Fitch Affirms Calpine at 'B '; Outlook Stable
In addition, Fitch has affirmed Calpine Construction Finance Company, L.P. (CCFC)'s Long-term IDR at 'B+' and senior secured debt rating at 'BB+/RR1'. The Outlook is Stable.
The affirmation reflects Fitch's view that Calpine can continue to generate stable levels of adjusted EBITDA amid weakening near-term natural gas fundamentals. Given the relative efficiency of Calpine's fleet compared to the market, low natural gas prices can boost the run times for its generation fleet, thus, offsetting the compression in generation margins to a large extent. This phenomenon was observed in spring of 2012 as natural gas prices fell to \$2/MMBtu, a trend that may be replicated in 2015. Fitch's base deck for natural gas prices calls for \$4/MMBtu levels over 2015-16 and \$4.25/MMBtu in 2017. At these prices, Fitch expects Calpine to generate 2015 adjusted EBITDA within its stated guidance range of \$1.9 billion - \$2.1 billion. Beyond 2015, Fitch expects adjusted EBITDA to modestly increase reflecting capital deployment in already announced new generation projects and recently completed acquisitions/ divestitures.
Fitch also has a positive view of management's portfolio strategy, which has resulted in a sharper focus on its core regions of Northeast, California and Texas. Divestiture of six Southeast generation plants and acquisition of two plants in Texas and New England in 2014 not only improved Calpine's scale in core regions but also proved to be financially lucrative, generating excess cash proceeds with no significant change to overall adjusted EBITDA.
Fitch's rating concerns primarily lie with Calpine's capital allocation policy. Fitch can appreciate that with the balance sheet restructuring behind it, management is increasingly focused on growth capex and share repurchases as its primary uses of excess cash. However, the pace of share repurchases has been tracking above Fitch's expectations, in part due to proceeds from asset sales, and the net debt/EBITDA metric has consistently trailed, albeit modestly, management's stated 4.5x target.
KEY RATING DRIVERS
EBITDA Resiliency Through Cycles
Calpine's adjusted EBITDA has proved to be resilient in different natural gas price scenarios. While Calpine's adjusted EBITDA remains biased towards higher natural gas prices given the relative efficiency of its fleet compared to the market, low natural gas prices have boosted the generation output as gas-fired generation displaces coal. This level of adjusted EBITDA stability is quite unique among merchant generation companies and is usually seen for those generators that sell under long-term contracts with minimum fuel risk. Fitch does note, however, that Calpine's open position for the forward years (77% in 2016 and 85% in 2017 as of September 30, 2014) is the highest it has been since the company emerged from bankruptcy in 2008 and is driven by reduced liquidity in the forward markets, the divestiture of contracted assets and subsequent reinvestment in competitive wholesale power markets, and management's fundamental view of improving power prices.
Favorable Generation Mix
The combination of efficient natural-gas fired combined cycle plants and Geysers (geothermal) assets make Calpine's fleet cleaner than other coal heavy IPPs. Calpine's fleet is also much younger than its peers. As a result, Calpine is comparatively much less vulnerable to both existing and potential stringent environment regulations addressing greenhouse gas emissions, other air emissions including SOx, NOx, Mercury and coal ash as well as water use. For these reasons, Fitch views Calpine's business mix as relatively strong compared with other merchant generators. Over the medium to long-term Calpine's predominant dependence on natural gas could see pressure from the rapid penetration of renewables, particularly in California and Texas.
Measured Approach to Growth
Fitch has a positive view of management's measured approach to growth, which has been largely geared towards new generation that is backed with long-term power purchase agreements with credit worthy counterparties, and merchant facilities where Calpine has significant cost advantages over other new entrants. Calpine has also been an active and opportunistic buyer and seller of generation assets, monetizing non-core assets and increasing scale in core regions. Enhancements to annual capacity auctions in PJM and New England will benefit Calpine's existing dual-fuel generation fleet and support Calpine's strategy of targeting new builds and acquisitions in these regions. Fitch expects management to continue to monetize its assets in non-core regions. Any asset purchases are likely to be measured, as demonstrated by management's past actions, and will probably consist of natural gas fired assets so as to maintain the company's relatively clean environmental profile. Fitch's current view does not incorporate any major foray by the company into the renewable sector such as wind and solar over the near-term.
Capital Allocation Geared Toward growth and Share Repurchases
Aside from the scheduled debt maturities/ amortizations, debt levels will be managed around management's stated net Debt/EBITDA target of 4.5x. Significant covenant cushion, incremental first lien debt capacity and the continuing shift to an unsecured debt structure affords Calpine tremendous financial flexibility to deploy capital. Fitch expects Calpine to generate approximately \$600 million of free cash flow in 2014; annual free cash flow could approach \$900 million by 2017. These free cash flow estimates incorporate both maintenance and growth capex based on announced new projects. We think management's policy of not announcing a formal share repurchase program in advance provides it flexibility to look for growth opportunities. Reinvestment of capital in new generation projects under long-term contracts would be viewed positively by Fitch. Investment in new generation projects at deeply discounted capital costs in tight power markets would be the next preferred deployment of excess cash. In absence of reinvestment opportunities, Fitch expects management to allocate a majority of the excess cash to stock repurchases.
