Light : Fitch Ratings Report

RATING ACTION COMMENTARY

Fitch Affrms Light at 'BB-'; Revises Outlook to Negative

Thu 05 Jan, 2023 - 4:18 PM ET

Fitch Ratings - São Paulo - 05 Jan 2023: Fitch Ratings has affrmed the Foreign Currency (FC) and Local Currency (LC) Issuer Default Ratings (IDRs) for Light S.A. (Light) and its wholly owned subsidiaries Light Servicos de Eletricidade S.A. (Light Sesa) and Light Energia S.A.'s (Light Energia) at 'BB-'. Fitch has also affrmed Light's National Scale Ratings at 'AA- (bra)' and the ratings of the subsidiaries' debt instruments. Fitch revised the Rating Outlook for the corporate ratings to Negative from Stable.

The Negative Outlook refects concerns about Light's ability to access new credit lines, given uncertainties on the renewal of Light Sesa's concession. Fitch considers the renewal in the base case, but expects relevant refnancing needs in 2023 and 2024, prior to the defnition for the concession. Light Sesa's capacity to securitize its receivables may be an important source of funding in 2023, but may not be suffcient to support refnancing in 2024. Challenges for Light Group will include preserving liquidity by reducing opex and capex, despite potentially negative effects on operation, in Fitch's opinion.

KEY RATING DRIVERS

Renewal Uncertainties Bring Refnancing Concerns: Fitch expects the renewal of Light Sesa's concession to occur before June 2025, the deadline imposed by debts maturing after 2026.But uncertainty through 2024 might constrain Light's ability to secure funding. The base case considers debt issuance up to BRL1.8 billion in 2023, backed by Sesa's receivables, with a funding requirement of at least BRL1.5 billion in 2024, which may be diffcult given the expected timing for a defnition on the concession. In case of non-

renewal, Light Sesa should receive an amount equal to its asset base, currently valued at BRL10.1 billion, which, together with other assets, fully covers the concession's liabilities. Refnancing in 2024 should rely on the renewal assumption and on the expectation that, in case of non-renewal, the outstanding debts (BRL10.3 billion) will be carried out by the new concessionaire or prepaid with proceeds from the indemnity.

Sesa's concession ends in June 2026, and the renewal assumption is based on the company's track record of service quality and on the expectation that the government will support fundamental changes in energy losses requirements. A potential breach of fnancial covenants established by the concession agreement, as of 2023, should not compromise the renewal, in Fitch's opinion.

Negative FCF in 2023: Higher interest rates and the transfer of BRL840 million in tax credits to Sesa's consumers will pressure cash fows in 2023. These negative effects will be partially offset by a signifcant reduction in Sesa's opex and capex, refecting a shift in strategy to prioritize liquidity, although it will likely result in higher energy losses. Average EBITDA in 2023-2024 is estimated at BRL1.9 billion for Light Sesa and BRL590 million for Light Energia. FCF should average negative BRL1.2 billion in 2022-2023 and positive BRL270 million in 2024-2025, assuming maintenance of a 25% dividend payout. The group's investments are expected to decrease to around BRL950 million in 2024-2025, on average, from BRL1.4 billion in 2021-2022 and BRL1.1 billion expected for 2023.

Fitch expects the group's net adjusted leverage to remain at 4.3x in 2022, as observed in 2021, declining to 4.1x and 3.9x in 2023 and 2024, following a modest market growth and tariff adjustments. The ratio for 2023 incorporates an increase by 0.3x from the transfer of tax credits and a decrease by 0.1 from the expected reduction in opex and capex. These ratios incorporate guarantees provided to Norte Energia S.A. as off-balance sheet debt (BRL733 million on September 2022). Gross leverage is estimated in 4.8x in 2022-2024, on average, from 6.2x in 2021.

Poor Performance on Distribution: Light Sesa's EBITDA is limited by energy losses and provisions for credit losses above tariff coverage and by higher-than-average indemnities to consumers. The last tariff review in March 2022 incorporated a BRL1.7 billion increment (+20%) in asset base and heightened the regulatory limit for energy losses. This uplift resulted in annual savings of around BRL350 million, but it is set to gradually decline as of the next tariff adjustment.

