NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded the rating on $8.7 billion of Puerto Rico Electric Power Authority (PREPA) power revenue bonds to 'BB+' from 'BBB-'.
The Rating Outlook is also revised to Negative from Stable.
The power revenue bonds are secured by a senior lien on net revenues of the electric system.
KEY RATING DRIVERS
COMMONWEALTH DETERIORATION DRIVES DOWNGRADE: The rating downgrade and Outlook revision reflect concerns prompted by Fitch's recent downgrade of the debt ratings of the Commonwealth of Puerto Rico (to 'BB' from 'BBB-' with a Negative Outlook) as a result of continuing challenges related to a weak economy, increasingly strained liquidity and deteriorating capital markets access. While PREPA's debt is not supported by the commonwealth, Fitch believes that these same challenges warrant a downgrade to below investment grade.
WEAK FINANCIAL PERFORMANCE: PREPA's financial performance has significantly weakened in recent years and drove Fitch's two-notch downgrade of the utility to 'BBB-' from 'BBB+' in July 2013. PREPA remains challenged by slim margins, inadequate cash flow and minimal debt service coverage due to the effects of the economic recession, declining energy usage and growing account receivables. Leverage is high and has steadily risen since 2009, but is expected to stabilize through fiscal 2015.
STRAINED LIQUIDITY AND CAPITAL MARKETS ACCESS: Fitch believes that the most recent challenges faced by the commonwealth and PREPA could strain the authority's liquidity, limit access to the broader capital markets, raise borrowing costs and deter improvement in outstanding government and municipal account receivables, further pressuring PREPA's weak financial position. Favorably, PREPA's anticipated capital needs are funded through fiscal 2015.
RECEIVABLES REMAIN HIGH: Total receivables remain high at 28.8% of fiscal 2013 revenues, an ongoing negative credit factor. Despite efforts by the commonwealth along with the Government Development Bank of Puerto Rico (GDB) to reduce outstanding receivables in recent years, government and municipal receivables rose 44% to $618 million in fiscal 2013. Private customer receivables also rose in 2013.
BROAD BUT WEAK SERVICE AREA: PREPA's retail customer base is diversified and not as dependent on tourism as other islands. However, the commonwealth remains economically weak, with a declining population base, limited wealth levels and high debt burden. Through the first six months of fiscal 2014, energy sales continued to fall by 2%.
POWER SUPPLY DIVERSIFICATION: Management is focused on reducing dependency on costly oil-fired generation, primarily via the conversion of existing plants to dual fuel (oil and natural gas) generation, which Fitch views favorably. Oil generation dependency has declined from close to 100% pre-2000 to roughly 61% currently. If remaining plant conversions are completed, annual fuel costs could decline 40% ($1 billion) by 2018. However, PREPA will need to access the capital markets in fiscal 2016 to fully execute this capital plan.
INABILITY TO MAINTAIN SUFFICIENT LIQUIDITY: Negative rating action would result from additional strain on PREPA's weak liquidity as evidenced by insufficient cash reserves, a failure to extend or replace existing bank lines, further growth in accounts receivable or the inability to finance its proposed capital plan.
FURTHER COMMONWEALTH CREDIT DECLINE: Continued erosion in the commonwealth's credit quality could heighten concerns regarding PREPA's ongoing market access and long-term service territory fundamentals that are beyond the current rating level.
IMPROVED FINANCIAL PERFORMANCE AND MARKET ACCESS: The current rating takes into account PREPA's weak balance sheet and marginal debt service coverage projected through fiscal 2015. Successful implementation of PREPA's plan to diversify fuel exposure, improvement in operating margins and stable access to capital would be required to stabilize the Outlook.
PREPA is one of the largest public power systems in the U.S. and the sole provider of power to the Commonwealth of Puerto Rico, an island of about 4 million people and about 1.49 million electric customers. The authority operates independent from the commonwealth.
PREPA's concentration of power resources in oil generation exposes the authority to volatile fuel costs and environmental mandates. Fitch views the utility's efforts to diversify its energy mix positively, as the continued reduction in oil generation dependency should alleviate some of the pressure on future financial margins as well as meet required U.S. EPA mandates.