'B+' Financial Profile
Fitch expects Calpine's credit portfolio to remain in line with its ratings. Fitch expects Adjusted Debt to EBITDAR ratio to improve to 5.3x in 2017 from 5.7x in 2014, primarily driven by scheduled debt amortizations and modest improvement in EBITDA, and FFO adjusted leverage to improve to 5.1x in 2017 from 5.6x in 2014. We expect coverage ratios to strengthen to 3.00x - 3.25x range given the recent successful refinancing of legacy high coupon debt. To the extent management deploys a portion of the excess cash to new generation projects instead of share repurchases, there would be upside to our forecasted EBITDA and FFO metrics.
Strong Liquidity
Calpine's liquidity position has improved with the upsizing of its corporate revolver by \$500 million to \$1.5 billion; the revolving facility matures in June 2018. Calpine had approximately \$1.5 billion of unrestricted cash and cash equivalents and \$1.3 billion of availability under the corporate revolver, as of Sept. 30, 2014. There is no corporate debt maturity until 2018 when the \$1.6 billion term loan matures and scheduled project debt amortizations approximate \$200 million - \$225 million annually.
Rating Linkages
There are strong contractual, operational and management ties between Calpine and CCFC. CCFC sells a majority of its power plant output under a long-term tolling arrangement with Calpine's wholly owned marketing subsidiary. CCFC is also a party to a master operation and maintenance agreement and a master maintenance services agreement with another wholly owned Calpine subsidiary. For these reasons, in accordance with its Parent and Subsidiary Rating Linkage Criteria, Fitch assigns the same IDR to CCFC as the parent even though its standalone credit profile is stronger.
KEY ASSUMPTIONS
--Natural gas prices of \$4.00/\$4.00/\$4.25 per MMBtu for 2015/16/2017, respectively.
--Expected generation hedged per management estimates of 53%, 23% and 15% for 2015, 2016 and 2017, respectively. Hedged margin of \$21/24/28 per MWh for 2015/16/17.
--O&M costs escalated at 2.5%.
--Growth and maintenance capex of approximately \$1.0 billion over 2015-17; major maintenance expense of \$750 million over this period.
--No additional growth projects except those already announced and under construction (Deer Park COD 2014, Channel COD 2014, Garrison COD 2015 and York 2 COD 2017). To the extent that management pursues other growth projects, Fitch's estimates of EBITDA and cash flows could prove conservative.
--In absence of additional growth projects, Fitch has assumed that free cash flow generation can support a \$500 million - 600 million stock buyback program on an annual basis.
RECOVERY ANALYSIS
The individual security ratings at Calpine are notched above or below the IDR, as a result of the relative recovery prospects in a hypothetical default scenario.
Fitch values the power generation assets that guarantee the parent debt using a net present value (NPV) analysis. A similar NPV analysis is used to value the generation assets that reside in non-guarantor subs and the excess equity value is added to the parent recovery prospects. The generation asset NPVs vary significantly based on future gas price assumptions and other variables, such as the discount rate and heat rate forecasts in California, ERCOT and the Northeast. For the NPV of generation assets used in Fitch's recovery analysis, Fitch uses the plant valuation provided by its third-party power market consultant, Wood Mackenzie as well as Fitch's own gas price deck and other assumptions.
Fitch rates Calpine's corporate revolving facility, first lien credit facility and senior secured notes, which rank pari passu, at 'BB+/RR1'. The 'RR1' rating reflects a three-notch positive differential from the 'B+' IDR and indicates that Fitch estimates outstanding recovery of 91 - 100%. Fitch has assigned a 'BB-'/RR3 rating to the senior unsecured debt at Calpine. The recovery analysis yields a 91-100% recovery for the outstanding unsecured debt but Fitch has constrained the rating given expectation of issuance of additional unsecured debt. Fitch rates the first lien senior secured term loan facility at CCFC at 'BB+/RR1'.
RATING SENSITIVITIES
Positive: Positive rating actions for Calpine and CCFC appear unlikely unless there is material and sustainable improvement in Calpine's credit metrics compared with Fitch's current expectations. Management's net leverage target of 4.5x effectively caps Calpine's IDR at the 'B+' category.
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
--Weak wholesale prices due to unfavorable power demand and supply dynamics, regulatory interference and /or distortion in market pricing signals that depress Calpine's EBITDA and FFO below Fitch's expectations on a sustained basis;
--An enhanced pace of share repurchases without hitting or sustaining the stated net leverage target of 4.5x;
--An aggressive growth strategy that diverts significant proportion of growth capex towards merchant assets and/ or inability to renew its expiring long-term contracts leading to a higher open position;
--Above 6.0x Total adjusted debt/EBITDAR; and
--Above 7.0x FFO adjusted leverage.
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