Fitch expects the cost of energy losses to increase by around BRL115 million in 2023 and 2024 and energy consumption to grow by a modest 0.5% rate as of 2022, after an average

annual decrease of 1.6% in 2016-2021. The expected EBITDA of BRL1.5 billion in 2022 should be 33% below the regulatory standard, compared to a 44% gap in 2021. The expected reduction in energy cost from Itaipu and Norte Fluminense, in 2023 and 2025, will reduce tariffs, with favorable effects on energy losses and delinquency. Possible exemptions on the Tax on the Circulation of Goods and Services (ICMS) would be especially positive for Light.

Balanced Business Profle: Light Energia should beneft from high contracted prices and favorable hydrology in 2023, as observed in 2022. For 2024 onwards, Fitch expects a decrease in EBITDA due to potentially declining prices. Contracted sales for 2023 and 2024 account for only 63% and 50% of its assured energy of 621 aMW, on a consolidated basis, and less than 20% as of 2025. This strategy refects a conservative hedge against hydrological risk, which compensates for the lack of diversifcation or protections, such as quotas or regulatory insurance.

Light Energia sold its energy to industrial clients at above-average prices, averaging around BRL255/MWh in 2023-2026. It contributes with cash fow predictability but faces uncertainty on the renewal of its hydroelectric plant's concessions, expiring in 2028.

DERIVATION SUMMARY

Light's credit profle is weaker than that of Companhia Energetica de Minas Gerais (Cemig), rated with Local-Currency and Foreign-Currency IDRs of 'BB+' and 'BB', respectively. Cemig has stronger credit profle, with most of its cash fows coming from energy generation and transmission. These segments account for around 38% of the group's EBITDA, compared with 46% for distribution, where Cemig operates with greater effciency and better market prospects, despite being more exposed to the exponential growth of distributed generation.

Cemig's fnancial leverage is expected to increase over the rating horizon, due to a strong capex plan in the distribution business, but should still remain below the levels projected for Light.

KEY ASSUMPTIONS

--Light Sesa's energy demand and market growing by 0.5% and 0.1% as of 2023, respectively;

--Cash outfow of BRL840 million mostly in 2023 for refund of tax credits;

--Energyshort-term prices from 2022 to 2024, on average (BRL/MWh): 189, 115 and 99;

--Light Energia's existing sales contracts of 309 aMW at BRL223/MWh in 2022-2025, on average;

--Average annual investments of BRL1.3 billion in 2022-2023 and BRL950 million in 2024- 2025;

--Dividend distribution equivalent to 25% of net income.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to a Stable Outlook:

--Renewal of Light Sesa's concession and a reduction of the group's refnancing risk.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

--Renewal of Light Sesa's concession under more favorable terms; --Improvements in distribution segment operating performance; --Net leverage consistently less than or equal to 3.5x;

--Total leverage consistently less than or equal to 4.5x.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

--Fitch's expectation that Light Sesa's concession will not be renewed; --Deterioration of the group's liquidity;

--Net leverage consistently at or above 4.5x; --Total leverage consistently at or above 5.5x.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defned as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defned as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specifc best- and worst-case scenario credit ratings, visit https://www.ftchratings.com/site/re/10111579.

LIQUIDITY AND DEBT STRUCTURE

High Refnancing Risk: Fitch projects a total refnancing need of BRL3.3 billion in 2023- 2024. Fitch anticipates debt issuance of up to BRL1.8 billion in 2023, backed by Sesa's receivables and projects a funding requirement of at least BRL1.5 billion in 2024. This fnancing should rely on the renewal assumption and on the expectation that, in case of non-renewal, the outstanding debts will be carried out by the new concessionaire or prepaid with proceeds from the indemnity.

Light's consolidated cash and equivalents were BRL4.0 billion at the end of September 2022, which covered the expected negative FCFs (BRL1.6 billion) and debt payments (BRL2.2 billion) through 2023. Short-term debt was BRL2.6 billion. Total adjusted consolidated debt of BRL13.5 billion mainly consisted of debentures (BRL7.8 billion) and Eurobonds issued in June 2021 (BRL3.2 billion), and included off-balance sheet debt of BRL733 million related to guarantees provided to Norte Energia S.A. There is no debt at the holding level.

ISSUER PROFILE

Light Sesa is the fourth largest power concession in Brazil, serving more than 90% of Rio de Janeiro's consumption, and accounts for 70% of the group's EBITDA. Light Energia has 511 aMW of assured energy, on a consolidated basis. Light S.A. is listed on B3 and has a pulverized share ownership.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG CONSIDERATIONS