Panama Canal: Risk Rating Confirmed

Because of its financial and competitive strength, the rating agency Fitch Ratings confirmed that the risk rating as an issuer of long-term debt is "A", with a stable outlook.

Friday, August 16, 2019

The ratings reflect an underlying asset that is critical not only for Panama, but also for international trade, as evidenced by its stable volume performance, solid competitive position and well-diversified cargo mix, the ratings company explained.

From Fitch Ratings statement:

Fitch Ratings - Mexico City - 15 August 2019: Fitch Ratings has affirmed the Long-Term Issuer Defualt Rating (IDR) for the Autoridad del Canal de Panama (ACP) and the rating on USD450 million senior unsecurex notes at 'A'. The Rating Outlook is Stable.

RATING RATIONALE
The ratings reflect an underlying asset that is critical not only for Panama, but for international commerce, as demonstrated by its stable volume performance, solid competitive position and well-diversified cargo mix, causing ACP´s volume profile to exhibit high levels of resilience. The ratings also reflect ACP's strong ability to modify tariffs that have strategically influenced demand and contributed to steady revenue growth. The ratings also incorporate the legal framework that provides autonomy to the entity, as well as Fitch's view that there are appropriate incentives to keep the asset profitable over the long-run. Despite very strong financial metrics under Fitch's rating case of negative leverage and debt service coverage ratios (DSCR) of over 4x post fiscal year (FY) 2019 that would indicate a higher rating in comparison with Fitch's Rating Criteria for Ports, the rating is constrained at three notches above Panama's sovereign rating (BBB/Stable) given the linkages between ACP and the Panamanian government.

The Stable Outlook reflects Fitch's expectation that the strength of ACP's financial profile will provide more than sufficient financial cushion to withstand the potential adverse effects of a global trade war on its container business, unexpected capex and unfavorable outcomes of outstanding legal disputes at the currently assigned rating level.

KEY RATING DRIVERS
Strategic Asset for Global Trade Flows
The Canal is a key player in global trade as it has a privileged geographical position. Over 3% of world maritime commerce transits the Panama Canal. The Canal offers connectivity to world maritime trade, linking the Atlantic and Pacific Oceans, ports, rails and ancillary services, adding value as the main transhipment hub in the region.

Legal Framework Supports ACP's Autonomy
ACP is an entity of the Panamanian Nation established under the Constitution with exclusive charge of operation, management and modernization of the Canal. The risk of government interference is adequately mitigated by ACP's extraordinary legal framework, which provides it with institutional, operational and financial autonomy. Furthermore, incentives are aligned to maintain the Canal's profitability, given moderate reliance of the sovereign on financial contributions from ACP to meet its financial targets, evidenced by ACP's long track record of managing profitable operations through different administrations. Moreover, the rating reflects expectations that the Canal will continue to be managed under the same legal framework.

Strong Market Position - Revenue Risk (Volume): Stronger
The Canal processes a well-diversified mix of cargo types and services a wide array of international trade partners, resulting in a strong demand profile that has exhibited high levels of resilience following global macro trade fluctuations and economic downturns. The Canal's largest business line consists of container cargo between the Eastern United States and Asia. While this sector's industry is competitive, which could cause related volumes to exhibit a moderate level of price elasticity, the Canal benefits from a significant competitive advantage in terms of shipping times and costs over other modes of transit, which has been bolstered even further following the opening of the third set of locks in 2016.

Robust Tariff-Setting Flexibility - Revenue Risk (Price): Stronger
ACP has successfully implemented a toll structure that periodically changes to capture the changing dynamics of the maritime industry. A proactive approach in adjusting tariffs periodically in accordance with varying types of content in cargo and sailing schedules has provided stable cash flow generation. However, shipping line consolidation to improve margins coupled with transport alternatives poses economic challenges to the Canal's pricing flexibility, particularly with regard to its container cargo business.

