Fitch Lowers IDRs of EFH and Related Entities to 'RD'; Simultaneously Upgrades IDRs on Debt Exchange

NEW YORK--()--Fitch Ratings has deemed the recently concluded exchange offer to exchange a portion of the LBO notes and legacy notes at Energy Future Holdings Corp (EFH) for new 11.25%/12.25% senior toggle notes due 2018 at Energy Future Intermediate Holding Company LLC (EFIH) as a distressed debt exchange (DDE). As a result, Fitch has lowered the Issuer Default Rating (IDR) of EFH to 'Restricted Default' (RD) from 'CC'. Fitch has also lowered the IDRs of EFIH, Energy Future Competitive Holdings Company (EFCH) and Texas Competitive Electric Holdings Company LLC (TCEH) to 'RD' from 'CC'. The rating for EFH's LBO notes, a portion of which are subject to DDE, has been downgraded to 'CC/RR3' from 'CCC-/RR3'. The rating for EFH's legacy notes, which are also subject to DDE, is unchanged at 'C/RR6'.

On Dec. 5, 2012, EFIH announced that it will be issuing $1.145 billion of new 11.25%/12.25% senior toggle notes due 2018 in exchange for $1.6 billion of EFH's debt as follows:

--$234 million of 5.55% series P senior notes due 2014;

--$510 million of 6.50% series Q senior notes due 2024;

--$453 million of 6.55% series R senior notes due 2034;

--$94 million of 10.875% senior notes due 2017;

--$313 million of 11.25%/12.00% senior toggle notes due 2017.

Fitch has deemed the debt exchange as DDE given the material reduction (an average of 71%) in the principal amount for the exchanges notes and change from a cash pay basis to pay-in-kind (PIK). The new notes carry a three-year PIK feature.. The material reduction in terms for the exchanged notes is only partially offset by increase in interest rates on the new notes and a higher seniority in the capital structure for the legacy notes.

Since the exchange offer has been completed under a privately negotiated transaction with investors, Fitch has simultaneously taken various rating actions based on the post-exchange capital structure and the fundamental outlook for each of the entities. Fitch has upgraded the IDRs of EFH and EFIH to 'CCC' from 'RD'. Fitch has also upgraded the IDRs of TCEH and EFCH to 'C' from 'RD'. Fitch has upgraded the ratings of EFH's LBO notes to 'CCC+/RR3' and EFH's legacy notes to 'CC/RR6'. Fitch has also assigned a 'CCC+/RR3' rating to the new notes issued by EFIH pursuant to the exchange offer, which rank pari passu to EFH's LBO notes. The ratings for Oncor Electric Delivery Company LLC (Oncor) are unaffected by today's rating actions.

Fitch has delinked the ratings of TCEH and EFH/EFIH based on the expectation that EFH will either make EFCH an unrestricted subsidiary or remove the cross-default language from the LBO notes' indenture in the near future, thereby, insulating EFH/EFIH's credit profile from any potential restructuring at TCEH. The repayment of the inter-company loans (ICL) to TCEH year-to-date, including the commitment to repay $680 million of remaining ICLs in January 2013, reduces the financial ties between the two entities significantly. Fitch considers it highly unlikely that EFH will provide any significant financial support to TCEH going forward. The just concluded exchange offer is further viewed by Fitch as a step to affect liability management at EFH/EFIH as a stand-alone entity. As a result, Fitch believes that the degree of linkage between EFH and TCEH is significantly weaker than before and the IDRs are, therefore, being based on the respective stand-alone credit profiles of the two entities.

The 'CCC' IDRs for EFH and EFIH reflect the highly leveraged capital structure, sufficient but declining liquidity, and currently constrained, but growing distributions and tax payments from Oncor. Fitch expects dividend distributions and corporate tax payments as the only principal source of cash flows for EFH/EFIH going forward. Fitch expects EFH/EFIH's FFO to consolidated debt to be in a 6%-7% range and FFO to interest ratio to be 1.7x-1.8x over 2013-2018, which is indicative of a 'CCC' IDR. Fitch's financial forecasts assume no tax implications for EFH due to any potential restructuring activities at TCEH.

The just concluded exchange offer is marginally positive for EFH/EFIH's credit profile given the $450 million debt reduction and $360 million interest expense savings over three years (due to the PIK feature) that benefits near-term liquidity. Combined liquidity at EFH/EFIH has been bolstered by $2.25 billion of first and second lien debt issuances year-to-date, of which a significant portion has been utilized or committed to repay the ICLs to TCEH that stood at $1.6 billion at the end of 2011. The repayment of the demand note does not alter the overall leverage at EFIH, since the inter-company notes were guaranteed by EFIH on a senior unsecured basis, but the interest cost to EFIH did increase materially as a result of the issuances.

