Eskom is TBTF, but investors still seek 100bps premium to SA, guarantee language raises recourse questions

01 August 2018

South Africa’s fate is inextricably linked to Eskom. Not only is the state-owned electricity company too big to fail, given its political importance, but the presence of ZAR 350bn (USD 26.33bn) of contingent guarantees handcuffs the sovereign to it. Lately, Eskom’s standalone credit ratings have slipped markedly to several notches below South Africa’s, leading to the decision to issue its first Eurobond utilising the guarantees. It is also taking feedback on a non-guaranteed tranche, say investors.

The burning question for prospective buyers is what yield premium the guaranteed deal should trade to South Africa and what rights and protections do they offer compared to existing unsecured debt?
 
Just looking
 
Those polled by Debtwire, reviewing the estimated USD 1.5bn, up to 10-year deal, suggest it should offer 75bps-100bps premium to the sovereign (6.25%-6.5% yield), including a new-issue premium of around 25bps, with demand mostly driven by CEMBI buyers.
 
To determine the spread, some looked where domestic guaranteed notes trade relative to SAGBs. However, the bulk of these are owned by the Public Investment Corporation, on the hook for ZAR 85bn-ZAR 90bn of Eskom risk, according to media reports.
 
"For the 10-year guaranteed tranche, we’re thinking 70bps-75bps over the sovereign," said one fund manager looking at the deal. The FM said he is basing his price thoughts on the Transnet 2022s, which are not guaranteed but have the same rating as the sovereign and trade at 80bps-85bps over it.
 
However, a source close to the deal suggested there would be a 50bps-75bps pick-up over sovereign unsecured, sufficient to compensate for choosing Eskom over South Africa. The South African guarantees programme is very well known among investors looking at the region, the source added.
 
The size and maturity of any non-guaranteed tranche will be determined by investor feedback. Appetite for the standalone bonds is expected to be significantly less, according to those polled.
 
There should be a standard new-issue premium of 50bps-75bps on top of the 100bps-125bps pick-up the unsecured bonds trade to the sovereign guaranteed bonds, suggested a second fund manager.
 
"For the unguaranteed tranche, they haven’t set a maturity yet, but if we look at the Eskom unguaranteed 2025s and the sovereign 2025s – Eskom trades 260bps cheap," said the first fund manager.
 
Eskom 25s are currently trading at a cash price of 96.5 yielding 7.83%, compared to South Africa 2025s at 103.75 to yield 5.24%, whereas the sovereign 2028 bonds are trading at 90.5 to yield 5.53%, he added.
 
"Issuing a guaranteed bond is bad news for existing bondholders - an immediate subordination. If you hold the USD 1.25bn [unsecured] 2025s you're suddenly at the back of the queue," said a third fund manager.
 
However, as our research note observes, under the terms of the guarantee, Eskom’s cash must be used to service unguaranteed debt first in preference to guaranteed debt.
 
Mr Writer
 
As our sister publication Xtract explains, under the documentation for the MTN programme there is effectively no bondholder recourse to Eskom given the inability of holders to enforce upon the utility. The docs say that there is limited recourse, but under the drafting there is no ability to enforce after acceleration, even in the event that South Africa does not pay out on the guarantees.
 
Debtwire’s credit report today suggests that bondholders should view these bonds as South African Government risk, albeit one where Eskom has the option to pay if it has the ability. As a result, enforcement and recovery options in a default should be viewed in a Sovereign context.
 
Initially, the Xtract lawyers thought it must be a major mistake via a drafting error, but the summary under the bond prospectus suggests that this was intended by the writers. For their report click here.
 
A sceptic could suggest that the guarantees are a neat way of getting quasi-sovereign obligations off balance sheet. Many commentators expect South Africa may eventually be forced to bail out the over-levered utility, but arguably by stepping in and meeting interest payments the day of reckoning could be postponed by the drip feeding of payments via the guarantees, structured as a subordinated loan.
 
It means nothing
 
Most investors polled by Debtwire were uninterested in the details and the mechanics.
 
"The guarantee wasn't an issue for us, as they made it clear that was irrevocable and unconditional," said a fourth PM looking at the deal.
 
"Maybe it’s true to say that you are in a better legal position if you are in unguaranteed, but South Africa is in a far stronger financial position than Eskom and I just can’t imagine they wouldn’t honour the guarantee," said the first fund manager.
 
The role of the guarantee is normal for South Africa structuring. The China Development Bank (CDB) loan has the same guarantee structure in place, said the source close to the deal.
 