Modern Facilities, Big-Ship Readiness - Infrastructure Development & Renewal:  Stronger
With completion of the USD5.4 billion major Canal expansion, annual capital investments are expected to be lower in the near term. The Canal's new, eight-year USD2.4 billion capital plan mostly consists of maintenance and strategically related works, including the opening of the Atlantic Bridge that took place in August 2019 and a new Roll-on/Roll-off terminal over the upcoming years. Overall, Fitch considers the Canal's capital funding and planning mechanisms to be strong, evidenced by its ability to fully cash fund all of its needs and maintain good dialogue with relevant parties to continue diversifying its revenue profile.

Some Variable Rate Exposure - Debt Structure: Midrange
Approximately half of ACP's debt is expected to bear unhedged variable rates, causing some uncertainty with respect to the size of future debt service obligations, justifying the midrange assessment, despite its other stronger characteristics. All of ACP's debt is senior, with approximately 85% of outstanding debt exhibiting a fully-amortizing structure while the rest has a balloon structure. Refinancing risk is considered remote given the small portion of balloon debt combined with the relatively small future principal payments relative to ACP's expected cash flow. Bondholders also benefit from very strong financial covenants through 2028 and ACP's healthy cash position.

Financial Profile
In Fitch's rating case, leverage, measured as net debt/cash flow available for debt service (CFADS), is negative with outstanding debt balances being completely offset by cash balances, while DSCR levels are very strong at over 4x once ACP starts to amortize its debt in FY 2019. Despite metrics that are very strong for the current rating category, ratings are constrained as the degree of separation between ACP and the Panamanian government is considered not to fully ring-fence the entity under relevant criteria. This is evidenced by the state ownership of the asset and the appointment of the majority of the board members by Presidents of Panama, although under a stagered regime. Also, while the law dictates that only after all operting costs, including capex, and contigency reserves are funded, the remaining surplus cash can be distributed to the National Treasury, the structure does not have an explicit covenant that needs to be complied with in order to distribute these monies.


PEER GROUP
Among Fitch's rated transportation portfolio there is no direct comparison for the Panama Canal. However, Harbor Department of Los Angeles (AA/Stable) is comparable given its large scale container operations. ACP benefits from a much larger revenue base and less throughput volatility, but Los Angeles´s throughput volatility is mitigated by a much larger percentage of minimum annual guarantee revenue. ACP´s average rating case coverage levels are higher than that of Los Angeles at 4x or more, though the rating is currently constrained for the aforementioned reasons.

RATING SENSITIVITIES
Future Developments That May, Individually or Collectively, Lead to Negative Rating Action:
-    Although unlikely, significant adverse changes in trade policies or the overall macro environment that negatively affect the Canal's volume growth prospects on a sustained basis;
-    A negative rating action on the sovereign rating of Panama;
-    A material change in ACP's autonomy or operational ties with the sovereign through adjustments to the legal framework.

Future Developments That May, Individually or Collectively, Lead to Positive Rating Action:
-    A positive rating action on the sovereign rating of Panama.

CREDIT UPDATE
In FY 2018 (ended Sept. 30), tonnage performance grew over 9%, reflecting the Canal´s first two full years following the opening of the third set of locks in June 2016, which has permitted vessels of much greater capacity to pass through the locks. Canal revenues and transit tons have grown at a CAGR of 13% and 16%, respectively, since the opening of the third set of locks. For the first ten months of FY 2019, tonnage levels have continued to grow following the opening of the new locks, particularly within the container and LNG segments, with total cargo growing by 4.4% overall.

Strong growth in cargo volumes has driven revenue outperformance relative to Fitch´s base case expectations. Specifically, FY 2018 and FY 2019 (October 2018 - July 2019) toll revenues grew by nearly 11.0% and 2.7% versus Fitch´s expectations of 8.5% and -1.1%, respectively.

In addition to toll revenue outperformance, expenses were also lower than expected and cash balances were higher in FY 2018, causing net debt leverage metrics to improve significantly to -0.2x from expectations of 0.7x in Fitch´s base case.