Combined liquidity at EFH/EFIH stood at $1.48 billion as of Sept. 30, 2012, which does not reflect the $253 million first lien issuance in October and includes the $680 million held in escrow to repay the remaining ICLs to TCEH. Looking forward, Fitch expects combined liquidity to be affected by reduced upstream dividend and cash tax payments from Oncor during 2012-2013 and higher interest expense associated with the new debt issued by EFIH year-to-date, partially offset by interest cost savings from the recently concluded exchange offer. Fitch expects liquidity to be adequate until 2016 given EFIH has capacity to issue an incremental $250 million in second lien debt based on current debt incurrence restrictions. Further liability management, refinancing of the current high cost debt, and/ or equity infusion will be needed to right size the capital structure and support liquidity at EFH/EFIH, in Fitch's view.

The 'C' IDR for TCEH reflects Fitch's view that the current highly leveraged capital structure is not sustainable. Despite the upward movement in the shorter-term natural gas prices and declining reserve margins in Texas, Fitch believes it highly unlikely that power prices will recover to levels required for TCEH to reach cash breakeven. TCEH's generation output continues to suffer from partial economic back-down as natural gas power plants displace coal units during certain off-peak periods. While TXU Energy has been able to somewhat stem customer defections and sustain attractive margins year-to-date due to falling wholesale prices, intensified competition and significant headroom between TXU Energy's and competitive offers are likely to put pressure on both margins and customer retention.

Liquidity at TCEH stood at $2.3 billion as of Sept. 30, 2012, which consists of $309 million of cash and cash equivalents, $1.77 billion availability under its revolving facility and $265 million availability under its letter of credit facility. The cash balances as of Sept. 30, 2012 do not include the $680 million held in escrow to settle demand notes payable by EFH but include $750 million in cash collateral received from counterparties for commodity hedging and trading transactions. Fitch forecasts the free cash flow deficit in 2013 to significantly deplete TCEH's current available liquidity and with the expiration of $645 million unextended portion of the revolving credit facility in October 2013, liquidity runs out in late 2013/early 2014 timeframe.

TCEH's near-term debt maturities are significant including the $3,851 million unextended portion of term loans and deposit letter of credit (LOC) loans in October 2014 and the $4,875 million of cash pay/PIK toggle notes in 2015/2016 (which excludes approximately $363 million of notes held by EFH and EFIH). The debt maturity schedule could be exacerbated by the springing maturity provision for the extended portions of the term loans and deposit LOC loans if the requisite conditions are not met. Fitch considers a material restructuring of TCEH's capital structure highly likely over the next 12 months.

Recovery Analysis

The individual security ratings at TCEH and EFH/EFIH are notched above or below the IDR, as a result of the relative recovery prospects in a hypothetical default scenario.

Fitch's assessment of the collateral valuation at EFH/ EFIH continues to depend solely on the value of Oncor Electric Delivery Holdings Company LLC's (Oncor Holdings) 80% ownership interest in Oncor. Fitch values Oncor Holdings' proportional interest in Oncor at $7.5 billion by using an 8.5x EV/EBITDA multiple and Oncor's expected 2014 EBITDA of $1.8 billion. Fitch's recovery analysis yields a 100% recovery for both the first lien and second lien debt. As a result, Fitch has notched up the ratings for the first and second lien debt by three notches to 'B/RR1'. The recoveries for all categories of debt instruments involved in the just concluded exchange offer are approximately equal or higher than the prior recoveries. Fitch expects improved recoveries for the remaining EFH's legacy notes driven by lower amount outstanding and the cap on the second lien and unsecured debt capacity at EFIH per the current debt incurrence restrictions. EFH's remaining LBO notes benefit from a hard cap on the second lien capacity at EFIH and lose only marginally in a revised recovery analysis due to additional pari passu debt being issued pursuant to the exchange offer.

For the recovery analysis for TCEH, Fitch values the power generation assets at Luminant using a net present value (NPV) analysis. Fitch uses the plant valuation provided by its third-party power market consultant, Wood Mackenzie, as an input as well as Fitch's own gas price deck and other assumptions. The generation asset NPVs vary significantly based on future gas price assumptions and other variables, such as the discount rate and heat rate forecasts in Electric Reliability Council of Texas (ERCOT).

Fitch's valuation of Luminant's generation fleet at approximately $13.5 billion reflects a value of approximately $1,700 per kilowatt (kw) for the nuclear units, $700/kw for the older coal fleet, $1,500/kw for the newer coal units and $600/kw for the natural gas plants. Fitch values TXU Energy at $2.5 billion using an EV/EBITDA multiple of 5.0 times (x). For the purpose of the recovery analysis, Fitch has assumed that the credit facilities are fully drawn and the first-lien capacity is fully utilized. Fitch has also assumed that the current balance of $680 million of demand notes payable to TCEH by EFH has been paid in full. Fitch does note that natural gas prices are a key variable that drives the valuation of TCEH's power generation assets. According to Fitch's estimates, every $1/MMBtu move in natural gas prices can drive approximately $450 million variance in TCEH's EBITDA beyond 2014.

