OREANDA-NEWS. Fitch Ratings has affirmed the 'BBB' rating on the following Paducah Power System (PPS) revenue bonds:

--$148 million revenue bonds series 2009A;
--$515,000 refunding revenue bonds series 2010.

The Rating Outlook has been revised to Stable from Negative.

SECURITY

The bonds are secured by a first lien on PPS's net revenues derived from electric system operations.

KEY RATING DRIVERS

OUTLOOK TO STABLE: Revision of the Rating Outlook to Stable from Negative primarily reflects PPS's successful implementation of a rate recovery plan, as well as the stronger operating performance of Prairie State Energy Campus (PSEC) Units 1 and 2, both of which contributed to improved financial results. Although Fitch expects recent action to stabilize financial performance over the near-term, higher fixed charges beginning in fiscal 2019 present longer-term challenges.

CONSTRAINED FINANCIAL POSITION: PPS's transition to owner and operator of generating resources from distributor of purchased power led to several years of inadequate rate relief and diminished credit quality, ultimately prompting multiple rating downgrades. Cash flow and liquidity metrics strengthened to more acceptable levels in fiscal 2015 with Fitch calculated debt service coverage of 1.45x and 48 days of cash on hand, respectively. However, much of the improvement was attributable to the execution of the rate recovery plan, which Fitch believes provides only near-term relief.

LIMITED FLEXIBILITY: PPS's long resource position and limited opportunity to utilize off-system sales given currently depressed wholesale market prices necessitates high electric rates (12.8 cents/kWh) that exceed regional and statewide averages and limit overall financial flexibility. Turnover in management and a rate freeze imposed throughout much of fiscal 2015 evidence a somewhat charged political environment that could impede future rate action.
BELOW-AVERAGE ECONOMIC INDICATORS: PPS serves a sufficiently diverse service territory exhibiting below-average wealth indicators. Unemployment has trended downward over the prior year, but remains somewhat elevated relative to state and national figures. Nevertheless, revenue collection has remained strong.

HIGH LEVERAGE: PPS's development and acquisition of generation resources, including 120 MWs of natural-gas fired peaking capacity and interests in PSEC and two hydroelectric projects, has increased the utility's debt per customer ratio to a high $29,000, including off-balance sheet obligations.

RATING SENSITIVITIES

EXPIRATION OF RATE RECOVERY PLAN: Scheduled increases in Paducah Power System's purchased power and debt service obligations beyond fiscal 2019 will challenge PPS's already limited financial flexibility. The inability of PPS to generate off-system sales and/or raise rates to support financial performance would put downward pressure on the rating. Conversely, improved operating performance, coupled with appropriate rate setting policies could result in consideration of an upgrade.

CREDIT PROFILE

RECOVERY PLAN EXECUTED

PPS's financial results stabilized in fiscal 2015 following the implementation of a rate recovery plan midway through the fiscal year. Under the plan, purchased power expenses owed to the Kentucky Municipal Power Agency (KMPA) were reduced by replacing KMPA's debt service reserve funds (DSRFs) with sureties and applying the cash to the agency's 2015 - 2019 scheduled principal payments. Similarly, PPS lowered its bond principal payments for the same period by replacing its DSRF with a surety. Both stop-gap measures allowed PPS to eliminate an accumulated deficit related to the under recovery of purchased power costs and restore its cash position to a healthier level.

The improved operating performance at PSEC as the fiscal year progressed also had a positive impact on PPS's financial results. Absent these developments, the under recovery of power costs - based on PPS's mid-year projections - would have reached $4.7 million by fiscal year-end.

Fitch expects year-end results for fiscal 2016 to approximate PPS's latest financial forecast provided in December 2014. Projections at that time reflected debt service coverage of 1.3x before adjusting for the application of funds derived from the DSRFs. Projections through fiscal 2018 also assume DSC of 1.3x and a continued strengthening of liquidity to closer to $13.5 million.

LONG RESOURCE PORTFOLIO

Power supply needs are met through various long-term purchase power agreements and owned generation. PPS created KMPA with Princeton, KY to secure a 7.82% undivided interest (124MW) in the PSEC. The utility is the larger of the two members with an 83.9% (104MW) share, pursuant to a take-or-pay contract.
Operating performance at PSEC was relatively weak upon entering commercial operation in 2013. During the initial ramp-up period, the plant experienced a series of unscheduled outages and capacity reductions due to operational issues and equipment adjustments. Plant availability suffered as a result, with PSEC achieving a capacity factor that ranged from 60% - 65% in fiscals 2013 and 2014.

Performance has gradually strengthened with combined availability for Units 1 and 2 reportedly at 90% for the five months June-October 2015 and expected to approach 81% for the full years 2015 and 2016. The improvements reflect greater management oversight at the plant level and overall enhancements made to equipment and operations.

PPS's overall power supply remains long by approximately 50-60%, including all sources of capacity online through 2016 and a reserve margin. As part of its broader rate recovery plan, PPS now employs American Municipal Power, Inc. as its resource portfolio manager. While Fitch expects opportunities for off-system sales to remain limited at least over the medium-term given depressed wholesale market prices, PPS was able to recently secure a two-year bilateral contract for the sale of a small portion of its excess capacity from PSEC.

HIGH RATES LIMIT FLEXIBILITY

Multiple base rate increases beginning in November 2012 meant to align with PPS's cost of service did not sufficiently recover costs and support financial metrics at previously projected levels, prompting management to implement a quarterly power cost adjustment (PCA) in November 2013. The PCA was increased significantly throughout fiscal 2014 to keep pace with escalating purchased power costs related to PSEC. As a result, PPS's total rate reached 13.3 cents/kWh by the early part of fiscal 2015, causing significant rate pressure from PPS's customer base.

Management ultimately implemented a rate freeze until the start of fiscal 2016, at which point the PCA was reduced to reflect lower purchased costs and the near elimination of a PCA deficit. Fitch notes that in conjunction with the recent PCA reduction, PPS's board approved a motion to limit the PCA to annual adjustment instead of quarterly. Fitch views the change with some concern given the system's volatile and often weak liquidity position.