Sept 12 -
Summary analysis -- Exelon Generation Co. LLC --------------------- 12-Sep-2012
CREDIT RATING: BBB/Stable/A-2 Country: United States
Primary SIC: Electric Services
Mult. CUSIP6: 30161M
Mult. CUSIP6: 3016E2
Mult. CUSIP6: 3016E3
Mult. CUSIP6: 3016E5
Credit Rating History:
Local currency Foreign currency
21-Oct-2008 BBB/A-2 BBB/A-2
03-Oct-2005 BBB+/A-2 BBB+/A-2
Standard & Poor's Ratings Services' corporate credit ratings on supply company, Exelon Generation Co. LLC reflects the consolidated business risk profile of parent Exelon Corp., which we view as "strong." In turn, Exelon's business risk profile reflects the higher-risk operations of unregulated supply affiliate Exelon Generation Co. LLC (ExGen), which has increased in size to subsume Constellation's unregulated business. Exelon's business risk also reflects the "excellent" business risk profiles of regulated delivery businesses, Commonwealth Edison (ComEd), PECO Energy Co. (PECO), and Baltimore Gas & Electric Co. (BGE), which have generally predictable transmission and distribution cash flows.
As of June 30, 2012, Exgen had about $7.2 billion of on-balance-sheet debt. However, parent Exelon had about $18.4 billion of on-balance-sheet debt. We also impute about $4.6 billion of off-balance-sheet debt on the books for computing financial ratios, pertaining mostly to unfunded pension and other postemployment benefit obligations and power-purchase agreements.
Through retail and wholesale channels, ExGen now provides about 170 terawatt-hours (TWhrs), or approximately 5%, of total U.S. power demand. We expect the switched markets in Pennsylvania, Ohio, Michigan, and Arizona to grow at about 10% in the commercial and industrial class and at about 15% in the residential class between 2011 and 2014. The fleet is well positioned to grow where capacity available for competitive supply has room to grow. We expect these incremental revenue streams to make the consolidated Exelon somewhat more resilient to commodity prices. The combination provides ExGen regional diversification of the generation fleet and a customer-facing load business, as generation and load positions are now better balanced across multiple regions. In most locations, ExGen will have adequate intermediate and peaking capacity within the portfolio for managing load shaping (matching resources with energy needs) risks. However, the company will still need to buy and sell length in the market to manage portfolio needs, in our opinion. Moreover, ExGen has a significant open position in the mid-west (exposed to merchant market), and a somewhat tight position in ERCOT and New England, where it has some risk of finding itself short when loads are high, in our opinion.
ExGen's, cash flow are sensitive to commodity prices as almost 95% of its premerger generation is nuclear, all of which sliding gas prices are impairing. ExGen's unregulated operations accounted for about 65% of the consolidated enterprise by cash flow and capital spending in 2011 (about 65% after ring-fencing BGE). Given that base-load generation is price-taking--it doesn't affect the market price--we expect ExGen's adjusted funds from operations (FFO) to debt to remain volatile--relative to its peers--and we expect it to swing in a band of over 40% in 2011 to about 27% by 2014. For instance, all else remaining equal, we estimate gross margins in 2014 will be lower by about $500 million for every $5 per MW-hour (round-the-clock) decline in power prices, about $215 million for every $0.5 per million cubic feet (Mcf) decline in gas prices, and about $110 million for every $1 per MWh decline in retail margins.
As a result, ExGen's contribution to the overall Exelon cash flow declines to about 55% under our base case, because of the decline in unregulated cash flow when commodity prices fall. However, despite the lower power prices, we view the business risk profile of parent Exelon as strong. We expect financial measures to decline through 2014. However, the corporate credit ratings reflect our expectation that 2014 will be the trough year. Based on the present forward curve, cash flow measures are still adequate for the rated level in that year. However, as a result of the decline in future gross margins, we view Exelon's cash flow adequacy ratio as more akin to the "significant" financial risk profile than the erstwhile "intermediate" one.
We view ExGen's ratable hedging strategy favorably, as it ensures that a high percentage of the company's near-term generation is locked in. Hedging not only protects unregulated generation cash flows from steep price declines, it also provides the company time to adjust its cost structure or its capital structure, should prices remain depressed. However, hedging activities insulate, but do not isolate, power merchants from commodity price effects. Current hedges show the significant value of Exelon's hedging program. Even though these hedges insulate ExGen, perversely, they also show the sensitivity of ExGen's margins to the prospect of a continued shale production onslaught. The decline in mark-to-market value through 2014 shows the limit to which Exelon can hedge--a price-taking fleet can hedge, but only at the prices the market will bear. Also, the merchant generation margins at ExGen will face a decline as high-priced hedges expire, evident in the drop in wholesale hedged gross margins. Still, the forwards do show a contango as reflected in the increase in ExGen's open EBITDA from higher natural gas forwards. Additionally, we believe retail contributions will increase, given the potential for cost savings, volumes gained from the constellation merger, and recent acquisitions (StarTex and MX Energy Holdings).
