Research Update: Norwegian Transport Group Vygruppen 'A-/A-2' Ratings Affirmed Despite Loss Of Second Contract; Outlook Remains Negative

October 16, 2019

Rating Action Overview PRIMARY CREDIT ANALYST

- During the tendering process in June 2019, Norwegian state-owned transportation group Beata Sperling-Tyler Vygruppen AS (VY) lost the Northern railway package concession, which had contributed 7% of London EBITDA in 2018. (44) 20-7176-3687 beata.sperling-tyler - With the cumulative loss of about 12% of EBITDA that the Southern and Northern packages had @spglobal.com contributed, VY's size and competitive position on the market have further decreased. SECONDARY CONTACT

- We are affirming our 'A-/A-2' long and short-term issuer credit ratings on VY, reflecting our Juliana C Gallo expectation that the company will sustain credit metrics commensurate with the ratings as a London result of the transfer of financial obligations related to the both packages. (44) 20-7176-3612 juliana.gallo - The negative outlook reflects the risk of a one-notch downgrade if VY does not compensate for @spglobal.com its loss of passenger rail market share by strengthening its financial metrics on a consistent RESEARCH CONTRIBUTOR basis. Kritika Verma Mumbai kritika.verma Rating Action Rationale @spglobal.com

The rating affirmation reflects our view that the improvement in VY's cash flow ratios somewhat offset the deterioration of the company's competitive position due to the loss of the Northern and Southern package concessions. VY will transfer the corresponding financial leases (16%) related to both packages, including about 5% corresponding to the Northern package. It will also reduce the pension obligation. In 2019, VY intends to settle a pension deficit of Norwegian krone (NOK) 1.8 billion using cash that it received following rail reform and the related unbundling of the Norwegian rail sector. This included the demerger of its real estate company to the infrastructure company Bane NOR; transfer of the maintenance, ticketing, and sales operations to the Ministry of Transport and Communication; and the Ministry's transfer of VY's rolling stock and debt to Norske Tog AS, a rolling stock company. We now expect VY to maintain stronger funds from operations (FFO) to debt above 30% in 2019-2022.

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In 2019, VY lost its Northern package, which was the second concession tendered out as part of Norway's rail liberalization program aimed at improving the quality of rail services by allowing competition. The seven-year contract was awarded to SJ Norge AS, the Norwegian subsidiary of SJ, the Swedish state-owned railway operator. SJ Norge will start to operate the contract from June 2020. The loss of the Northern package will result in VY generating 10% less revenue, including about 5% less subsidy from the Government under the Public Purchase Contract, from 2020. VY had previously lost the Southern package tender to the Go-Ahead Group in October 2018.

In our view, the loss of the Northern contract has further weakened VY's competitive positon, negotiating power, size, and earnings generation capacity. The operations of the Southern and Northern packages together represented about 27% of VY's current passenger numbers, and about 12% of EBITDA. VY's strategy entails replacing these earnings by expanding into the highly competitive bus segment and building tourism activities. This will increase to about 40%-45% the share of VY's EBITDA coming from operations that we see as more volatile. VY's profitability is also likely to decrease because the EBITDA margin from these activities will be lower than the 15%-20% in the more stable passenger rail services, due to higher staff and fuel costs. Over the past 12 months, VY has managed to replace lost bus contracts and its share in this competitive Nordic market has remained stable. Earnings from tourism remain minuscule.

There is uncertainty regarding the results of the future tenders. The winner of the Western package, which serves about 8% of VY's current passengers, and includes the Bergen line, which connects Norway's two biggest cities, Oslo and Bergen, will be announced in December 2019. This tender will take effect in December 2020. The most lucrative packages will be tendered last. The Eastern package--mostly commuter lines in the greater Oslo area, which contribute to about 20% of current VY passenger revenue--will transfer to the tender winner in December 2022. The second Eastern package--which includes both the inter-city and commuter line in the eastern part of Norway, and generate about 40% of the passenger revenue--will be transferred in December 2024.

