-- Increased competition because of lower wholesale electricity prices will continue to materially reduce DPL's profit margins.
-- We expect the unregulated retail business to grow because of the eventual transition to generation market rates.
-- The company's financial position is stressed due to the substantial amount of acquisition debt layered on by parent company AES.
-- We are lowering our ratings on DPL Inc. and its wholly owned subsidiary, Dayton Power & Light (DP&L), including the corporate credit rating on both entities, to 'BB' from 'BBB-' and removed them from CreditWatch with negative implications. We are also lowering our issue ratings on DPL's senior unsecured debt to 'BB-' from 'BB+' and on DP&L's senior secured debt to 'BBB-' from 'BBB+'.
-- The outlook is stable, reflecting our baseline forecast for consolidated adjusted FFO to debt of about 8% to 10% for the next three years. Rating Action On Nov. 8, 2012, Standard & Poor's Ratings Services lowered its corporate credit ratings on DPL Inc. and subsidiary Dayton Power & Light Co. (DP&L) two notches, to 'BB' from 'BBB-', and removed them from CreditWatch negative. The outlook is stable.
At the same time, we lowered our issue ratings on DPL's senior unsecured debt to 'BB-' from 'BB+'. We assigned a recovery rating of '5', indicating our expectation that lenders would receive modest (10% to 30%) recovery of principal in a default. We also lowered our issue rating on DP&L's senior secured debt two notches, to 'BBB-' from 'BBB+'. We revised the recovery rating on the senior secured debt to '1', reflecting high (90% to 100%) recovery, from '1+'. All debt issue ratings have also been removed from CreditWatch negative. Rationale Standard & Poor's ratings on DPL Inc. reflect the company's consolidated credit profile, which includes its association with the weaker credit quality of its parent, The AES Corp. (BB-/Stable/--). DPL is the holding company for regulated electric utility DP&L. The ratings also reflect DPL's "strong" business risk profile and its "aggressive" financial risk profile, as defined in our criteria. (We rank business risk from "excellent" to "vulnerable" and financial risk from "minimal" to "highly leveraged.") We view DPL and DP&L's business risk profiles as "strong" based on the increased competition among Midwest energy retail providers and the expected growth of the unregulated retail business. In addition, we expect competition to increase because of lower wholesale electricity prices, which will materially reduce DPL's profit margins.
The company's financial position has very little cushion due to the increased amount of acquisition debt from parent company AES. DPL recently announced that it will be taking an impairment charge of $1.85 billion on the goodwill associated with the AES purchase. Although we do not expect this impairment to affect cash flows, it will substantially weaken net income and earnings in 2012 as well as the total-debt-to-capital ratio. DPL's credit quality is heavily influenced by the substantial additional acquisition-related debt and its adverse impact on the company's key financial measures. Consequently, our baseline forecast calls for total debt to EBITDA of about 6.5x to 7.0x and adjusted FFO to total debt to be about 8% to 10%. Our ratings on DPL and DP&L are higher than our rating on parent AES, as structural protections (a separateness agreement, an independent director, and debt limitations and covenants) provide some insulation to the subsidiaries. Our assessment of both entities' strong business risk profiles is based on DP&L's eventual transition to generation market rates.
We expect increasing competition from lower wholesale electricity prices to materially reduce DPL's profit margins in the next 12 to 24 months. Our assessment also takes into account the expected growth of the unregulated retail subsidiary, a lack of fuel diversity, and a weak economy in Dayton. Those factors are partly offset, in our view, by the lower-risk regulated transmission and distribution portion of the business, generally low-cost generating facilities, and the completion of an extensive environmental compliance program. With heightened competition in Ohio, unrated affiliate DPL Energy Resources now provides electricity to about 77% of DP&L's estimated 57% switched load at market rates. DP&L recently filed a new electric security plan (ESP) for Jan. 1, 2013, through May 31, 2016. The company's current ESP expires on Dec. 31, 2012. The new plan would reflect a proportionate blend of the rate resulting from a competitive bidding process and DP&L's current ESP generation prices.
DP&L is proposing to blend in auction results with current standard-service offer rates, starting with a 10% mix of auction results and culminating in a 100% move to market rates in June 2016. DP&L has also requested approval for a non-bypassable service stability rider (SSR) and a customer-switching tracker. We view the SSR and the tracker as good for credit quality as they would provide additional cash flow that would otherwise be lost in the company's transition to full market rates. As a reference point, AEP Ohio's recent ESP filing with the Public Utilities Commission of Ohio includes a non-bypassable rider. AEP also filed to create a separate generation company for its Ohio generation assets. We assess DPL's financial risk profile as aggressive, reflecting our base-case scenario of adjusted funds from operations (FFO) to total debt of about 8% to 10% and adjusted total debt to EBITDA of about 6.5x for the next 12 months. For the 12 months ended June 30, 2012, adjusted FFO to debt was 11%, compared with 12% at year-end 2011; adjusted debt to EBITDA was 5.8x, slightly weaker than 5.2x at year-end 2011. Liquidity Liquidity is "adequate" under Standard & Poor's corporate liquidity methodology, which categorizes liquidity in five standard descriptors.
"Adequate" liquidity supports our 'BB' issuer credit rating on DPL and its subsidiary DP&L.