We assess ExGen's financial risk profile in conjunction with parent Exelon's. However, ExGen's financial measures are important because of its meaningful contribution to Exelon's financials. Because of the decline in commodity prices, we expect ExGen's FFO to debt to tumble to about 26% in 2014 from above 40% in 2011. Although ExGen's cash flows are relatively more volatile compared to peers because of the larger base-load generation, the low variable cost (and highly depreciated nature) of its nuclear fleet means that natural gas prices must decline and stay below $3 per mcf before its FFO to debt falls below 20%.
We view parent Exelon's financial policy and internal funding as "aggressive." The current level of dividends, at about $1.8 billion, results in a dividend payout of about 80%, according to our estimates--meaningfully higher than the 50% to 65% range for peers. Moreover, Exelon's capital spending requirements are significant between 2012 and 2014, at about $18.5 billion. Although utility capital spending tends to be funded in rate base, unregulated generation will have to fund its own capital requirements and recover them in market prices. However, cash flow from operations will be insufficient for capital spending and dividends, resulting in external needs of financing. We estimate that the funding gap would be greatest in 2014 because of a trough in earnings even though ExGen's requirement to contribute toward Exelon's dividend commitments are the highest internal financing needs of the utilities. We estimate Exelon's incremental long-term financing needs at an average of about $1.4 billion to $1.5 billion in 2014 and 2015. The company expects merger-related O&M cost savings, but higher-than-anticipated costs would widen the funding requirements. Still, incrementally lower gas prices would hurt ExGen's debt protection measures more than the level of new debt financing, or O&M cost increases in ExGen's forecast through 2015.
Under our consolidated base case (we assume lower gas prices and market heat rates that result in power prices roughly 10% lower than the current forward contracts), we expect FFO to total debt of the pro forma company (i.e., Exelon and Constellation combined) to decline to about 25% in 2012 and then to hover at 22% to 23% through 2015. We expect free operating cash flow to debt to remain marginally positive even in 2013 and 2014 when we expect financial measures to trough. However, we expect discretionary cash flow (after dividends) to turn significantly negative--in a range between $1.1 and $1.7 billion through the period--mostly because of high capital spending. Similarly, we expect total debt to total capital to be about 57% and debt to EBITDA to hover at about 4.0x. These ratios are still consistent with Standard & Poor's 'BBB' rating guideposts for a financial risk profile we assess as "significant," especially since a meaningful amount of capital expenditure is discretionary. The company's recent decision to defer the LaSalle extended power uprate (EPU) by two years demonstrates flexibility to adjust the program as needed based on market conditions. We estimate that deferring the project by two years will free-up about $400 million through 2014.
The short-term rating on Exelon and affiliates is 'A-2'. Standard & Poor's views the liquidity across the Exelon group of companies as "strong," in light of the debt maturities we expect and available credit facilities. We estimate that sources of cash will exceed the companies' uses by about 2x during the next 12 to 24 months. We expect sources over uses for Exelon and ExGen to remain positive even if EBITDA declines by 50%. In addition, because of Exelon's solid relationships with banks and high conversion of FFO to discretionary cash flow, we believe the company can absorb low-probability, high-impact shocks.
Exelon has sufficient alternative sources of liquidity to cover current liquidity needs, including ongoing capital requirements, moderate capital spending, and upcoming debt maturities. Ironically, a declining power price environment is favorable from a liquidity perspective as cash is being posted to ExGen on its forward hedges. The next large maturities are in 2015 for Exelon and 2014 for ExGen.
As of July 27, 2012, Exelon, ExGen, ComEd, PECO, and BGE had credit facilities of $2.84 billion, $5.6 billion, $1.0 billion, $0.6 billion, and $0.6 billion, respectively. These facilities expire between September 2013 and March 2017. Availability under these facilities was $2,319 million and $3,807 million respectively for Exelon and ExGen, respectively, and $999million, $599 million, and $564 million for ComEd, PECO, and BGE, respectively. Excluding commercial paper outstanding, the aggregate availability was $7.86 billion.
The outlook on the ratings is stable. That said, we believe that higher natural gas production from shale plays and a delay in environment rules related to plant retirements can significantly hurt the company's financial performance. We believe these headwinds have increased and Exelon faces a potential earnings decline in 2014. Should the prevailing commodity environment persist, the company may have to address its declining earnings profile by reducing capital spending. We expect Exelon and ExGen to maintain consolidated FFO to debt in the 22% to 23% and 25% to 27% ranges, respectively, in 2014 to maintain current ratings. We will specifically monitor the expected negative discretionary cash position that results from Exelon's large dividend commitment. A positive outlook--currently not under consideration--can result if natural gas prices stabilize and power prices respond favorably to coal-plant retirements, resulting in an improvement in consolidated FFO to debt levels of over 27%.
Related Criteria And Research
-- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Business Risk/Financial Risk Matrix Expanded, May 27, 2009
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008