# Hybrid Bonds Assessment for Terna S.p.A.

## Company Profile & Industry Context

Terna S.p.A. is Italy's national transmission system operator for electricity ("Terna" means "electrical network" in Italian). This is a **regulated utility** operating in the electricity transmission sector under a strong regulatory framework. The company operates as a natural monopoly with regulatory oversight ensuring cost and investment recovery.

## Key Financial Metrics Analysis (FY 2022)

### Capital Structure
- **Total Equity**: €6,169.1m (2023) vs €4,713.0m (2022)
- **Long-term Borrowings**: €8,416.7m (2023) vs €8,835.0m (2022)
- **Short-term Borrowings + Current portion of LT Debt**: €2,353.4m (2023)
- **Existing Hybrid Bonds**: €989.0m (issued during 2022)
- **Total Debt**: €10,770.1m (2023)
- **Total Adjusted Capital** (Equity + Debt): €16,939.1m

### Current Hybrid Positioning
- Hybrids represent **5.8%** of total adjusted capital (€989m / €16,939m)
- The company has recently issued €989m in perpetual hybrid bonds in 2022
- This suggests management's acknowledgment of capital structure optimization needs

### Leverage & Profitability Metrics (2022)
- **EBITDA**: €1,333.5m (Operating Profit) + €725.7m (D&A) = €2,059.2m
- **Net Debt**: €10,770.1m - €2,155.1m (cash) = €8,614.9m
- **Net Debt/EBITDA**: 4.2x
- **EBITDA Margin**: 71.0% (€2,059.2m / €2,898m Revenue)
- **ROE**: 13.9% (€857m / avg €6,141m equity)
- **Interest Coverage (EBIT/Interest Expense)**: 10.9x

### Capital Expenditure & Refinancing Needs
- **2022 Capex**: €1,492.3m (Property, Plant & Equipment)
- **2022 Free Operating Cash Flow**: €2,323.7m
- **Operating Cash Flow represents 80% of revenues** - excellent cash generation
- **Debt repayments**: €289m in 2022; long-term debt decreased by €418.3m

## Regulatory Advantage Assessment

Per S&P methodology for regulated utilities, Terna exhibits:

**Strong Preliminary Regulatory Advantage:**
- Italian regulatory framework provides **transparent, predictable cost recovery** for transmission operators
- **Full recovery of operating costs, capital investments, and reasonable return** enshrined in law
- **Regulatory stability**: The Italian transmission regulatory regime is stable and consistent
- **Tariff-setting mechanisms**: Regulated tariffs allow timely recovery of operating and capital costs
- **No commodity risk**: Pure transmission business with pass-through mechanisms
- **Regulatory independence**: Independent regulator (TERNA operates under ARERA oversight in Italy)

**Business Strategy Assessment**: Positive - Terna has demonstrated effective regulatory management and cost control, maintaining stable relationships with the regulator.

**Final Regulatory Advantage**: **STRONG**

## Scale, Scope & Diversity Assessment

- **National monopoly** position in Italian electricity transmission
- **Large asset base**: €16.2bn in PP&E (primarily transmission infrastructure)
- **Essential service** to the Italian economy
- **Stable, regulated revenue** with limited economic cyclicality
- **Geographic diversity** implicit in national transmission network

**Assessment**: STRONG

## Operating Efficiency Assessment

- **Cost structure**: Well-controlled; expenses of €1,631m (56% of revenue) reflect operational efficiency
- **Asset quality**: Modern transmission assets with ongoing capex for grid modernization
- **Safety/Reliability**: Transmission operator subject to strict regulatory standards
- **Management of capex**: Consistent capex discipline; projects managed within regulatory frameworks

**Assessment**: STRONG/ADEQUATE

## Financial Risk Profile Analysis

### Leverage Position
- Net Debt/EBITDA of **4.2x** is moderate for a regulated utility
- FFO/Debt coverage: Operating cash flow of €2,323.7m provides strong debt service capability
- Debt maturity profile is well-staggered with long-term debt of €8.4bn