"Yesterday, during the London lunch, an investor asked leads if Eskom defaults, because of the guarantee, would that trigger a cross default between the Eskom paper and other South African paper and the leads?" the source close said. "The answer was no; because the documentation says that there is not a cross-default clause."
 
However, if Eskom defaults, bondholders can enforce against the sovereign because of the guarantee, the source explained. "If South Africa can pay, it will pay. If South Africa can't pay, this becomes part of sovereign debt and at this point it enters the government balance sheet."
According to the source close, only once the guarantees are triggered, would there be a cross default against other sovereign paper.
 
"Prior to guarantees being triggered, the government has the option to pay Eskom's debt. If the government opts not to or can't, it goes to the government balance sheet, is added to its debt stock and generates a cross default. As this is an SEC registered bond, there is a cross-default sovereign clause that covers national and treasury credit guarantees."
 
Eskom details the guarantees, their structure, the process for exercising the guarantees, together with subordination of government claims in the event of an Eskom default on its investor relations page.
 
Despite the large split Baa3/BB rating, the deal is structured similarly to Investment Grade deals, says Xtract, with little or no covenants.
 
Hurry up and wait
 
The timing of the issue has raised some eyebrows. Several key decisions affecting Eskom in the long term are due in coming weeks, leaving investors in the dark. Given the summer lull and tough environment for EM issuers, is it better to hold off until September?
 
Funding secured from China Development Bank and announced at last week’s BRICs conference in Johannesburg alleviated concerns over the repayment of a ZAR 20bn six-month bridge due on 31 August. The banking group included the dealer managers for the new Eurobond. The ZAR investment means that Eskom has 62% of its 2018/19 funding needs secured. According to the latest earnings presentation the remainder will come from ECAs, DFIs and domestic bond issuance. By year-end just ZAR 15bn of the ZAR 350bn of guarantees will be un-utilised.
 
News about the USD 2.5bn from China is supportive, said the second fund manager. “But my view is that the government is too hung up on liability management, instead of providing a fundamental solution.”
 
No information was given by Eskom, nor the South African government, about the nature of the USD 2.5bn equivalent CDB funding, such as its ranking and tenor, and whether it was secured. Previous tranches of USD 2bn from the Chinese lender were secured on the new Medupi coal-fired power station - due to come online in 2023 with guarantees. The World Bank lent the remaining USD 3bn of finance towards the USD 10bn project.
 
Maybe tomorrow
 
Eskom is solely reliant on debt issuance to finance its capital expenditure programme. The guarantees were originally a temporary measure to enable the company to build capacity, but their issuance period was extended twice, most lately to March 2023 as Eskom failed to de-lever and found it increasingly difficult and costly to borrow on a standalone basis.
 
Eskom has approximately ZAR 215bn of interest payments and ZAR 228bn of debt repayments scheduled over the next five years alone, as of end-FY18. They issued ZAR 52bn in debt securities last year, but despite ZAR 12bn in repayments the group still burned through ZAR 5bn of cash.
 
Due to difficulties in rolling over its debt, capital expenditure needs were recently downgraded from around ZAR 70bn per year to around ZAR 40bn-ZAR 45bn per year. However, it has an ageing coal-fired fleet, which has 82% of its generating capacity and around 90% of its output.
 
Eskom has invested heavily in new capacity despite flat domestic demand over the past ten years. It is vulnerable to changes in coal prices and changes in the energy mix. It admits that many of its plants are past mid-life and require more capex. According to their latest presentation, no coal plant decommissioning costs are provisioned, with around ZAR 9.3bn for its sole nuclear plant.
 
South Africa’s Integrated Resource Plan (IRP) was originally scheduled for release in 2016. But this was delayed as the former president, Jacob Zuma, and his acolytes pushed for an expansive nuclear strategy, putting Eskom and ministers at odds with the Treasury, who balked at the cost. The report, due to be discussed by cabinet later this month, outlines decisions regarding future energy demand and the recommended energy mix. It should come into effect later this year.
 
Eskom says that the government has indicated South Africa will need approximately 50,000 MW of additional capacity (including 10,000 MW of replacement capacity) to come on stream by 2028. Of this amount, up to 30% could come from IPPs.
 
Eskom admits the highly successful renewable energy IPP programme is also a threat to its business model. After 18 months of wrangling and delays over tariffs it finally signed purchase power agreements in April for rounds 3.5 and four with the IPPs.
 
IPP power, more expensive than the current cost of Eskom power, is being purchased ahead of Eskom’s offering, creating a surplus on Eskom’s side, the company said in its latest presentation.
 