Despite VY's diminishing size, we still think VY has an important role for the Norwegian government as the country's incumbent provider of passenger rail services and main railway freight operator. VY's public policy mandate could strengthen if the company provides public transportation service in areas that are less likely to attract interest of private companies, for example due to low population. VY will also maintain its function as a passenger rail operator of last resort, meaning that it would need to take over from any other operator if it underperforms operationally or defaults. We also understand that VY will continue operating passenger trains in at least six of the eight geographical service areas in Norway until the public purchase contract finishes for VY in December 2022 and for VY Gjovikbanen in 2023.

We think VY maintains a very strong link with its sole owner, the Norwegian government. We base this view on the existing mechanisms and the government's capacity to provide support to VY, and the government's ownership classification of VY in category 3 (a company delivering commercial objectives and other specific goals). The assessment is also supported by our understanding that the state is not contemplating the privatization of VY in the medium to long term. We think there is a high likelihood that the government of Norway will provide sufficient and timely extraordinary support to VY if needed, due to the company's role and link to the state. This supports the three notches of uplift that we apply to the company's stand-alone credit profile of 'bbb-', resulting in an issuer credit rating of 'A-'.

The liberalization of the rail market in Europe, and the opening of previously national markets to competition, could result in a diminished role for VY in Norway but an increased presence and revenue generation internationally. Should market liberalization be more rapid or detrimental to VY, or should the government change its classification of VY, we could reconsider our assessment

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of the likelihood of extraordinary state support.

Outlook

The negative outlook reflects that we could lower the rating if VY continues losing its market share to competition and increases its reliance on riskier activities to supplement lost earnings, without being adequately compensated by stronger credit metrics.

Downside scenario

We could take a negative action if VY continues losing its share in the Norwegian passenger rail market and its competitive position continues deteriorating. This could happen if its profitability weakens, or if earnings from operations that are more volatile than passenger rail services--for example, bus transportation or tourism--exceed half of VY's total earnings.

We could lower the ratings by one notch even if VY retains the rest of the packages but sees a weakening of credit metrics--in particular, S&P Global Ratings-adjusted FFO to debt falling below 30%.

We could also lower the ratings if we assessed that the likelihood of extraordinary government support had weakened, for example due to a change in the government's classification of the company's role.

Upside scenario

We could revise the outlook back to stable if VY maintained its market share in passenger rail. We could also revise the outlook to stable if the company's expansion in other segments resulted in sufficient earnings expansion to compensate for the losses in the rail segment and strengthen profitability.

Company Description

Vygruppen AS (formerly Norges Statsbaner) is a Norway-based, 100% state-owned transport group that provides passenger and freight transportation services. It derives most of its earnings--about 60%--from passenger railway commercial operations in Norway, with the remainder coming from freight and bus business in Norway and Sweden.

Our Base-Case Scenario

In our base case for 2019-2021, we assume:

- Passenger volumes trends to follow the economic growth and ticket prices increasing in line with the consumer price index.

- Ticket revenue to drop in 2020 as a result of the loss of the Northern and Southern package contracts, and the related public purchase revenue (the government subsidy). We assume VY will win all the other contracts (package 3 Western, and packages 4 and 5 Eastern).

- Adjusted EBITDA margin declining to about 16% in 2020 from about 18% in 2018 due to the loss of the two tenders as well as increasing participation of bus services. VY plans to compensate the decline with the implementation of cost efficiencies, which we have factored into our

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forecasts, to some extent.

- Annual investments of about NOK0.9 billion-NOK1.0 billion, mainly via leasing, to support new contracts, mainly in the bus segment.

- We expect VY to close the defined benefit pension scheme in 2019 and repay outstanding pension liabilities of about NOK1.8 billion.

- No additional financial debt. The only obligations for VY will comprise financial leases. We expect these to be about NOK7 billion for the next three years. We also include finance lease payments in our forecasts of NOK1.5 billion-NOK1.7 billion.

Based on our assumptions, we arrive at the following weighted-average credit measures in 2019-2021:

- Adjusted FFO to debt of 38%-42%; and

- Adjusted debt to EBITDA of 2.2x-2.8x.

Liquidity

The short-term issuer credit rating is 'A-2'.