### Refinancing Needs (Next 18 months)
- **Short-term refinancing**: €2,353.4m due (short-term borrowings + current portion of LT debt)
- **Estimated annual capex**: €1,500m+ (based on 2022 levels)
- **Annual interest costs**: €121.8m (2022)
- **FCF generation**: €2,323.7m (2022) after capex and interest
- **Total 18-month funding needs**: Approximately €3.8-4.0bn (refinancing + capex)

### Cost of Debt Analysis
- **Current interest expense**: €121.8m / €10,770m = 1.13% all-in cost
- **Market conditions (2022)**: Swap rates at **1.93% (10Y)**, Corporate IG spreads at **2.30%**
- **Sub-senior delta**: 0.2% (hybrid would trade ~20bps higher than senior debt)
- **Estimated hybrid cost**: 4.1-4.5% (significantly above current 1.13% blended cost)
- **Cost of hybrid will INCREASE overall cost of debt**, but provided solid refinancing diversification

### Rating Implications
Terna's credit profile is strong:
- High EBITDA margins (71%)
- Essential service provider
- Strong regulatory framework
- Solid leverage metrics for the sector
- Likely **"A" range rating** or equivalent (investment grade, upper tier)

**Current assessment**: The company is NOT under downgrade pressure and has good rating headroom.

## Hybrid Bonds Assessment Against Guidance

### Key Observations

1. **Existing Hybrid Position**: €989m already outstanding (5.8% of adjusted capital) demonstrates recent capital optimization

2. **Refinancing Needs**: Moderate at €2.4bn over 18 months; manageable through traditional debt markets given strong cash generation

3. **Leverage Position**: At 4.2x Net Debt/EBITDA, there is modest leverage optimization opportunity, but not urgent

4. **Rating Profile**: Strong "A" range rating profile with headroom; no extraordinary downgrade pressure

5. **Cost Consideration**: Hybrid cost would be significantly higher (~4.2%) than current blended cost (~1.1%), implying materially increased cost of debt

6. **Capex Intensity**: While transmission grid requires ongoing capex (~€1.5bn annually), this is well-covered by FCF generation

7. **Regulatory Support**: Strong regulatory framework ensures cost recovery, reducing urgency of aggressive capital structure optimization

### Alignment with Guidance Categories

The company's profile is closest to **3.75% to 7.5% of adjusted capital**:

- ✓ Moderate refinancing needs (€2.4bn over 18 months)
- ✓ Mild to moderate leverage optimization rationale (4.2x leverage provides some room)
- ✓ Hybrid issuance provides useful rating flexibility and diversifies funding sources
- ✓ Cost of hybrid will **increase** current cost of debt (not favorable factor)
- ✓ Strong regulatory profile provides confidence in stable cash flow generation
- ✓ Not at risk of downgrade without hybrid support

### Maximum Capacity Analysis

- S&P cap: 15% of €16,939m = €2,540.5m
- Current hybrids: €989m
- Potential additional issuance: €1,551.5m
- Annual issuance limit: €3bn (can accommodate)

## Conclusion

**Terna presents a moderate case for hybrid bonds**, but several factors argue against aggressive utilization:

**Factors Supporting Limited Hybrid Issuance:**
- Moderate refinancing needs (not critical)
- Strong FCF generation (€2.3bn annually)
- Strong regulatory framework providing cash flow certainty
- Solid leverage metrics (4.2x is reasonable for regulated utilities)
- Good rating profile with headroom

**Factors Against Substantial Hybrid Issuance:**
- Materially increased cost of debt (~300+ bps) outweighs benefits
- No rating downgrade pressure requiring capital optimization
- Strong cash generation reduces urgency
- Already issued €989m hybrids in 2022 (recency factor)
- Essential monopoly utility has strong traditional debt market access

**Recommendation**: A **modest additional issuance** of hybrids would provide useful funding diversification and modest leverage optimization without the cost penalties of larger programs. This aligns with a **7.5% target** (approximately €500-700m additional issuance), representing reasonable diversification while respecting the cost disadvantage versus traditional debt.

This level:
- Provides meaningful but not excessive leverage optimization
- Offers funding source diversification
- Respects the cost-benefit trade-off
- Maintains financial flexibility
- Is achievable within annual issuance guidelines

<answer>7.5%</answer>