Fitch Affirms Pepco and Subs' Ratings; Outlook Stable
A full list of the ratings follows the end of this release.
KEY RATING DRIVERS
Pepco Holdings Inc.
Regulated Earnings Contribution: PHI's ratings are supported by the predictable cash flows generated by its three regulated transmission and distribution utility subsidiaries. The three utilities are expected to provide approximately 98% of consolidated earnings over the next several years. The remaining earnings are generated by PHI's non-regulated subsidiary, Pepco Energy Services (PES), which provides energy management and underground and transmission construction services.
Predictable Cash Flows: The three operating utilities, Pepco, DPL and ACE have virtually no commodity price risk and limited volumetric exposure due to decoupling mechanisms in both Maryland and the District of Columbia (DC) covering approximately two-thirds of retail sales. In addition, the revenue mix is largely residential and commercial with a relatively small industrial customer base which tends to minimize the effect of economic downturns.
Pending Acquisition by Exelon Corp.: The pending merger between PHI and Exelon Corp. (EXC) will provide a stronger, better capitalized parent company with far greater financial flexibility. Post-closing, PHI will become a second tier holding company of EXC and be the direct parent of Pepco, DPL and ACE (DPL and ACE are currently the direct subsidiary of a now dormant, debt free, intermediate holding company from a previous merger). Regulatory approvals for this acquisition have been received by the Federal Energy Regulatory Commission, The Virginia State Corporation Commission and the New Jersey Board of Public Utilities. In addition a settlement agreement has been reached with the staff of the Delaware Public Service Commission (PSC) and several other parties that is subject to PSC approval. DC and Maryland have yet to make a decision, although a settlement with certain parties has been filed in Maryland. The transaction is expected to close in the second quarter or third quarter of 2015 (3Q'15).
Significant Capital Investment: PHI's utilities are in the midst of a significant capital expenditure plan of approximately \$6.6 billion over 2015-2019. A large portion of the expenditures are to address reliability issues that have been a point of contention with regulators, particularly for Pepco in Maryland. The high capex contributes to the near-term financial weakness, but should provide growing cash flow over time. The ratings assume a balanced mix of debt and equity will be used to fund the expenditures.
Persistent Regulatory Lag: Persistent regulatory lag at the three utility subsidiaries is a primary credit concern. The lag, which primarily results from the reliance on historical test years with limited forward adjustments, restricts the companies from earning their authorized returns on equity (ROE) and adversely affects credit quality measures. The lag is particularly troublesome during this period of high capex. To combat regulatory lag management has been filing annual rate cases while also pursuing various adjustment mechanisms to accelerate capital and cost recovery. The strategy has had the intended effect of improving credit metrics over the past two years. However, rate filings have been deferred during the regulatory review of the pending EXC merger which will pressure credit metrics through mid-2016. No new rate filings are expected before 4Q'15 to be effective mid to late 2016, depending on the jurisdiction.
Ample Liquidity: A \$1.5 billion unsecured credit facility provides ample liquidity for PHI and its utility subsidiaries. The facility expires Aug. 1, 2018. The only financial covenant is a 65% debt/capital ratio, which is in line with industry standards and not expected to impact the company's ability to borrow. Debt maturities are well laddered, but will require capital market access. To provide additional liquidity during the merger review process, EXC has an agreement to purchase up to \$180 million of PHI preferred stock with a dividend of 0.1%. Preferred stock of \$126 million was issued to EXC in 2014.
Rate Increases: Since mid-2013 PHI's three utility's implemented eight electric and gas rate increases aggregating \$141.5 million or roughly 40% of the \$355 million requested. The rate increases improved credit quality for each entity as expected.
