13.05.2016, 06:39

Fitch Downgrades Southern Co.

OREANDA-NEWS. Fitch Ratings has downgraded the Long-Term Issuer Default Rating (IDR) of Southern Company to 'A-'/Stable from 'A'. The ratings are removed from Rating Watch Negative where they were placed on Aug. 5, 2015 following the announcement of an agreement to acquire AGL Resources Inc. (AGL; 'BBB+'/Stable) in an all-cash transaction. The downgrade reflects the expected degradation in Southern Company's credit metrics following the closing of the predominantly debt-financed AGL acquisition. Fitch expects the acquisition to close in the second half of 2016 (2H16). In addition, Fitch has affirmed the Short-Term IDR for Southern Company at 'F1'.

Fitch has downgraded the Long-Term IDR of Mississippi Power Company to 'BBB' from 'BBB+', which maintains the two-notch differential with the parent company's long-term IDR, and Short-Term IDR to 'F3' from 'F2'. Fitch has also revised the Rating Outlook for Mississippi Power to Stable from Negative. We acknowledge that the risks surrounding the Kemper Integrated Gasification Combined Cycle (IGCC) project still remain elevated, and include the execution risk associated with the completion of the project within currently estimated costs and schedule. The timing of the implementation of permanent rates for the remainder of the IGCC plant also remains uncertain. However, the strong rating linkages with the parent company are limiting further negative rating actions for Mississippi Power at this time. Southern Company has demonstrated tangible financial support for Mississippi Power during the construction of the Kemper project and Fitch expects this support to continue.

Fitch has affirmed the IDRs for Southern Company's other subsidiaries as follows: Alabama Power Company at 'A/F1'; Georgia Power Company at 'A/F1'; Gulf Power Company at 'A-/F1'; Southern Power Company at 'BBB+/F2', and Southern Electric Generating Company (SEGCO) at 'A'. The Rating Outlook for these entities is Stable. Fitch has also affirmed the 'F1' commercial paper (CP) rating for Southern Company Funding Corporation. A full list of rating actions follows at the end of this release.

KEY RATING DRIVERS FOR SOUTHERN COMPANY
Meaningful Increase in Leverage: The proposed $8 billion cash acquisition of AGL, which is largely funded by debt, results in a meaningful increase in consolidated leverage compared to Southern Company's current and projected stand-alone financial condition. The company has issued $1.4 billion in equity and is expected to issue $8 billion in debt to finance the acquisition and meet other capital needs. The combination of acquisition debt and the assumption of existing AGL consolidated debt ($4.3 billion at March 31, 2016) will cause consolidated FFO adjusted leverage and FFO fixed charge coverage of the combined entity to meaningfully weaken in the short- to medium-term. Excluding benefits of any potential synergies, Fitch forecasts pro forma adjusted FFO leverage to jump to 5.1x in 2017 and gradually improve to 4.7x by 2019. Pro forma FFO fixed charge coverage is expected to be in the 4.5x - 5.0x range over 2016 - 2019. Fitch would like to see the FFO adjusted leverage improve and sustain below the 4.5x level before considering any upward migration of ratings.

Improved Business Profile: The acquisition of AGL meaningfully improves Southern Company's risk profile, in Fitch's view. Fitch generally views gas distribution businesses as low risk and AGL's utilities are generally well managed with numerous supportive regulatory mechanisms in place. AGL's rising investments in inter-state pipelines carry moderately higher competitive market risks, but these are offset to a large extent by long-term offtake agreements with credit-worthy counterparties. While the non-regulated retail and wholesale businesses of AGL are volatile, the exposure is somewhat contained given these will be a small part of the combined company. Southern Company gains tremendous scale and geographic diversity with this acquisition and its inaugural pursuit of natural gas businesses can smooth out earnings and cash flow of its predominantly summer-peaking electric utilities. The combination also lowers the contribution of its non-regulated, albeit conservatively managed, Southern Power Company in the overall business mix as well as that of Mississippi Power, which is undergoing significant stress related to the construction cost overrun for the Kemper IGCC project.

Execution Risk of Two Large Construction Projects: Fitch's rating concerns for Southern Company include significant construction and regulatory risks associated with the two large baseload projects under construction, namely the 2,200 MW Vogtle nuclear units 3 and 4 and the 580 megawatt (MW) Kemper IGCC plant. The risks related to Vogtle 3 and 4 nuclear units have abated somewhat with the October resolution of the pending litigation between Vogtle owners and the EPC contractors, changes in the EPC agreement, and the contractor changes. The modified EPC agreement confirmed the in-service dates as June 30, 2019 for Unit 3 and June 30, 2020 for Unit 4. Ongoing proceedings with the Georgia Public Service Commission (GPSC) Staff could result in a favorable outcome that provides more certainty regarding the recovery of costs currently not included in the existing $6.1 billion cost certification and would be credit positive.

