Rating Action Overview

• Vector Ltd.'s. business risk profile will strengthen with the divestiture of 50% of its unregulated metering business to a joint venture (JV) with Queensland Investment Corp. Ltd. (QIC, not rated).
• We believe Vector's management will use the proceeds to deleverage the business somewhat over the next few years, leading to lower debt and cash interest costs. We forecast the company's ratio of funds from operations (FFO) to debt at 10%-11% in fiscal 2024, strengthening to above 13% after that.
• On April 26, 2023, S&P Global Ratings raised its long-term issuer credit rating on Vector to 'BBB+' from 'BBB'. At the same time, we raised the long-term issue ratings on the company's senior unsecured debt to 'BBB+', from 'BBB', and subordinated capital bonds to 'BBB-', from 'BB+'.
• The positive outlook on the issuer credit rating indicates that we could raise the rating by a notch, dependent on the final extent of deleveraging undertaken by the New Zealand-based company over the next one to two years.

Rating Action Rationale

Vector's business risk profile will strengthen with a higher proportion of revenue and cash flow derived from its regulated monopoly business after the divestment of the 50% stake in the company's metering business. We believe all conditions have been met, pending only the approval under the Overseas Investment Act (New Zealand) and Foreign Acquisitions and Takeovers Act (Australia). Regulatory approval is expected by the end of June 2023, and we do not anticipate this to pose a constraint to transaction completion. After divesting the metering business to the JV with QIC, about 85% of EBITDA will come from Vector's regulated electricity and gas businesses, compared with about 60% in the fiscal year ending June 2023. The increased dominance of EBITDA from its regulated businesses and its boost to cash flow stability mean the company could operate with lower threshold metrics for the same rating.

Our view of Vector's business risk profile is tempered by the significant and growing proportion of EBITDA that will be derived from its metering JV.  Dividends paid to Vector are included in our EBITDA calculation under an equity accounting approach. These dividends are ultimately underpinned by the JV's comparatively weaker unregulated business, which is subject to market competition.

We expect the JV's EBITDA contribution to progressively increase with rising dividends, driven by growth aspiration for its Australian operations. After incorporating Vector's other smaller unregulated businesses, we forecast the proportion of EBITDA derived from unregulated sources will increase to nearly 20% in fiscal 2026, from about 15% in fiscal 2024. We reflect this growth and incremental dilution of Vector's business risk profile through a negative assessment on the comparative ratings analysis.

Our analysis incorporates the equity accounting treatment of the JV with dividends added back to our S&P Global Ratings Global Ratings-adjusted EBITDA. This reflects the stand-alone nature of the JV with a separate management and board in addition to Vector's non-controlling interest in the JV. Furthermore, we anticipate that any debt raised at the JV level will have no recourse back to Vector itself.

By our estimates, Vector's FFO-to-debt ratio will strengthen above 13% in fiscal 2025 and beyond, from 10%-11% in fiscal 2024.  This is based on our belief that the company will utilize divestment proceeds to deleverage in the next one to two years. This will have a two-fold impact on the FFO-to-debt ratio, lowering both net debt and cash interest cost. At the same time, EBITDA will progressively benefit from escalating JV dividend flows associated with gradual expansion in the Australian market, further strengthening FFO.

The magnitude of strengthening will depend on the extent and timing of deleveraging. In addition, any improvement will be shaped by how management ultimately decides to balance debt reduction against shareholder distributions, network investment or any other growth opportunities that may emerge. We have therefore revised our opinion of its financial policy to negative.

Vector's liquidity will strengthen on the back of divestment proceeds inflow.  The anticipated NZ$1.72 billion in net cash proceeds from the divestment will significantly bolster Vector's liquidity position. This will enable the company to easily cover approaching debt maturities over the next one to two years, in addition to meeting its capital expenditure (capex) and dividend commitments.

Outlook

The positive outlook on Vector reflects potential for greater deleveraging than we anticipated following the divestiture of Vector's metering business. We expect net proceeds from the transaction to be used to retire a proportion of outstanding debt, leading to the company's FFO-to-debt ratio rising above 13% in fiscal 2025 and beyond, from 10%-11% in fiscal 2024.

The extent of deleveraging will depend on several factors, including the balance sheet strength the company wishes to maintain ahead of the 2025 regulatory reset and any post-transaction revision to its dividend policy.

Downside scenario

We could revise the outlook to stable if Vector engages in a material acquisition or growth opportunity, dividends to shareholders are materially higher than forecast, or required network capex is significantly higher. An indication of this would be the FFO-to-debt ratio falling below 13% on a sustainable basis.

A dilution to the business risk profile without an offsetting improvement in financial strength can also affect the rating. This can occur if there is a material increase in EBITDA contribution toward 25% from the metering business, which is relatively more competitive.