In 2018, the U.S. imposed three rounds of tariffs on more than USD250 billion worth of Chinese goods; the duties of up to 25% cover a wide range of products. China retaliated by imposing tariffs from 5% to 25% on USD110 billion of U.S. products. On Aug, 1, 2019, the U.S. announced it would impose a 10% tariff on a further USD300 billion in Chinese imports. The new duties will be imposed beginning Sept. 1, 2019. Given that roughly 70% of cargo processed through the Canal is either destined to or from the United States, ACP´s volume profile could be adversely affected in the event that the aforementioned developments translate into lower volumes transported between these trade partners. Additionally, in January 2020, the new emission standards set by the International Maritime Organization (IMO) aimed at reducing the current 3.5% sulphur cap on fuel to 0.5%, will be enforced. Although ACP has already undertaken a series of initiatives to position the asset at a competitive advantage, Fitch has incorporated conservatism into its forecasts in order to account for the potential of lower or declining future volume performance, but acknowledges that significant uncertainty continues to exist that could cause volumes to exhibit worse performance than assumed.

Outstanding claims related to the construction of the third set of locks remain, on behalf of Grupo Unidos por el Canal, S.A. (GUPCSA), the consortium responsible for their design and construction. These claims relate to concrete works, lock gates and disruption related issues, among others. As of the end of FY 2018, GUPCSA filed 119 claims, of which 41 have been resolved and cancelled and ACP´s contingent liability related to these claims was USD5.5 billion. However, the final outcomes of the legal proceedings are not expected to materially affect ACP, and Fitch considers the Canal´s financial position sufficiently strong to offset potentially unfavorable outcomes.

FINANCIAL ANALYSIS
Fitch Cases

In both of Fitch´s cases, Fitch has considered ACP´s financial performance in FY 2019 to date with no revenue growth incorporated through the end of the fiscal year. No future toll increases are considered. Cash balances are expected to remain flat from FY2019. Fitch does not consider any litigation payment for claims related to construction of the third set of locks.

Following FY 2019, Fitch´s base case assumes revenue growth averaging 0.7%, with a 2.0% growth in FY 2020 that gradually decreases thereafter, reflecting lower growth due to the current trade environment. Expenses grow in line with projected Panamanian inflation and volume growth.
 
Fitch´s rating case following FY 2019 assumes revenue growth that follows the same trend as the base case, but with a lower average growth rate at 0.0%, which is considerably more severe than ACP´s historical revenue performance but considered warranted given aforementioned concerns. Expense growth is slightly lower than in the base case, given lower expected volume growth, consistent with ACP´s financial structure and historical performance.

The mentioned assumptions yield strong metrics in both cases, evidenced by healthy average DSCR levels of 4.7x in the base case that decline to 4.37x in the rating case. Net leverage metrics remain negative in both cases, and gross leverage metrics remain low, at 1.41x in the base case and 1.43x in the rating case. Projected leverage metrics are similar to those in last year´s review, primarily due to Fitch´s assumption that ACP will not issue additional debt or significantly deplete its cash balances in order to allow transfers to the sovereign to continue to be maintained at levels projected before FY 2021 and FY 2022, given management's expectations to fully fund all capex needs with cash flow or reserves. However, Fitch expects that in the event that EBITDA performed at a much lower level than projected, ACP would take action either by increasing tolls and deferring or debt-funding capex in order to maintain the growing trend of transfers, as has typically been the case historically.

In comparison with Fitch's Rating Criteria for Ports and relevant peers, these metrics would be consistent with a higher rating, but the rating is limited by the lack of robust contractual ring-fencing between ACP and the sovereign, capping the rating at three notches above that of Panama.

Criteria Variation
For this transaction, a criteria variation was applied on the Government-Related Entities Criteria. This methodology establishes that for projects with a stronger standalone credit profile than that of the government parent, the relevant considerations of the Parent and Subsidiary Linkage criteria will be applied to determine relative notching. The weak linkage between ACP and the government of Panama and the ring-fencing characteristics of the Canal would normally only provide for a two-notch uplift above the sovereign rating. However, the very unique nature of the asset given its strategic importance to world commerce, extraordinary legal framework and existence of appropriate incentives to keep the asset profitable over the long-run have led Fitch to determine that these characteristics add considerable financial strength to the entity and therefore support the positioning of the rating at three notches above the sovereign rating of Panama.



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