Credit Metrics: Credit metrics improved for the second consecutive year in 2014 in line with expectations, but will be pressured through 2016 due to rate case avoidance during the merger review process and customer credits required to gain merger approval. Fitch anticipates consolidated funds from operations (FFO) adjusted leverage and debt/EBITDAR will both approximate 5x in 2015 and then improve to about 4.3x in 2017. FFO fixed charge coverage is expected to be about 3.75x in 2015 improving to about 4.4x in 2017. The forecast does not take into consideration potential cost savings due to the merger or other financial support (other than the preferred stock) from EXC.
KEY ASSUMPTIONS
--Base distribution rates held at current level through mid-2016 to late 2016; annual rate filings thereafter.
--Exelon merger is approved.
--O&M increases of 2.5% annually.
--Consolidated capex of \$4.1 billion over the 2015-2017 periods.
--Capex funded in a manner to preserve existing capital structure.
RATING SENSITIVITIES
Positive Rating Action: Positive rating action is not likely through the rate case avoidance period, but could occur if debt/EBITDAR and FFO leverage fall below 3.75x and 4.5x on a sustainable basis and FFO coverage is 4.5x or better.
Negative Rating Action: FFO lease adjusted leverage in excess of 5x and/or FFO fixed charge coverage below 4x on a sustained basis could result in lower ratings.
The inability to close the EXC merger and/or lack of regulatory support for expected post-merger rate filings could also result in lower ratings.
Potomac Electric Power Co.
KEY RATING DRIVERS
Revenue Stability: Pepco's regulated electric transmission and distribution operations have minimal commodity, volumetric and environmental exposure. Regulators in both Maryland and DC implemented revenue decoupling mechanisms eliminating the revenue impact of weather and changes in usage patterns and permit full recovery of power procurement costs with a modest profit margin. Revenue stability is further enhanced by the significant presence of state and federal government customers which tends to reduce economic volatility in the service territory.
Significant Capital Program: Pepco is in the midst of a significant capital program of approximately \$3.4 billion over 2015-2019. A large portion of the expenditures are to address reliability issues that have in the past been a point of contention with Maryland regulators. The large capex budget is particularly challenging given the rate lag issues.
Credit Metrics: Following two years of improvement, credit metrics will be pressured through 2016 as the company avoids base rate filings during the regulatory review of the pending merger between Pepco's parent PHI and EXC. Fitch anticipates lease adjusted FFO leverage will increase to about 4.7x in 2016 before improving to about 4.25x in 2018. Debt/EBITDAR is expected by Fitch to peak at about 4.2x in 2016 improving to about 3.9x in 2018. FFO fixed charge coverage declines to an estimated 4.1x in 2016, increasing to about 4.7x in 2018. The forecast does not include any merger related benefits.
Exelon Merger: The pending merger between PHI and EXC has no direct impact on Pepco's credit quality, but does provide a stronger, better capitalized parent company with far greater financial flexibility. Moreover, Fitch anticipates Pepco to benefit from improved operating efficiency and lower costs as a result of the merger. Nonetheless, rate case avoidance and a likely package of rate payer benefits will adversely affect cash flow in the near term. EXC and PHI have proposed an investment fund in Maryland for Pepco and DPL customers of \$94.4 million that can be used for rate credits, energy efficiency or low income customer assistance.
Challenging Regulatory Environment: Earnings and cash flow measures have been constrained by a string of restrictive rate decisions in Maryland dating back to 2007. The two most recent cases were based on ROE of 9.62% and 9.36%, which are below the industry average. Particularly troubling is the Maryland Public Service Commission's (MPSC) reluctance to permit forward adjustments to address regulatory lag which will likely prevent Pepco from earning its allowed ROE.
Tariff Increase: In March 2014, the Washington DC Public Service Commission (PSC) authorized Pepco a \$23.4 million rate increase based on a 9.40% ROE and a 49.19% equity ratio or about 52% of the company's \$44.8 million rate request. In July, the Maryland PSC approved an \$8.8 million increase equal to 24% of the company's \$37.4 million rate request.