We assess VY's liquidity as strong, with sources exceeding uses by more than 1.5x over the 12 months from June 30, 2019, and by more than 1.0x in the following 12 months. The high cash balance includes proceeds received in the first quarter of 2017 after spinning off a real estate subsidiary, ROM Eiendom AS. VY plans to use some of its significant cash balance to reduce its pension deficit in 2019.

VY's sound relationship with banks and generally prudent risk management supports our liquidity assessment. The company repaid financial debt of Swiss francs 325 million on Nov. 15, 2017, and it has no outstanding debt and no refinancing risk. Therefore, we think the company will maintain its strong liquidity.

We expect the principal liquidity sources over the 12 months from June 30, 2019 will include:

- Cash and cash equivalents totaling about NOK4.87 billion;

- Undrawn committed overdraft facility of NOK50 million available until October 2020. In March 2018, VY canceled the NOK2 billion revolving credit facility available until April 2019; and

- Forecast FFO of approximately NOK1.3 billion.

We expect the following principal liquidity uses over the same period will include:

- Capital investments of about NOK1.0 billion, mainly via operating leases;

- Dividends of about NOK200 million-NOK220 million; and

- Pension payments of about NOK1.8 billion.

Ratings Score Snapshot

Issuer Credit Rating: A-/Negative/A-2

Business risk: Satisfactory

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- Country risk: Very low

- Industry risk: Intermediate

- Competitive position: Satisfactory

Financial risk: Intermediate

- Cash flow/Leverage: Intermediate

Anchor: bbb-

Modifiers

- Diversification/portfolio effect: Neutral/undiversified (no impact)

- Capital structure: Neutral (no impact)

- Financial policy: Neutral (no impact)

- Liquidity: Strong (no impact)

- Management and governance: Satisfactory (no impact)

- Comparable rating analysis: Neutral (no impact)

Stand-alone credit profile (SACP): bbb-

- Group credit profile: bbb-

- Likelihood of government support: High (+3 notches from SACP)

- GRE link: Very strong

- GRE role: Important

Related Criteria

- General Criteria: Group Rating Methodology, July 1, 2019

- Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments, April 1, 2019

- General Criteria: Methodology For Linking Long-Term And Short-Term Ratings, April 7, 2017

- General Criteria: Rating Government-Related Entities: Methodology And Assumptions, March 25, 2015

- Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Dec. 16, 2014

- Criteria | Corporates | General: Corporate Methodology, Nov. 19, 2013

- General Criteria: Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013

- Criteria | Corporates | Industrials: Key Credit Factors For The Transportation Infrastructure Industry, 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

www.spglobal.com/ratingsdirect October 16, 2019 5 Research Update: Norwegian Transport Group Vygruppen 'A-/A-2' Ratings Affirmed Despite Loss Of Second Contract; Outlook Remains Negative

- General Criteria: Stand-Alone Credit Profiles: One Component Of A Rating, Oct. 1, 2010

- General Criteria: Use Of CreditWatch And Outlooks, Sept. 14, 2009

Related Research

- Transport Group Norges Statsbaner AS 'A-/A-2' Ratings Affirmed Despite Loss Of Concession Contract; Outlook Negative, Oct. 24, 2018

- Norway-Based Norges Statsbaner Downgraded To 'A-/A-2' On Weaker Credit Ratios After Rail Reform; Outlook Negative, May 5, 2017

- Norway-Based Norges Statsbaner 'A+' Rating On CreditWatch Negative On Details Of Rail Reform Implementation, Oct. 25, 2016

- Norwegian Railway Operator Norges Statsbaner ASA Downgraded To 'A+' On Rail Reform Implementation; Outlook Negative, Feb. 11, 2016

Ratings List

Ratings Affirmed

Vygruppen AS

Issuer Credit Rating A-/Negative/A-2

Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. All ratings affected by this rating action can be found on S&P Global Ratings' public website at www.standardandpoors.com. Use the Ratings search box located in the left column. Alternatively, call one of the following S&P Global Ratings numbers: Client Support Europe (44) 20-7176-7176; London Press Office (44) 20-7176-3605; Paris (33) 1-4420-6708; Frankfurt (49) 69-33-999-225; Stockholm (46) 8-440-5914; or Moscow 7 (495) 783-4009.

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