The construction costs and expected commercial operations date (COD) for the Kemper IGCC plant continue to show modest escalation as the project enters its critical start-up phase. While the 3-0 PSC vote on the $126 million permanent rate increase order in December 2015 for the in-service portion of the Kemper plant is encouraging, significant regulatory uncertainties remain for the recovery of the remainder of the project costs in rates. We believe the plant may need to demonstrate a successful start-up and sustained operating performance before Mississippi Power can file for the next rate proceeding.

Significant Growth at Southern Power: Fitch views Southern Power's fast-growing renewable business as neutral to ratings at this time. The extension of bonus depreciation and federal subsidies for wind and solar projects and a strong interest from both utility and non-traditional offtakers is expected to result in a significant growth of renewable power generation in the U.S. Southern Power has made several project acquisitions in recent months and, combined with a placeholder capex, could potentially invest approximately $5 billion over 2016 - 2018. Long-term contracts with creditworthy counterparties, a balanced mix of debt and equity to finance the growth capex and management's current intent to limit the earnings contribution from Southern Power to approximately 10% of the combined entity mitigate any rating pressure at this time.

KEY RATING DRIVERS FOR ALABAMA POWER
Strong Regulatory Mechanisms: The ratings and Stable Outlook for Alabama Power reflect Fitch's view that the utility will continue to generate strong credit metrics over the next three years driven by a gradual improvement in industrial sales and potential rate increases under the environmental cost recovery clauses. Falling fuel prices create headroom for Alabama Power to increase RSE rates. Cost-of-service recovery mechanisms provide timely recovery of all prudent costs through various rates/cost trackers, such as those incurred for fuel, purchased power, storm costs, environmental expenditures and new generation facilities.

Robust Credit Metrics: For the last 12 months (LTM), Alabama Power's FFO adjusted leverage was 3.1x. Fitch expects this metric to remain in the 3.1x - 3.3x range over 2016-18. Year-end (YE) 2015 adjusted debt-to-EBITDAR was 3x and we expect this metric to sustain at these levels until 2018. FFO fixed charged cover is expected to average approximately 6x - 6.8x over the same period.

High Reliance on Industrial Sales: Rating concerns for Alabama Power include a high reliance on the industrial sector, which makes up for approximately 42% of its total retail MWH sales and 28% of total revenues. The dominant industrial customers in its service territory comprise chemicals, primary metals, pulp and paper, and transportation. Industrial sales were weak in 2015 and lacklustre customer usage trends continue to be a concern. However, Fitch sees enough room in the credit metrics to absorb a prolonged period of stagnant sales.

High Proportion of Coal in Fuel Mix: Other rating concerns include Alabama Power's large coal mix (approximately 53% of total generation), which leaves the utility exposed to potential higher environmental expenditures such as those related to coal ash. The utility will also have to transform its generation fleet to a cleaner mix as carbon compliance rules eventually get implemented. While Alabama Power has both an environmental clause that allows for recovery of all prudent and federally mandated expenditures and new generation clause, the upward pressure on retail rates would have to be managed to preserve a constructive regulatory compact.

KEY RATING DRIVERS FOR GEORGIA POWER
Moderation in Vogtle Construction Risk: While still elevated, Fitch views the execution risk associated with the construction of Vogtle 3 and 4 nuclear units as having moderated somewhat over the last few months. This has been primarily driven by the October resolution of the pending litigation between Vogtle owners and the EPC contractors, changes in the EPC agreement, and the contractor changes. Favorable amendments to the original EPC agreement significantly limit the circumstances that the contractors could claim as material changes to the nuclear regulatory law, thereby reducing the likelihood of future disputes. Now that Westinghouse has assumed the role of the primary contractor, Fitch's concerns regarding inter-contractor disputes have diminished.