Our assessment is based on the following factors and assumptions:
-- We expect liquidity sources (including FFO and credit facility availability) to exceed uses by more than 1.2x over the next 12 months;
-- Debt maturities over the next year are manageable;
-- Even if EBITDA declines by 15%, we believe net sources will be well in excess of liquidity requirements; and
-- The company has good relationships with its banks and has a good standing in the credit markets. DPL's projected sources of liquidity are mostly operating cash flow and available bank lines. Its projected uses are mainly for necessary capital expenditures and debt maturities. The company's ability to absorb high-impact, low-probability events with limited need for refinancing, its flexibility to reduce capital spending or sell assets, its sound bank relationships, its solid standing in credit markets, and its generally prudent risk management further support our assessment of its liquidity as adequate. DP&L's next maturity, in October 2013, is significant, at $470 million. Given the magnitude of the maturity, we expect the company to address it well in advance of the due date. DP&L maintains a $200 million revolving credit facility that matures on April 20, 2013. The company also has another $200 million revolving credit facility that expires in August 2015. Subject to certain conditions and approvals, DP&L has the option to increase both facilities by up to an additional $50 million each. DPL recently reduced the limit on its $125 million credit facility to $75 million and negotiated changes to the covenant requirements with the bank group.
The first financial covenant, originally a total-debt-to-capitalization ratio, was changed, effective Sept. 30, 2012, to a total-debt-to-EBITDA ratio.
The ratio is not to exceed 7.0x to 10.0x as of Sept. 30, 2012, and the ratio steps up to 8.25x to 10.0x by Sept. 30, 2013. The company is currently in compliance with this covenant. In addition, EBITDA to interest must be at least 2.5x under the covenant. The company is currently in compliance with this covenant as well. Both DP&L bank agreements have one financial covenant requiring that DP&L's total debt to capital not exceed 65%; the company is comfortably in compliance, as its actual ratio is about 43%. In our analysis, we assumed liquidity of about $680 million over the next 12 months, consisting of projected FFO, excess cash, and availability under the credit facilities. We estimate liquidity uses of roughly $560 million during the same period for capital spending, dividends, and debt maturities. Recovery analysis We assign recovery ratings on all debt issued by non-investment-grade rated corporate entities, and these ratings determine potential notching of issue ratings relative to our corporate credit rating on that company.
Our recovery analysis is based on a simulated default by the company with its existing capital structure.
Highlights of our recovery analysis are as follows:
-- Our recovery analysis for DPL and DP&L was based on a simulated default in 2016, at which point all of its power assets will have transitioned to competitive-merchant status.
-- Following a simulated default, we valued the regulated assets (the transmission and distribution equipment and non-bypassable charge) at their approximate net book value of $955 million as a proxy for the allowed regulated return on these critical assets, and we valued the power assets at about $905 million using a dollar-per-kilowatt (kw) approach that considers the nature of the individual assets and the conditions assumed in our simulated default scenario.
-- We assumed a higher dollar-per-kilowatt multiple for the Zimmer ($450/kw), Killen ($425/kw), and Miami ($425/kw) coal plants because environmental updates will have been completed prior to our simulated default date and because these facilities are newer and run with greater efficiency than the other coal assets.
Conversely, we used lower multiples for the Stuart ($375/kw), East Bend ($350/kw), and Conesville ($350/kw) coal plants because these facilities are somewhat older or less efficient and because these facilities could require additional environmental upgrades to meet federal and state laws. We have assigned no value to the Beckjord and Hutchings coal plants, which should be decommissioned, or to the low-margin retail marketing business.
These assumptions produced a gross enterprise value of $1.86 billion. Based on the company's relatively simple capital structure, we have estimated administrative bankruptcy expenses at 3%, producing a net enterprise value of about $1.8 billion.
-- DP&L's secured debt is expected to total $923 million at default (including an estimate of six months' accrued interest) and would have the highest priority claim to this value. This suggests the potential for full recovery and total coverage of 195%, but the transfer of regulated assets to a merchant arm would leave only about 100% of the remaining regulated-asset value.
Under our first-mortgage-bond criteria, this produces a '1' recovery rating, reflecting our expectation of 90% to 100%, thus the secured issue rating of 'BBB-', which is two notches higher than the corporate credit rating, although certain debt backed by bond insurance from Berkshire Hathaway is rated higher based on the insurer's credit rating. After accounting for other estimated claims at DP&L (two revolving facilities, which we assume would be fully drawn at default, and structurally senior preferred stock) of about $424 million, roughly $447.5 million in remaining value would be available to DPL creditors.
This suggests total coverage of about 24% for DPL's unsecured debt of roughly $1.8 billion. As such, this debt has a '5' recovery rating, reflecting modest (10% to 30%) recovery prospects, and an issue rating of 'BB-'. Outlook The stable rating outlook on DPL reflects Standard & Poor's baseline forecast that consolidated adjusted FFO to debt will be about 8% to 10% over the next 12 to 18 months. Significant risks to the forecast include increasing competition from lower electricity prices that could materially lower DPL's profit margins and a weaker economy than we currently expect.
We could lower the ratings if FFO to debt is consistently lower than 8% or the business risk profile weakens as a result of the disproportionate growth of the competitive energy business.
Conversely, we could raise the ratings if FFO to debt consistently strengthens to greater than 15% on a sustained basis, which we would expect to result mostly from higher electricity prices and an improved economy.
Related Criteria And Research
-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Analytical Methodology, April 15, 2008
Downgraded; Off CreditWatch
Dayton Power & Light Co.
Corporate credit rating BB/Stable/-- BBB-/Watch Neg/--
Senior unsecured BB- BB+/Watch Neg
Recovery rating 5
Dayton Power & Light Co.
Senior secured BBB- BBB+/Watch Neg
Recovery rating 1 1+
DPL Capital Trust II
Preferred stock B+ BB/Watch Neg