Is yesterday, tomorrow, today
 
Eskom’s electricity prices are set by the Energy regulator NERSA, which determines the allowable return based on projections and submissions from the utility from its Multi-Year Price Determination (MYPD) application. The company says it is preparing MYPD round four, covering the next three years.
Earlier this year, NERSA allowed just a 5.2% tariff increase, well below the 19.9% rise demanded by Eskom. With unions striking after refusing a 7.5% pay offer, and input costs rising, the price rises are not enough to cover the cost of capital, forcing Eskom into further cost cuts and fresh efficiencies.
The company said during their presentation that it has appealed the 5.2% tariff hike, with a provisional response from the regulator expected this month, noted the first fund manager.
 
There is a mechanism for Eskom to recoup money from NERSA called RCA recovery. The reconciliation looks at the difference between the revenues received by Eskom and those projected – including incurring higher costs than planned.
 
Eskom says in its FY18 earnings presentation that it notes with dismay NERSA’s decision to grant ZAR 32.7bn out of ZAR 66.7bn applied for the preceding three years. A payment mechanism has yet to be devised, but the funds are unlikely to be received until at least 2019/20, it adds.
 
“Yes, there is a large number of uncertainties such as the strategic review in September, the integrated resource plan and the CDB loan,” said the third fund manager. But he added, that the uncertainty should be priced in to the outstanding bonds and, with the right new-issue premium, they should be able to get the deal away.
 
You stole my money honey
 
In January, Cyril Ramaphosa, the incoming president, wasted no time in removing Eskom’s previous management team amid charges of nepotism and corruption.
 
Several scandals had emerged regarding transactions with companies part-owned by board members, inflated consultancy fees and procurement anomalies. ANC members connected to Jacob Zuma were seen as having used Eskom as their piggy bank, with seven former board members now facing criminal charges. Management consultants McKinsey & Company also announced that the firm will return over ZAR 1bn in fees.
 
Last year, Eskom was in breach of its Public Finance Management Act (PFMA) requirements, with its auditors qualifying completeness of the information required on irregular expenditure, fruitless and wasteful expenditure and losses due to misconduct in the year.
 
The auditors were unable to determine whether any adjustment was necessary to the irregular expenditure worth ZAR 20.7bn (2017: ZAR 2.5bn), fruitless and wasteful expenditure of ZAR 143m (2017: ZAR 547m), material losses from criminal conduct at ZAR 1.5bn (2017: ZAR 1.4bn). Therefore, certain of the group’s performance information could not be relied upon, they added.
 
Arguably the biggest wasteful expenditure is wages. With a bloated workforce, which Eskom admits is over a third too high (the World Bank estimates two-thirds), over 11,000 workers could be cut. But this issue is highly politicised, and redundancy costs could be high – the average salary of an Eskom employee is estimated at more than ZAR 500,000.
 
I'm All Right - You Gotta Go There to Come Back
 
Debtwire’s disclosure that Lazard had been appointed as financial advisor for balance sheet optimisation caused the 2025 bonds to fall 3-4 points early last month. Many market participants suspected that a long-awaited debt restructuring was being planned.
 
"You need to reduce the debt substantially," said one sceptical investor. "You have ZAR 27bn of operating cash flow and ZAR 32bn of interest. Adding in ZAR 45bn of capex, you are essentially adding debt every month," he said.
 
“Restructuring is still something they will likely be considering, though clearly everything they are currently doing appears designed to avoid that, given the political considerations,” the PM added.
 
For now, Eskom’s plan is to look at liability management and find ways to monetise assets to improve liquidity, as reported. Eskom is looking at the possible securitisation or other form of monetisation of municipality receivables. Of ZAR 19.4bn in outstanding receivables as of September 2017, Eskom was owed ZAR 12.4bn in principal and interest from municipalities.
 
Another option is the concession of assets owned by Eskom, such as energy distribution networks and coal power plants, a source close said previously. The disposal of these assets is also a possibility, but an unlikely one at this stage, they added.
 
The company wants to achieve a cost reduction of ZAR 100bn over the next five years by optimising its operational expenditures and capital investment programme. It seeks to boost its EBITDA margin from 25% currently to around 35% and boost flatlining sales via existing customers and selling surplus energy to South Africa’s neighbours.
 
Whether the above are enough to meet Eskom’s stated objective of reaching Investment Grade status in the near future is moot. If it is unable to achieve the turnaround and the SA Government assumes liabilities it could add as much as 12% to debt-to-GDP ratios, prompting multi-notch downgrades.
However, Eskom is solvent if you look at the ZAR 130.5bn un-guaranteed portion only, which is fully recourse – it is 2.92x levered based on FY17 EBITDA.
 
by the Debtwire CEEMEA editorial team