The Vogtle units have been recovering the financing costs on construction work in progress (CWIP) through a tracker since 2011. The GPSC has approved $3.1 billion in costs incurred through June 30, 2015 as part of the semi-annual Vogtle Construction Monitoring (VCM) proceedings. Ongoing discussions between Georgia Power and the PSC Staff to ascertain reasonableness and prudency of the revised capital costs and schedule estimates could result in a settlement that provides more certainty regarding the recovery of costs currently not included in the existing $6.1 billion certified costs. The ratings and Stable Outlook for Georgia Power reflect Fitch's expectation that any adjustments to the current certified project costs will be deemed prudent and recoverable by the PSC. Georgia Power sees no change to its assessment of a 6%-8% impact on customer rates as a result of the construction delay and this should minimize the regulatory risk, in Fitch's opinion.

Deteriorating Credit Profile of Toshiba: Fitch is concerned with the weakening credit profile of Toshiba Corporation (not rated by Fitch), which is the majority owner of Westinghouse and has guaranteed certain Westinghouse obligations. Toshiba's credit rating has been lowered to well below investment grade by the other rating agencies. Per the terms of the EPC contract, Westinghouse has posted approximately $920 million in letters of credit, which partly mitigates Fitch's concern.

Cost Control Key to Maintaining ROE: Georgia Power agreed to a three-year stay-out for base rate increases in Georgia as part of the AGL merger approval proceedings. Continued strong sales growth in its service territory, extension of bonus depreciation and absence of sizeable environmental projects over the next three years had diminished the need for a large base rate increase in 2017. By controlling costs, Georgia Power can continue to earn its above average authorized return on equity (ROE) of 10.95%. The utility will file its next rate case in July 2019 for new rates effective January 2020. Anticipating a modest deterioration in Georgia Power's credit metrics, Fitch estimates adjusted debt-to-EBITDAR and FFO adjusted leverage to be approximately 3.4x and 4.0x, respectively, by 2018.

KEY RATING DRIVERS FOR GULF POWER
Constructive Regulation: Fitch has a favorable view of the current regulatory environment in Florida. Gulf Power enjoys several rate riders that provide timely recovery of all prudent costs related to fuel, purchased power costs, energy conservation, and environmental expenditures. While Gulf Power is dependent on coal-fired generation capacity that must comply with stringent emissions standards, the fuel and environmental recovery clauses promote timely recovery of associated costs. Gulf Power's current base rates are based on authorized ROE of 10.25% and it may not request a base rate increase to be effective until after June 2017 unless the retail ROE falls below the authorized ROE range and the $62.5 million depreciation credit allowed in the last rate case is exhausted.

Improvement in Retail Sales: Gulf Power's service territory continues to see slow but steady improvement in the local economy with economic indicators such as housing starts, unemployment and income growth all showing positive trends. However, customer usage trends continue to be challenging.

Credit Metrics: Fitch forecasts Gulf Power's adjusted debt-to-EBITDAR and FFO adjusted leverage to be approximately 3.3x and 3.6x, respectively, in 2018, which is in line with its rating level.

KEY RATING DRIVERS FOR MISSISSIPPI POWER
Financial Support by Parent: Southern Company's tangible financial support to Mississippi Power in the form of direct equity infusion and inter-company loans to meet a portion of the Kemper construction costs has been a key factor in assessing Mississippi Power's creditworthiness.

Construction and Operational Risk at Kemper: As the project enters its critical phase of gasifier start-up and integration with the combined cycle turbines, Fitch continues to be concerned with the possibility of a further delay in schedule and the resultant cost creep. The project is now expected to cost approximately $6.6 billion, of which Mississippi Power does not intend to seek rate recovery for $2.47 billion of costs incurred above the $2.88 billion cost cap and has taken an equivalent charge to income through its first quarter 2016 (1Q16) financial results. The project spend is approximately 95% complete with $6.24 billion of actual costs incurred through the end of March 2016. Any extension of the in-service date beyond Sept. 30, 2016 is currently estimated to result in additional base costs of approximately $25 million to $35 million per month, AFUDC costs of approximately $14 million per month, as well as carrying costs and operating expenses on Kemper IGCC assets placed in service and consulting and legal fees of approximately $2 million per month. However, additional costs may be required for remediation of any further equipment and/or design issues identified.

Permanent Rate Recovery Approved: Despite the heightened Kemper-related focus in the PSC elections last fall, the year-to-date decisions of the Mississippi Public Service Commission (MPSC) regarding Kemper appear to be constructive. In a 3-0 vote, the MPSC approved the permanent rate recovery for the in-service and related assets (primarily the combined cycle portion of the plant). In January 2016, the MPSC denied two requests for rehearing regarding the permanent rate increase. However, significant regulatory challenges could yet lie ahead when Mississippi Power files for a rate increase for the remainder of the Kemper plant. Per the last rate order, dated Dec. 3, 2015, Mississippi Power is required to file a rate case within 18 months. Fitch believes the rate case timing will be contingent upon a successful and sustained commercial operation of the IGCC plant.

