Fitch Downgrades Potomac Electric; Affirms PEPCO Holdings, Delmarva Power, & Atlantic Electric

Thu Jul 18, 2013 5:27pm EDT

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(The following statement was released by the rating agency) NEW YORK, July 18 (Fitch) Fitch Ratings has downgraded the Issuer Default Rating (IDR) of Potomac Electric Power Co. (Pepco) to 'BBB' from 'BBB+' and revised the Rating Outlook to Stable from Negative. Concurrently, Fitch affirmed the 'BBB' IDRs of Pepco Holdings, Inc. (PHI) and Atlantic City Electric Co, (ACE) and the 'BBB+' IDR of Delmarva Power and Light Co. (DPL). Fitch also downgraded the short-term IDR rating of PHI to 'F3' from 'F2' and affirmed the short-term ratings of Pepco, DPL and ACE at 'F2'. A full list of the rating actions appears at the end of this release. Key Rating Drivers Regulated Utility 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 98% of consolidated operating income over the next several years. PHI's non-regulated subsidiary, Pepco Energy Services (PES), which provides energy services to government and other institutional customers and takes no commodity risk, accounts for the remaining earnings. Predictable Cash Flows: The three operating utilities 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 2013-2017 that will require ongoing rate support. 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. 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. To combat the regulatory lag, management plans to file annual rate cases while also pursuing various adjustment mechanisms to accelerate capital and cost recovery. Cross Border Lease Portfolio: Earlier this year PHI made a $242 million deposit with the IRS that should resolve its tax dispute regarding its cross-border lease portfolio. The deposit is well below the total tax exposure, previously estimated to be approximately $750 million, due to the application of accumulated tax deductions unrelated to the lease portfolio, the carry back or forward of net operating losses, settled tax positions and deposits with the IRS. PHI is in the process of liquidating the lease portfolio which will provide a significant influx of cash. Year to date, PHI liquidated two lease transactions with total proceeds of $373 million. The remaining leases are expected to be terminated later this year. A portion of the lease liquidation proceeds will be allocated to the utilities, which accounted for the majority of the tax offsets. Rate Increases: During the second half of 2012 PHI's three utility's implemented five rate increases aggregating $104 million or roughly 43% of the $242 million requested. Additional rate increases of $53.4 million were implemented in 2013 (about 40% of requested amounts) and $129.1 million of rate requests are pending. Credit Metrics: Consolidated credit metrics are generally comparable to PHI's peer group of similarly rated parent holding companies, although leverage is moderately high, and should improve due to actual and pending rate increases and application of a portion of the lease liquidation proceeds to debt reduction. Going forward Fitch anticipates FFO to debt will range between 16% to 17% and Debt/EBITDA to be about 4.5x. FFO/interest and EBITDA/interest are forecasted to be in excess of 4.0x. Improving credit metrics reflect actual and pending rate requests and the reduction in short-term debt related to the settlement of a forward equity contract for $312 million earlier this year and the use of lease liquidation proceeds. Short-term Ratings: The lower short-term rating for PHI is consistent with Fitch criteria. Non-utility corporate issuers rated 'BBB' with negative free cash flow are assigned F3 ratings. Rating Sensitivities The regulatory treatment of utility capital investments is the primary driver of credit quality and ratings. An IRS finding of additional taxes, interest or penalties related to the cross border lease portfolio would offset some of the expected improvement in credit quality measures. PEPCO Key Rating Drivers Ratings Downgrade: The downgrade reflects leverage measures that are weak for the rating category, a challenging regulatory environment in Maryland and a large capital investment program and high level of O&M spending to address reliability issues. Rate Decision: A July 2013 rate decision was disappointing, albeit moderately better than the previous rate case decided in July 2012. The Maryland Public Service Commission (PSC) authorized Pepco a $27.9 million rate increase based on a 9.36% return on equity (ROE), which is among the lowest in the industry, and a 48.9% equity ratio. The rate increase equates to 46% of the company's $60.8 million rate request. Particularly troubling for fixed income investors is the PSC's continued reluctance to permit forward adjustments to address regulatory lag which will prevent Pepco from earning its allowed ROE. 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. Low Business Risk: Pepco's regulated electric transmission and distribution operations have minimal commodity, volumetric and environmental exposure. Moreover, the significant presence of state and federal government customers tends to reduce economic volatility in the region. Also, both Maryland and DC have permitted revenue decoupling, which eliminates fluctuations due to weather and changes in usage patterns. However, the positive impact of decoupling is mitigated by regulatory lag and authorized ROEs that are well below the industry average. Significant Capital Investment: Pepco is in the midst of a significant capital expenditure plan of approximately $3 billion over 2013-2017. 