The recovery analysis results in a 'CC/RR3' rating for TCEH's first-lien bank facilities and first-lien senior secured notes. The 'RR3' rating reflects a one-notch positive differential from the 'C' IDR and indicates that Fitch estimates recovery of 51%-70%. The recovery waterfall yields no recovery for all debt junior to the first lien as the first-lien debtholders are not paid in full.

What Could Trigger a Rating Action:

Commodity Price Changes: Fitch considers it highly unlikely that TCEH's IDR will be upgraded unless the commodity environment was to significantly improve in TCEH's favor in a very short period of time. The debt instrument ratings for TCEH, however, could be upgraded or downgraded depending upon Fitch's long-term view of power prices in ERCOT, which forms a key assumption for TCEH's recovery analysis.

Increased Retail Competition: Rising competitive intensity in the retail markets in Texas could lower the value that Fitch ascribes to TXU Energy, thereby, lowering the recovery values for TCEH's senior secured first lien debt.

Change in Leverage at EFH/EFIH: A reduction in debt at EFH and EFIH will be positive for the credit profile of the two entities. Any reduction in leverage through liability management activities will be evaluated by Fitch based on the terms of the transaction and could lead to changes in the recovery analysis for the debt instruments.

Lower Than Expected Cash Flows: A material shortfall in cash flows at EFH/EFIH versus Fitch's current expectations due to factors such as reduced dividend and/or corporate tax payments from Oncor, federal tax obligations triggered by a potential restructuring at TCEH or other reasons could lead to a downgrade in the ratings of these two entities.

Change in Oncor's Valuation: Any change in Fitch's assessment of valuation of Oncor due to reasons such as change in regulatory environment, any restriction placed on upstream dividend distribution, a changes in electric sales outlook etc. could lead to a change in recovery ratings for EFH/EFIH's debt instruments.

Fitch has taken the following rating actions:

EFH

-- IDR downgraded to 'RD' from 'CC' and simultaneously upgraded to 'CCC';

-- Senior secured first lien debt upgraded to 'B/RR1' from 'CCC+/RR1';

-- Senior unsecured guaranteed notes downgraded to 'CC/RR3' from 'CCC-/RR3' and simultaneously upgraded to 'CCC+/RR3';

-- Senior unsecured non-guaranteed notes affirmed at 'C/RR6' as a result of DDE and simultaneously upgraded to 'CC/RR6'.

EFIH

-- IDR downgraded to 'RD' from 'CC' and simultaneously upgraded to 'CCC';

-- Senior secured first lien debt upgraded to 'B/RR1' from 'CCC+/RR1';

-- Senior secured second lien debt upgraded to 'B/RR1' from 'CCC+/RR1';

-- Senior toggle notes assigned a rating of 'CCC+/RR3'.

EFCH

-- IDR downgraded to 'RD' from 'CC' and simultaneously upgraded to 'C';

-- Senior unsecured notes affirmed at 'C/RR6'.

TCEH

-- IDR downgraded to 'RD' from 'CC' and simultaneously upgraded to 'C';

-- Senior secured first lien debt downgraded to 'CC/RR3' from 'CCC-/RR3';

-- Senior secured second lien debt affirmed at 'C/RR6';

-- Senior unsecured notes affirmed at 'C/RR6';

-- Unsecured pollution control bonds affirmed at 'C';

-- Lease facility bonds downgraded to 'CC/RR3' from 'CCC/RR3'.

Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (Aug. 8, 2012);

-- Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers' (May 4, 2012);

--'Parent and Subsidiary Rating Linkage' (Aug. 8, 2012);

--'Distressed Debt Exchange' (Aug. 8, 2012).

Applicable Criteria and Related Research:

Corporate Rating Methodology

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=684460

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=693773

Parent and Subsidiary Rating Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=685552

Distressed Debt Exchange

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=685903

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Contacts

9Fitch Ratings
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Shalini Mahajan, CFA, +1 212-908-0351
Director
Fitch, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst
Phillip Smyth, CFA, +1 212-908-0531
Senior Director
or
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or
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Contacts

9Fitch Ratings
Primary Analyst
Shalini Mahajan, CFA, +1 212-908-0351
Director
Fitch, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst
Phillip Smyth, CFA, +1 212-908-0531
Senior Director
or
Committee Chairperson
Glen Grabelsky, +1 212-908-0577
Managing Director
or
Brian Bertsch, +1 212-908-0549 (New York)
brian.bertsch@fitchratings.com