EFFECT OF COMMONWEALTH RATING DOWNGRADE
PREPA operates as a self-funded utility enterprise. As a result, Fitch does not strictly link the two ratings. However, PRPEA's financial strength is affected by the economic and financial viability of the commonwealth and its residents, as evidenced by PREPA's growing account receivables and declining energy sales.
The authority has meaningful market access risk exposure stemming from short-term lines of credit (LOCs) that come due over the course of the year and will need to be refinanced with long-term debt or renegotiated for an extended term. The LOCs total $900 million and are heavily utilized ($812 million at Dec. 31, 2013). Longer-term debt issuance is not expected until after fiscal 2015 but will be necessary to fund planned capital investment and refinance maturing debt.
At a minimum, the recent deterioration in the credit quality of both the commonwealth and PREPA are expected to lead to higher borrowing costs when the authority seeks to renew its LOCs or refinance maturities. Although failure to address the expiring LOCs would not lead to an event of default on the power revenue bonds, according to PREPA, it would further evidence the authority's strained financial profile. The higher capital cost structure and market access risk, however unlikely, are better reflected at the 'BB+' rating level.
WEAKENED FINANCIAL PROFILE
Fitch downgraded PREPA on July 1, 2013 due to its weakened financial performance resulting from the ongoing economic recession (2008-2013) coupled with high fuel costs that contributed to a significant decline in electricity sales and reductions in PREPA's operating and cash flow margins. Net account receivables have returned to historically high levels, after progress had been made in reducing municipal receivables in fiscal 2009 and 2010.
Fitch-calculated debt service coverage for the past five years (fiscal 2009-2013), which includes CILTs as an operating expense, was close to 1.0x and declined to less than 1.0x in fiscal 2011 and 2013. Additional borrowings were periodically necessary to meet total obligations. A reluctance to raise base rates also persists, as base rates remain unchanged since 1989.
REASONABLE OPERATING STRATEGY
PREPA has previously developed a reasonable plan to restore prospective financial margins in concert with the GDB and with the support of legislative initiatives. PREPA is implementing measures to improve revenue collections and reduce operating costs (non-fuel) that were designed to improve operating margins by $120 million per year by 2014. However, realizing the savings may be more challenging given current strains. Operating cost reductions achieved through the first six months of 2014 were largely offset by declining energy sales.
With PREPA's completed conversion of the Costa Sur generating facility to dual-fuel (25% of energy mix) fuel costs are also expected to decline in fiscal 2014, providing some rate relief due to the lower fuel cost component.
NO MEANINGFUL IMPROVEMENT EXPECTED THROUGH 2016
Based on PREPA's last financial forecast and capital strategy reviewed by Fitch, debt service coverage, including CILTs as an operating expenses, was forecast at about 1.0x through fiscal 2016 reflecting cost cutting initiatives, a somewhat aggressive electric sales growth forecast (CAGR 0.9% per year 2014-2017), and annual debt service payments that are scheduled to increase over the same period.
Additionally, PREPA's equity-to-total capitalization ratio is not likely to notably improve going forward (-9.8% as of fiscal year-end 2013) given the authority's $1.5 billion five-year capital expenditure program and plans for debt funding.
Additional information is available at www.fitchratings.com.
This rating action was informed by the sources of information identified in Fitch's U.S. Public Power Rating Criteria.
Applicable Criteria and Related Research:
--'Fitch Downgrades Puerto Rico GO and Related Debt Ratings to 'BB'; Outlook Negative' (Feb. 11, 2014);
--'U.S. Public Power Peer Study Addendum -- February 2014', (Feb. 7, 2014);
--'U.S. Public Power Peer Study -- June 2013' (June 13, 2013);
--'U.S. Public Power Rating Criteria' (Dec. 18, 2012).
Applicable Criteria and Related Research:
U.S. Public Power Peer Study Addendum -- February 2014
U.S. Public Power Peer Study -- June 2013
U.S. Public Power Rating Criteria