Upside scenario

We may raise our rating if Vector ultimately deleverages following the completion of the divestiture of the metering business. Its FFO-to-debt ratio of greater than 13% on a sustained basis, backed by policy commitments to maintain a higher rating, would drive an upgrade.

Company Description

Vector is the dominant energy network company in New Zealand. It is 75.1% owned by Entrust, and the balance is listed. Vector owns and operates three distinct businesses as below:

• Electricity distribution network in Auckland,
• Auckland gas distribution network, and
• Gas trading.

In addition to the above, it also has an interest in metering through its 50%/50% New Zealand- and Australia-based JV with QIC.

Our Base-Case Scenario

Assumptions

• New Zealand's GDP and inflation to trend as per the table below. Electricity and gas demand trends are not linearly correlated with economic factors.
• Revenue path for regulated electricity and gas networks to grow in line with approved tariff paths for the periods ending March 31, 2025, and Sept. 30, 2026, respectively. Subsequent reset estimate to be based on prevailing interest rate conditions at the time.
• Minimal growth in energy volumes and customer numbers over the next two to three years.
• Overall EBITDA margin of 44.5%-51.5% over the next two to three years, recovering as a lagged recovery of inflation commences in fiscal 2024 and JV dividends ramp up.
• Net proceeds from the sale of a 50% stake in metering JV of about NZ$1.72 billion to be received in fiscal 2024.
• Metering JV dividends commencing in fiscal 2024 of about NZ$13 million and NZ$38 million in fiscal 2025.
• Dividends to be relatively stable over our forecast period, trending at NZ$165 million-NZ$175 million.
• All-in cash interest cost of 5.1%-5.3% over our forecast period.
• One-off swap break fees of approximately NZ$30 million in fiscal 2024, associated with deleveraging and included in cash interest. The final quantum of these break fees will ultimately be determined by market conditions at the time they are broken.

Key metrics

Liquidity

We consider Vector's liquidity to be strong. This is based on our expectation that the company's sources of funds over the next 12 months are likely to cover its uses by at least 1.5x, and would exceed uses even with a 30% decline in EBITDA. We do not anticipate much flexibility on dividends, though there could be an intra-year shift in capex, if needed.

Vector has a good track record of refinancing its debt ahead of maturity and has good relationships with banks to acquire credit lines to manage its finances. Vector's facilities are subject to gearing and interest coverage covenants, with significant headroom against these levels.

Principal liquidity sources:

• Cash on hand and undrawn bank lines of about NZ$370 million as of March 31, 2023.
• Cash flow from operations of about NZ$460 million over the 12 months ending March 31, 2024.
• Proceeds from sale of interest in the metering business of NZ$1.72 billion.

Principal liquidity uses:

• Debt maturities of about NZ$575 million over the 12 months ending March 31, 2024.
• Capital spending of NZ$550 million-NZ$575 million (before adjusting for customer contribution) over the same period.
• Dividend payments of NZ$165 million-NZ$175 million over the same period.

Issue Ratings - Subordination Risk Analysis

Capital structure

Vector's capital structure consisted of committed drawn senior unsecured bank facilities of NZ$1,126 million, senior unsecured bonds of NZ$885 million, U.S. private placements of NZ$1.213 billion, and subordinated perpetual capital bonds of NZ$307 million as of March 31, 2023.

Analytical conclusions

We rate Vector's senior unsecured debt at 'BBB+', the same as the issuer credit rating, given that this debt is senior, and no significant elements of subordination risk are present.

In addition, we rate the subordinated debt two notches below at 'BBB-', in line with our criteria on hybrids, given the subordinated nature and deferability characteristics. Although the bonds are perpetual in nature, the next call date is in June 2027. Vector replaced these capital bonds in June 2022 at the end of the second term of five years, and the company expects to do so again in 2027. We believe these facilities will remain an integral part of Vector's capital structure due to the restricted access to equity capital.

Ratings Score Snapshot

Related Criteria

• General Criteria: Hybrid Capital: Methodology And Assumptions , March 2, 2022
• General Criteria: Environmental, Social, And Governance Principles In Credit Ratings , Oct. 10, 2021
• General Criteria: Group Rating Methodology , July 1, 2019
• Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments , April 1, 2019
• Criteria | Corporates | General: Reflecting Subordination Risk In Corporate Issue Ratings , March 28, 2018
• Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers , Dec. 16, 2014
• Criteria | Corporates | General: Corporate Methodology , Nov. 19, 2013
• Criteria | Corporates | Utilities: Key Credit Factors For The Regulated Utilities Industry , Nov. 19, 2013
• General Criteria: Country Risk Assessment Methodology And Assumptions , Nov. 19, 2013
• General Criteria: Methodology: Industry Risk , Nov. 19, 2013
• General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities , Nov. 13, 2012
• General Criteria: Principles Of Credit Ratings , Feb. 16, 2011

Ratings List