KEY ASSUMPTIONS
--Base distribution rates held at current level through mid-2016 in Maryland and late-2016 in DC; annual rate filings thereafter.
--Annual customer growth of 0.5% and flat sales growth.
--O&M increases of 2.5% annually.
--Capex of \$2.1 billion over the 2015-2017 periods.
--Capex funded in a manner to preserve existing capital structure.
RATING SENSITIVITIES
Positive Rating Action: Positive rating action is not expected through the rate avoidance period, but could occur if debt/EBITDAR and FFO leverage fall below 3.75x and 5x on a sustainable basis and FFO coverage is maintained at 4.5x or better.
Negative Rating Action: FFO leverage above 5x or FFO coverage below 4.5x on a sustained basis could result in lower ratings.
The inability to close the EXC merger and/or lack of regulatory support for expected post-merger rate filings could also result in lower ratings.
Delmarva Power and Light Co.
KEY RATING DRIVERS
Credit Metrics: Following two years of improvement, leverage measures are expected to weaken through 2016 as the company avoids base rate filings while regulators review the pending merger between PHI and EXC. Fitch expects lease adjusted FFO leverage and debt/EBITDAR to increase to 4.2x and 5.0x, respectively in 2016 and then improve to about 3.8x and 4.6x by 2018. FFO fixed charge coverage is also expected to decline, but remain supportive of the existing rating at about 4.4x in 2016 improving to 5x in 2018. The forecast does not include any merger related benefits.
Exelon Merger: The pending merger between PHI and EXC has no direct impact on Pepco's credit quality, but does provide a stronger, better capitalized parent company with far greater financial flexibility. Moreover, Fitch anticipates improved operating efficiency and lower costs as a result of the merger. Nonetheless, rate case avoidance and a likely package of rate payer benefits will adversely affect cash flow in the near term.
Rate Increases: Since September 2013, DPL has been authorized three tariff increases aggregating \$36.9 million. In Delaware, electric and natural gas rate hikes were implemented in April 2014 and October 2013, respectively, and in Maryland electric rates were increased in September 2013. Annual rate filings are part of management's strategy to soften the impact of rate lag. Due to the pending EXC merger review, however, rate filings have been deferred. There were no rate filings in 2014 and the next rate request is not likely before 4Q'15.
Significant Capital Program: DPL is in the midst of a significant capital program of approximately \$1.7 billion over 2015-2019 that will require on-going rate support. The expenditures are for distribution reliability, transmission and new customer connections.
Decoupling: In Maryland, which accounts for about 35% of retail sales, DPL operates with a Bill Stabilization Adjustment (BSA) that reduces volumetric exposure and stabilizes revenue. The BSA provides for a fixed distribution charge per customer rather than a charge based on usage. Any deviation from the approved charge is either recovered from or credited to customers effectively decoupling revenue from sales.
Merger Approval: EXC, PHI and the staff of the Delaware Public Service Commission (PSC) reached a settlement agreement on the pending merger in February 2015. The agreement, which is subject to BPU approval, includes \$49 million of rate credits over 10 years. The settlement agreement is subject to approval by the PSC.
KEY ASSUMPTIONS
--Base distribution rates held at current level through mid-2016; annual rate filings thereafter.
--Annual customer growth of 0.5% and flat sales growth.
--O&M increases of 2.5% annually.
--Capex of \$1.1 billion over the 2015 - 2017 periods.
--Capex funded in a manner to preserve existing capital structure.
RATING SENSITIVITIES
Positive Rating Action: Positive rating action is not likely during the rate case avoidance period, but could occur if debt/EBITDAR falls below 3.6x on a sustainable basis.
Negative Rating Action: Lease adjusted FFO leverage above 4.5x and/or FFO fixed charge coverage below 4.7x on a sustained basis could result in lower ratings.
The inability to close the EXC merger and/or lack of regulatory support for expected post-merger rate filings could also result in lower ratings.
