OREANDA-NEWS. Fitch Ratings has affirmed the rating on South Texas Electric Cooperative's (STEC) implied senior secured obligations at 'A-'. The rating is on implied senior secured obligations because none of STEC's currently $920 million of outstanding long-term debt is publically held.

The Rating Outlook is revised to Positive from Stable.

SECURITY

STEC's senior secured obligations are secured by first lien on substantially all of the cooperative's assets, including its eight member contracts.

KEY RATING DRIVERS

OUTLOOK TO POSITIVE: STEC has prudently managed a period of rapid growth while maintaining consistently strong financial margins and reducing the size of its capital program. The Positive Outlook reflects Fitch's expectation that this trend will continue, supported by new financial policies, and that the upward rating movement is likely.

LARGE TEXAS G&T COOPERATIVE: STEC is a generation and transmission (G&T) electric cooperative serving eight growing distribution cooperative members pursuant to all-requirements contracts through 2049 that provide a highly reliable revenue base. Transmission services within the Electric Reliability Council of Texas (ERCOT) provide the cooperative additional, predictable margins.

HIGH GROWTH IS MANAGABLE: STEC has prudently managed very high load growth averaging 9% annually over the last five years, mostly reflecting gains from development of the Eagle Ford Shale. A generation portfolio with a large purchased component and a load-following contract for the largest member limit the credit risk associated with a potentially lower growth scenario.

MODIFICATIONS TO GENERATION PLAN: STEC has historically relied on natural-gas fired purchased power for most of its energy supply. It had planned to significantly increase owned generation and dramatically increase its capital program. More recently, the plan was modified to remove certain generation construction, relying more on adding to its share of an operating coal facility and constructing new peaking units.

HEALTHY FINANCIAL MARGINS: STEC's financial position is healthy, with financial policies designed to keep DSC between 1.3x and 1.5x annually. The new policies target minimum equity of 20%, which should be achievable given STEC's reduced capital needs.

SOLID MEMBER SYSTEMS: Member systems are experiencing robust sales growth and residential sales are a strong component. Aggregated DSC consistently equals more than 2.5x, and the equity-to-capitalization ratio has improved to a sound 58%.

RATING SENSITIVITIES

CONSISTENTLY HEALTHY FINANCIAL PERFORMANCE: Continued healthy debt service coverage of 1.4x and improved equity ratios to 20% at South Texas Electric Cooperative (STEC), as additional peaking capacity and purchased power costs are absorbed, could support a higher rating. Management of robust load growth and limited capital and debt-financing needs are expected to continue.

CREDIT PROFILE

STEC is a G&T wholesale provider to eight distribution cooperative members in the growing south Texas region. STEC's eight members serve approximately 260,000 customers in 42 counties. Growth in the past four years has been exceptionally strong given the economic growth in the region related to the Eagle Ford shale development. STEC's overall MWh sales have averaged 9% annual growth over the past five years with much of this growth in the large commercial and industrial load sector (27% over the past five years).

Lower oil and natural gas prices have raised the potential for slower growth to occur within the service area, although STEC reports its members continue to work through a backlog of requests for new service. Management consistently updates expected load, generation, transmission and capital investment needs in light of the evolving Texas energy market.

GOVERNANCE CHANGES APPEAR POSITIVE

In 2014, a new general manager came to STEC and the Board of Directors was expanded from eight to 16 members. Each member cooperative now has two board representatives with one of two required to be the member cooperative chief executive.

Governance changes at STEC appear positive. While the over-riding business strategies appear unchanged, in 2015, the new board accomplished a strategic resource planning process that will drive resource acquisitions in the coming years and adopted new financial policies that are supportive of credit quality. The financial policies establish minimum and maximum debt service coverage targets of 1.3x and 1.5x, respectively. Rates will be adjusted mid-year, if needed, to achieve this range, including a rate decrease if coverage is expected to exceed 1.5x. The policies also target minimum equity of 20%.

FLEXIBLE RESOURCE SUPPLY STRATEGY

STEC's resource plan positions it to service significant load growth. A balance of owned versus purchased power contracts allows the cooperative to selectively add resources. This has been demonstrated in the past three years as STEC has altered its generation construction plans to take advantage of low-priced energy in the ERCOT market. STEC's power supply strategy has benefitted wholesale rates in recent years, with 2015 projected to be the lower overall rate than the last five years.

Historically, 70% of STEC's total resources were natural gas fired. Reliance on natural gas-fired capacity will decrease slightly with the additional coal-fired purchased power beginning in 2016, as STEC assumes Brazos Electric Cooperative's share of the San Miguel Electric Cooperative plant output.

While adding more coal-fired capacity may introduce future regulatory uncertainty, the capacity provides greater fuel diversity for STEC. STEC will also place 225 MW of additional peaking capacity into commercial operation in mid-2016 at the Red Gate plant. Similar to a 200 MW plant built in 2010, the quick-start natural gas reciprocating engines provide flexibility to balance price variations and renewable output risk present in the ERCOT energy market.

STRONG FINANCIAL PERFORMANCE

STEC's overall financial metrics have been strong during a period of very rapid growth over the past several years. From 2008-2012, the cooperative's revenue base grew by a considerable 57% to $321 million with the full integration of Magic Valley Electric Cooperative. Between 2012 and 2014, revenues grew another 39% to $439 million as a result of 25% load growth.

STEC's debt service coverage was over 1.8x in fiscals 2010 and 2011 as a result of a temporary surcharge put in place to build system equity. Coverage has stabilized between 1.4x and 1.5x in the past three years, which is consistent with management's healthy 1.4x target and above Fitch's 'A-' rating category median of 1.36x. STEC's coverage of full obligations in fiscal 2014 was 1.22x, consistent with Fitch's median.
STEC's equity-to-capitalization ratio improved to 17.8%. Limited debt-financing plans should help the cooperative's equity ratio grow to reach the minimum target of 20% in fiscal 2016.

Transmission margins have averaged about one-fifth of the total over the past five years. This reflects the addition primarily of new transmission lines in STEC's service area and a 1.5x regulated rate of return.

CAPITAL SPENDING COULD PRESSURE EQUITY LEVELS

STEC's five-year capital plan (2016-2020) totals $447.5 million, and the 10-year plan (2016-2025) totals $720.4 million. Over half ($286 million) of the planned five-year spending is for transmission projects in STEC's service area, which will be repaid by users across the ERCOT system. Management currently estimates that 60% of spending in fiscal 2016 ($109 million) will be funded from debt but over the 10-year capital plan, average debt funding will be around 75% ($540.3 million). STEC currently has about $920 million of existing debt.

Developments within the ERCOT market that increase energy prices could prompt a shift in strategy to finance additional generation capacity at STEC, which could increase projected capital plan and debt amounts. Within the ERCOT market, low natural gas prices and the addition of substantial wind generation and transmission capacity have contributed to low energy prices and the lack of new non-renewable capacity construction in the region. Low energy prices have provided an economic option for meeting load in the service area for utilities across ERCOT, not just STEC.