Fitch Revises FirstEnergy's Outlook to Positive; 'BB+' IDR Affirmed
KEY RATING DRIVERS
--Recent and future rate case outcomes, especially FE's pending Ohio rate case;
--Strategic efforts to reduce risk at FE's competitive business and focus future investment on transmission and distribution;
--High parent-only and consolidated debt;
--The extended downturn in U.S. power prices and its adverse effect on operating profits;
--High capex directed primarily toward utility and transmission operations;
--Relatively stable electric utility operations and cash flows.
Modified Stipulation Filed
The rating affirmation and Positive Outlook follow FE's announcement that the company's Ohio operating utilities filed a modified stipulation with the Public Utilities Commission of Ohio (PUCO) on Dec. 1, 2015. Importantly, the modified stipulation includes the commission staff among its 16 signatories. Staff had opposed the previous stipulation as filed with the commission.
Economic Stability Plan
The modified, proposed stipulation in FE's Ohio utilities' ESP IV rate proceeding includes an 8-year PPA. Under the PPA, FirstEnergy Solutions (FES) will enter into a PPA with Ohio Edison Co., The Cleveland Electric Illuminating Co., and The Toledo Edison Co. from June 1, 2016 through May 31, 2024. The revised stipulation also extends the Ohio utilities' distribution rate freeze through May 31, 2024.
PUCO Outcome Uncertain
Fitch believes that the support of the PUCO staff significantly improves the stipulation's prospects for approval. Nonetheless, the stipulation is highly controversial and PUCO approval is not assured. Judicial review of the stipulation is a virtual certainty. A final PUCO decision is expected in the first quarter 2016. The PUCO may adopt the stipulation as proposed, adopt the stipulation with modification or reject the proposed stipulation.
The stipulated agreement, if approved by the commission, would be a significant positive event for FE's credit profile on both a quantitative and qualitative basis. If approved by the PUCO as proposed, Fitch estimates FE's EBITDA leverage would improve by nearly a turn in 2016 versus Fitch's previous expectations.
High Debt Levels
FE's consolidated debt is high with total debt approximating $23 billion on a consolidated basis, including parent-only long-term debt of $4.2 billion as of Sept. 30, 2015. However, consolidated FE debt-to-EBITDA is estimated by Fitch at 4.6x - 4.7x during 2016 - 2018 and FFO adjusted debt 4.8x - 5.1x, levels that are consistent with a low investment-grade credit rating given the company's improved business-risk profile.
De-Risking Competitive Operations
Operational changes implemented in 2015 by incoming CEO Chuck Jones to de-risk FE's competitive business and emphasize growth in regulated operations are meaningful positive developments from a credit point-of-view. The competitive generation business is now managed more conservatively, maintaining a long generation position for contingencies and exiting more weather-sensitive and volatile sales channels. Fitch believes this strategic change in how FE is managing its competitive risk and the potential, incremental risk mitigation associated with the modified stipulation (due to the 8-year PPA) meaningfully improve FE's business-risk profile.
The proposed stipulation if approved by PUCO would provide a more predictable stream of revenues for 3,244 mW of generating capacity through June 1, 2024. In that scenario, approximately 42% of FE's generation would be price regulated or under long-term contract.
Utility Impact
The proposed stipulation includes an economic stability program that includes the 8-year PPA and a retail rate stability rider (RRS). Under the terms of the stipulation, FE's Ohio operating utilities would pay FES a cost-based rate for power, including a 10.38% PPA return on equity. The utilities would sell the power acquired from FES via the PPA in wholesale markets. When wholesale market revenues exceed cost, customers receive a credit to their monthly bill. Conversely, when wholesale market revenues are less than cost, customers pay a charge. If approved as proposed, the PPA is estimated by FE to save Ohio ratepayers $560 million over its 8-year term.
The proposed stipulation extends the utilities' distribution rate freeze through May 31, 2024, contains guaranteed credits to customers of $10 million beginning in year five, increasing to $40 million in year eight. The stipulation also extends increases to the distribution capital rider (DCR) cap through May 31, 2024. Under the terms of the stipulation, FE will pursue carbon reduction through investment in grid enhancement, including smart meters and battery technologies, fuel diversity and other means. The stipulation calls for timely cost recovery of future investment through specific riders. This alignment of utility strategy with Ohio energy policy is, in our opinion, credit supportive for FE's Ohio utilities.
Focus on Regulated Assets
FE's focus on improving its regulated utility and transmission returns while investing significant capital in these assets and de-risking its competitive business is credit supportive in Fitch's view. FE is in the midst of a $4.2 billion transmission buildout 2014 - 2017 with the majority of projects targeting FE's American Transmission System, Inc. (ATSI). Recent rate case decisions with the exception of the March 2015 $34 million rate decrease for Jersey Central Power and Light have been generally supportive from a credit point of view. Earlier this year, regulators in West Virginia and Pennsylvania approved settlement agreements authorizing rate increases and the Federal Energy Regulatory Commission (FERC) approved ATSI's settlement of its transmission rate filing in October 2015. The FERC order authorizes use of a forward test year in formula rates and a 10.38% return on equity.
Low Power Prices
FE's ratings and Stable Outlook reflect the prolonged downturn in power prices driven by a surfeit of natural gas supply, strong reserve margins, and sluggish residential demand. Low, albeit gradually improving, power prices are expected by Fitch to continue to constrain margins and cash flows at FE's merchant operations.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for FE include:
--PUCO approval of FE's ESP IV stipulation as filed.
--Incorporate jurisdictional rate changes authorized by FERC and state regulatory commissions in Pennsylvania, West Virginia and New Jersey and assume balanced future rate case outcomes.
--PJM capacity auction results included in estimates.
--Continued equity issuance of approximately $100 million per annum.
--Effective tax rate of 36% - 38%.
RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to a positive rating action include:
--Approval of FE's ESP IV as proposed or with minor modification;
--Improvement in debt-to-EBITDA to 4.5x and FFO adjusted leverage of 5.5x or better;
--Continued management commitment to de-risking and deleveraging FE's business model.
Future developments that may, individually or collectively, lead to a negative rating action include:
--Lower than expected margins and volumes and continued high leverage at FE and its competitive business;
--An unsupportive final decision in FE's pending ESP IV filing in Ohio;
--Weakening of FE's FFO adjusted leverage to 6.5x or worse on a sustained basis.
LIQUIDITY
Fitch believes FE's consolidated liquidity position is solid. As of Sept. 30, 2015, FE had approximately $4 billion of liquidity available under its consolidated $6 billion of revolving credit facilities and $59 million of cash.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following:
FirstEnergy Corp.
--IDR at 'BB+';
--Senior unsecured debt at 'BB+/RR4';
--Short-term IDR at 'B.
The Rating Outlook is revised to Positive from Stable.
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