Atlantic City Electric Co.
KEY RATING DRIVERS
Low Business Risk: ACE's ratings and Stable Outlook are supported by low business risk and predictable cash flows generated by its regulated electric transmission and distribution operations. ACE bears no commodity risk. However, ACE does face timing mismatch in recovering the power costs associated with three power purchase contracts with non-utility generators (NUG).
Credit Metrics: After two years of improvement, credit metrics are generally in line with the current ratings, but will be pressured through 2016 as ACE avoids rate filings while regulators review the pending merger between PHI and EXC. Fitch anticipates debt/EBITDAR to approximate 4.3x in 2016 and then improve to about 3.6x in 2017. Lease adjusted FFO leverage and FFO fixed charge coverage are expected to approximate 4.2x and 3.8x, respectively in 2016 and then improve to about 3.9x and 4.1x in 2018.
Exelon Merger: If approved, the pending merger provides a stronger, better capitalized parent company with far greater financial flexibility. Moreover, Fitch anticipates improved operating efficiency and lower costs as a result of the merger. Nonetheless, rate case avoidance and rate credits will adversely affect cash flow in the near term.
Merger Approval: In February 2015, the BPU approved a settlement agreement in the pending merger between PHI and EXC. The settlement agreement includes \$62 million of rate credits and \$15 million in energy efficiency savings.
Significant Capital Program: ACE is in the midst of a significant capex program that will require regular rate filings once regulators reach a decision on the pending merger application. Peak spending is in 2016 and 2017 and then tapers off in subsequent years. Current ratings assume capex will be funded in a manner to preserve the current capital structure. The rise in capex is primarily facility replacement and upgrades to the distribution system, but also on-going investment in Federal Energy Regulatory Commission (FERC) regulated transmission.
Restrictive Rate Decision: ACE implemented a \$19 million rate increase effective Sept. 1, 2014 based on a 9.75% ROE. The tariff increase is less than one-third of the company's \$61.7 million rate request and is not expected by Fitch to meaningfully improve ACE's relatively weak financial position. ACE has filed rate requests in each of the past three years as part of a strategy to offset regulatory lag. The prior increase implemented in July 2013 amounted to about 37% of the company's request also based on a 9.75% ROE.
KEY ASSUMPTIONS
--Base distribution rates held at current level through late-2016; annual rate filings thereafter.
--Flat customer growth of declining sales growth of about 1%.
--O&M increases of 2.5% annually.
--Capex of \$910 million over the 2015-2017 periods.
--Capex funded in a manner to preserve existing capital structure.
Positive Rating Action: Positive rating action is not likely during the rate case avoidance period, but could occur if, on a sustainable basis, debt/EBITDAR falls below 3.75x, lease adjusted FFO leverage is at or below 5.0x and FFO coverage exceeds 4.5x.
Negative Rating Action: Lease adjusted FFO leverage above 5x on a sustained basis and/or the inability to reduce debt/EBITDAR to roughly 4.0x by 2017 could result in lower ratings.
The inability to close the EXC merger and/or lack of regulatory support for expected post-merger rate filings could also result in lower ratings.
Fitch affirms the following ratings with a Stable Outlook:
Pepco Holdings, Inc.
--IDR at 'BBB';
--Senior unsecured notes at 'BBB';
--Short-term IDR/commercial paper at 'F3'.
Potomac Electric Power Company
--IDR at 'BBB';
--Secured debt at 'A-';
--Short-term IDR/commercial paper at 'F2'.
Delmarva Power & Light
--IDR at 'BBB+';
--Secured debt and PCRBs at 'A';
--Senior unsecured notes at 'A-';
--Short-term IDR/commercial paper at 'F2'.
Atlantic City Electric Company
--IDR at 'BBB';
--Secured debt at 'A-';
--Senior unsecured notes at 'BBB+';
--Short-term IDR/commercial paper at 'F2'.
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