Stress on Credit Metrics: The delay in recovery of financing costs has already put significant stress on Mississippi Power's credit metrics. For the year ending 2015, FFO adjusted leverage increased to 7.5x. Fitch expects this metric to decline to 5.3x in 2018 based on the assumption that the project becomes operational within the currently projected capital costs and schedule and Mississippi Power is able to secure a permanent rate increase once the balance of the plant becomes operational. Fitch's financial forecasts also reflect the proposed securitization of approximately $1 billion in proceeds in 2017.

KEY RATING DRIVERS FOR SOUTHERN POWER
Conservative Contracting Strategy: Southern Power's ratings are underpinned by its conservative contracting strategy. The company sells power primarily under long-term power sales agreements with investment-grade counterparties. As of March 31, 2016, the company had an average investment coverage ratio of 91% for the next five years and 90% for the next 10 years. Southern Power is generally able to pass through fuel costs to its customers under power sales contracts for its natural gas generation assets, although it retains margin exposure to the operating efficiency of its plants. For the renewable generation projects, Southern Power retains volumetric risks associated with resource variability.

Significant Expansion in Renewable Generation: Fitch views the company's foray into solar and wind as largely neutral to its credit profile at this time. These projects benefit from long-term power purchase agreements (PPAs) with creditworthy offtakers. The long PPA contractual term on renewable projects is offsetting the decline in contract coverage on the natural gas portfolio. Fitch views the technological, completion and operational risks of the solar and wind projects as manageable.

Elevated Near-Term Credit Metrics: Fitch expects Southern Power's leverage-based credit metrics to be elevated in the near term primarily influenced by the delay in using the investment tax credits (ITC). Bonus depreciation has reduced the tax appetite of the company and deferred the recognition of ITCs. For year-end 2015, Southern Power's FFO adjusted leverage jumped to 5.2x. Fitch expects this measure to moderate to 2.7x by 2018. FFO fixed charge coverage is expected to average around 7.4x over the forecast period. These estimates include a capex estimate of $5 billion over 2016-2018.

KEY RATING DRIVERS FOR SOUTHERN ELECTRIC GENERATING COMPANY

SEGCO's ratings are supported by joint ownership by Georgia Power and Alabama Power. SEGCO's debt is fully and unconditionally guaranteed by Alabama Power, which, in turn, has an indemnification from Georgia Power to cover 50% of SEGCO's debt repayment in case of a default by SEGCO.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case are as follows:

Alabama Power

--Modest increases in Rate Stabilization & Equalization (RSE) rates over 2016 - 2018
--No increases under CNP C (environmental) rates over 2016 - 2018
--0.5% increase in electricity sales over 2016 - 2018

Georgia Power

--1% increase in electricity sales over 2016 - 2018
--$140 million rate increase effective Jan. 1, 2016 that reflects base rate increase of $49 million, Environmental Compliance Cost Recovery (ECCR) tariff increase of $75 million, Demand Side Management (DSM) tariff increase of $3 million and other tariff increase of $13 million
--Nuclear Construction Cost Recovery (NCCR) tariff increases of 0.5% - 1% over 2016 - 2018
--Vogtle 3 & 4 in-service in 2019 and 2020

Gulf Power

--Sales growth of 0.5% in 2016 and 1% in 2017 and 2018
--Rate increases per the last rate order

Mississippi Power

--ROE of 9.87% for 2016 - 2018, 9.2% for Kemper rates from 2016 - 2020
--100% ownership of Kemper IGCC with 85% recovered through regulated rates
--Securitization of $1 billion million in 2H17
--Kemper IGCC COD by September 2016 and additional Kemper rates before the end of 2017
--Modest Performance Evaluation Plan (PEP) and Environmental Compliance Overview (ECO) rate increase over 2016 - 2018
--1% electricity sales growth over 2016 - 2018

Southern Power

--Growth projects as announced
--Funding of growth capex at approximately 55% debt
--2016 - 2018 FFO ratios include ITCs for the solar projects during construction

Southern Company
--AGL acquisition closes in 2H 2016
--No material retention of synergies from the AGL acquisition
--Future capital needs funded in a balanced manner

RATING SENSITIVITIES

RATING SENSITIVITIES FOR SOUTHERN COMPANY