expectations are still:

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a change in Fitchs view on the viability of the euro as a common currency; and any formalised move towards soft capital controls (eg, any attempt by a sovereign to install virtual capital controls or deposit freezes in local banks to limit deposit flight from its banking system), in any individual jurisdiction.

These possibilities are currently considered by Fitch to be components of a future downside scenario. Rather than an exhaustive list of tail risks, they represent the largest foreseeable threat to the ratings of purely domestic corporates in a troubled euro-zone jurisdiction.

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Eurozone Sovereign/Corporate Links 2012 Update March 2012