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 the District of Columbia to maintain credit quality. Credit Metrics: Going forward Fitch anticipates FFO to debt to range between 17% to 18% and debt/EBITDA about 4.25x. FFO/interest and EBITDA/interest are expected to be in the 4.5x - 5.0x range. Rating Sensitivities The outcome of a pending rate case in D.C. will be important to maintaining credit quality. The current ratings assume a constructive rate decision in D.C The extent of cost cutting measures to offset the recent unfavorable rate decision in Maryland will also be an important driver of credit quality. The amount of lease liquidation proceeds allocated to Pepco and used to reduce or eliminate future debt financings will also affect credit quality and ratings. Delmarva Power & Light Rating Drivers 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. About two-thirds of electricity sales are in Delaware, which has a relatively constructive regulatory environment. Rate cases are pending in both Maryland and Delaware with decisions in both states expected in 2013 Q4. Solid Credit Metrics: Credit metrics are largely in line with the rating category, although leverage is somewhat high. Going forward Fitch expects FFO/debt to range between 19% to 21% and debt/EBITDA to range between 3.5x and 4.0x. FFO/interest and EBITDA/interest are expected to approximate 4.5x and 5.0x, respectively. Significant capital investment: DPL is also in the midst of an aggressive capital investment plan that calls for approximately $1.6 billion to be spent over 2013-2017 and will require on-going rate support. Rating Sensitivities No rating actions are anticipated, but credit quality will be affected by: The outcome of three pending rate cases in Delaware (electric and gas) and Maryland aggregating $77 million; each of the rate cases will be decided before year-end. The amount of lease liquidation proceeds allocated to DPL and used to reduce or eliminate future debt financings will also affect credit quality. 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 supportive of the rating category. Going forward Fitch anticipates FFO/debt to range between 14% and 18% and Debt/EBITDA to approximate 4.0x. FFO/interest is expected to average over 4.0x and EBITDA/interest in excess of 4.5x. Manageable Capital Budget: ACE's ratings reflect a manageable capital expenditure plan and moderate external financing needs 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. Rate Increase: On June 21, 2013, the BPU approved a settlement agreement in ACE's pending rate case. The settlement authorized a $25.5 million rate increase premised on a 9.75% ROE or about 36% of the company's rate request. The settlement included full recovery of approximately $70 million of storm restoration costs related to the June 2012 Derecho and Hurricane Sandy in October 2012. This was ACE's second rate increase in approximately 8 months. In light of the disappointing rate order, ACE intends to reduce capital expenditures by a total of $150 million through 2015. Rating Sensitivities No rating changes are expected at this time however credit quality will be affected by: The amount of lease liquidation proceeds allocated to ACE and used to reduce or eliminate future debt financings will also affect credit quality measures. The continued support of capital investments and recovery of commodity costs are important rating factors. Fitch affirms the following ratings with a Stable Outlook: Pepco Holdings, Inc. --IDR at 'BBB'; --Senior Unsecured Notes at 'BBB'. 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'. Potomac Electric Power Company --Short-term IDR/Commercial paper at 'F2'. Fitch downgrades the following ratings: Potomac Electric Power Company --IDR to 'BBB' from 'BBB+'; --Secured Debt to 'A-' from 'A'; --Senior Unsecured Notes to 'BBB+' from 'A-'; Pepco Holdings, Inc. --Short-term IDR/Commercial paper to 'F3' from 'F2'. Contact: Primary Analyst Robert Hornick Senor Director +1-212-908-0523 Fitch Ratings, Inc. One State Street Plaza New York, NY 10004 Secondary Analyst Daniel Neama Associate Director +1-212-908-0561 Committee Chairperson Glen Grabelsky +1 212-908-0577 Media Relations: Elizabeth Fogerty, New York, Tel: +1 (212) 908 0526, Email: elizabeth.fogerty@fitchratings.com. Additional information is available at 'www.fitchratings.com'. Applicable Criteria and Related Research: --'Corporate Rating Methodology' (Aug. 8, 2012); --'Recovery Ratings and Notching Criteria for Utilities' (Nov. 13, 2012); --'Parent and Subsidiary rating Linkage' (Aug. 8, 2012); --'Rating North American Utilities, Power, Gas and Water Companies' (May 16, 2011); --'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit analysis' (Dec. 13, 2012); --'Short-term Ratings Criteria for Nonfinancial Corporates' (Aug. 9, 2012). Applicable Criteria and Related Research: Corporate Rating Methodology here Recovery Ratings and Notching Criteria for Utilities here Parent and Subsidiary Rating Linkage here Rating North American Utilities, Power, Gas, and Water Companies here Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis here Short-Term Ratings Criteria for Non-Financial Corporates here Additional Disclosure Solicitation Status here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

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