I need to analyze Fortum Oyj's financial position to determine the optimal utilization of hybrid bonds relative to S&P Global Ratings' 15% cap on equity credit from hybrids. ## Key Analysis Steps ### 1. Calculate Total Adjusted Capital Total adjusted capital = Debt + Equity From the balance sheet (2023-01-01, i.e., end of 2022): - Equity: 7,737,000,000 EUR - Total Liabilities: 15,905,000,000 EUR However, for "total adjusted capital" in the S&P context, we need to focus on debt-like instruments. Let me identify the debt components: From current and non-current liabilities that represent debt: - Other Noncurrent Financial Liabilities: 3,658,000,000 EUR - Noncurrent Derivative Financial Liabilities: 756,000,000 EUR - Other Current Financial Liabilities: 4,127,000,000 EUR - Current Derivative Financial Liabilities: 3,973,000,000 EUR Total financial/debt-like liabilities: ~12,514,000,000 EUR But more importantly, let me look at the capital structure more carefully. The key ratio is equity credit from hybrids as % of total adjusted capital. ### 2. Assess Fortum's Financial Condition **Profitability and Performance:** - 2022 Revenue: 8,804M EUR (up from 6,422M EUR in 2021) - Comparable Operating Profit: 1,871M EUR (up from 1,429M EUR) - However, reported Profit/Loss: **-10,290M EUR** massive loss due to discontinued operations (-11,302M EUR) - Profit from continuing operations: 1,011M EUR **Key Problem - Massive Losses and Balance Sheet Deterioration:** - Total Assets collapsed from 149,661M EUR to 23,642M EUR (2022 to 2023) - Equity collapsed from 13,665M EUR to 7,737M EUR - This is largely due to the massive losses from discontinued operations and likely deconsolidation **Cash Flow Analysis:** - Operating cash flow from continuing operations: 2,104M EUR (positive) - But overall operating cash flow: -8,767M EUR (negative due to discontinued ops) - Free cash flow from continuing operations (operating + investing): 3,568M EUR **Leverage and Credit Quality Indicators:** - The company has significant derivative exposures (both assets and liabilities) - Margin receivables: 2,607M EUR; Margin liabilities: 352M EUR - The balance sheet shrunk dramatically, suggesting major divestitures/deconsolidations ### 3. Interest Rate Environment Analysis (2022) Swap rates rose dramatically in 2022: - 5Y swap: from -0.264% to 1.726% (average) - 7Y swap: from -0.137% to 1.806% - 10Y swap: from 0.053% to 1.927% - Corporate bond yields (iBoxx): from 1.298% to 2.295% This dramatic rise in rates means: - Refinancing costs have increased significantly - Hybrid bonds would be more expensive to issue than in 2020-2021 - However, hybrids still offer coupon flexibility (deferrable coupons) compared to regular debt ### 4. S&P Hybrid Equity Credit Considerations S&P's 15% cap on equity credit from hybrids is based on: - The issuer's credit quality - The structural features of the hybrid (deferrability, subordination, maturity) - The overall capital structure needs **Fortum's Specific Situation:** 1. **Weak reported equity position**: Despite 7,737M EUR equity, the company just suffered massive losses 2. **High discontinued operations risk**: -11,302M EUR loss from discontinued ops 3. **Negative comprehensive income**: -10,757M EUR 4. **Declining retained earnings**: from 10,062M to 6,467M (then adjusted to 9,499M in 2023 due to equity components reclassification) **Critical Factor - Nuclear Provisions and Decommissioning:** - Nuclear non-current provisions: 966M EUR (down from 3,891M EUR) - Share in State Nuclear Waste Management Fund: 966M EUR (down from 3,515M EUR) - This suggests major changes in nuclear asset ownership (likely the Uniper divestiture/exit) ### 5. Optimal Hybrid Utilization Assessment Given Fortum's situation in 2022: **Arguments for lower hybrid utilization (0-25%):** - Massive losses and balance sheet deterioration - High risk profile due to discontinued operations - Need to preserve financial flexibility - Rising interest rates make hybrids more expensive - Credit rating concerns - adding too much hybrid debt could signal distress **Arguments for moderate hybrid utilization (50%):** - Continuing operations are profitable (1,011M EUR) - Strong comparable EBITDA: 2,436M EUR - Need for equity-like capital without diluting shareholders - Hybrids can provide buffer against further losses **Arguments against higher utilization (75-100%):** - Company is in restructuring/divestiture mode - S&P's 15% cap is a maximum, not a target - With weak equity base, maximizing hybrid equity credit could be seen as aggressive financial engineering - The 2022 losses would make S&P cautious about granting full equity credit ### 6. Credit Rating Perspective S&P would likely view Fortum in 2022 as: - Under stress due to massive losses and balance sheet shrinkage - In transition due to discontinued operations - Needing to demonstrate sustainable capital structure before getting full hybrid equity credit The optimal strategy would be to use hybrids **moderately** - enough to diversify funding and provide some equity-like capital, but not so much as to appear to be maximizing financial leverage at a time of stress. Given the 15% cap, the question asks what percentage of that cap Fortum should utilize: - 0%: Too conservative, misses opportunity for equity-like financing - 25%: Very conservative, might be appropriate if credit rating is under pressure - 50%: Moderate - balances need for equity-like capital with prudence - 75%: Aggressive given the losses and restructuring - 100%: Too aggressive given financial stress **Conclusion:** Fortum should utilize **50%** of the S&P hybrid equity credit cap. This reflects: - Need for some equity-like capital given the losses - Prudent restraint given the massive 2022 losses and restructuring - Balanced approach during a transitional year - Avoiding excessive reliance on hybrid instruments when credit quality is under pressure 50%