TEXT-Fitch revises Pepco Holdings outlook to negative
July 27 - Fitch Ratings has affirmed the 'BBB' Issuer Default Rating (IDR) of Pepco Holdings, Inc. (PHI), 'BBB+' IDRs of Potomac Electric Power Co. (Pepco) and Delmarva Power and Light Co. (DPL) and 'BBB' IDR of Atlantic City Electric Co, (ACE). The Rating Outlooks for PHI, DPL and ACE are Stable. Pepco's Rating Outlook is revised to Negative from Stable. A full list of the rating actions is provided at the end of this release. Rating Drivers Regulated Earnings Contribution: PHI's ratings are supported by the cash flows generated by its three regulated transmission and distribution utility subsidiaries, Pepco, DPL and ACE, which are expected to provide approximately 85% to 90% of consolidated earnings. PHI's non-regulated subsidiaries, Pepco Energy Services (PES), which primarily provides energy services to government and other institutional customers, and Potomac Capital Investment Corporation (PCI), which maintains a portfolio of cross-border energy lease investments, account for the remaining earnings. Predictable Cash Flows: The three operating utilities, Pepco, DPL and ACE have minimal commodity price exposure and only about one-third of utility revenue is subject to volumetric risk due to decoupling mechanisms in both Maryland and the District of Columbia. Significant Capital Investment: PHI's utilities are in the midst of a significant capital expenditure plan of approximately $5.7 billion over 2012-2016. 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 ratings assume a balanced mix of debt and equity will be used to fund the expenditures, including exercising an equity forward transaction of approximately $350 million by year-end 2012. 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 company from earning its allowed return on equity (ROE) and adversely affects credit quality measures. The lag is particularly troublesome during this period of high capex. Cross Border Lease Portfolio: Potential tax refunds related to the lease portfolio have no impact on the current ratings since the outcome is uncertain and no resolution is likely before 2015. The lease transactions have been under examination by the IRS since 2005. In the event the IRS is successful in disallowing all of the tax benefits, PHI's estimated exposure is $764 million plus penalties of up to 20% of taxes owed. Based on current market values management estimates liquidation of the entire portfolio would generate cash in excess of the taxes and interest due. Ample Liquidity: A $1.5 billion unsecured credit facility provides ample liquidity for PHI and its utility subsidiaries. The facility expires Aug. 1, 2016. A financial covenant that requires each borrower to maintain a 65% debt/capital ratio is in line with industry standards and not expected to impact the company's ability to borrow. The absence of a material adverse change in PHI's financial condition is not a condition for borrowing and the credit agreement does not contain any rating triggers. Debt maturities are well laddered, but will require capital market access. Credit Metrics: Consolidated credit metrics have improved in recent years and are generally comparable to PHI's peer group of similarly rated parent holding companies, although leverage is moderately high. Going forward, Fitch anticipates FFO to debt will range between 16% to 18% and FFO to interest to be in excess of 4.0x. What would lead to consideration of a negative rating action? --Lack of regulatory support for capital investments; --Unexpected rise in parent leverage. What would lead to consideration of a positive rating action? --Not likely during current capital investment program. PEPCO Negative Outlook: The Negative Rating Outlook reflects credit quality measures that are moderately weak for the rating category, and the regulatory risk associated with a large capital investment program and high level of O&M spending, in large part, to address reliability issues. Improvement in financial metrics will be restricted by the Maryland Public Service Commission's recent rate decision, which was less than anticipated by Fitch, and about 25% of the company's rate request. A significant portion of the disallowed revenue related to vegetation management expenses intended to limit storm related outages and to improve reliability, which heightens the regulatory risk for recovery of future capital investments. While Fitch expects management to offset a portion of the reduced revenue with cost reductions, the company will be hard pressed to reduce its planned capital investments in light of past reliability issues. Full and timely recovery of planned capital investments is critical to maintaining the current ratings. Low Business Risk: Pepco's regulated electric transmission and distribution operations have minimal commodity, volumetric and environmental exposure. Both Maryland and DC have permitted revenue decoupling, which eliminates fluctuations due to weather and changes in usage patterns. The positive impact of decoupling is partly mitigated by regulatory lag and authorized returns on equity that are generally below the industry average. Significant Capital Investment: Pepco is in the midst of a significant capital expenditure plan of approximately $2.6 billion over 2012-2016. A large portion of the expenditures are to address reliability issues that have been a point of contention with Maryland regulators. The capital plan will require annual rate increases in both Maryland and DC to maintain credit quality Credit Metrics: Going forward, Fitch anticipates FFO to debt to range between 17% to 19% and FFO to interest to be range between 3.8x and 4.0x. Delmarva Power & Light Low Business Risk: DPL's ratings and Stable Outlook are supported by the predictable cash flows generated from its regulated electric transmission and distribution and gas distribution operations. DPL bears no commodity price risks and has decoupling in Maryland. Credit Metrics: Going forward, Fitch FFO to debt to range between 15% to 18% and FFO to interest between 4.0x and 4.75x. Significant Capital Investment: DPL is also in the midst of an aggressive capital investment plan that calls for approximately $1.7 billion to be spent over 2012-2016. Fitch expects the credit metrics to weaken somewhat over the forecast period yet remain consistent with DPL's 'BBB+' IDR. Atlantic City Electric Company 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: Credit metrics are strong for the rating category. Going forward Fitch anticipates FFO to debt to range between 17% and 19% and FFO to interest between 4.0x and 4.75x. Manageable Capital Budget: ACE's ratings reflect a manageable capital expenditure plan, moderate external financing needs and absence of debt maturities over Fitch's forecast period. ACE has not been able to get approvals from BPU for decoupling and smart grid investments, unlike its sister utilities. 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 'F2'. Delmarva Power & Light --IDR at 'BBB+'; --Secured debt 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'. Fitch affirms the following ratings and revises the Outlook to Negative from Stable. Potomac Electric Power Company --IDR at 'BBB+'; --Secured debt at 'A'; --Senior unsecured notes at 'A-'; --Short-term IDR/commercial paper at 'F2'. Fitch withdraws the following ratings: Atlantic City Electric Company --Preferred stock at 'BBB-'.
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