NEW YORK--(BUSINESS WIRE)--Fitch Ratings has upgraded the long-term IDR of PPL Electric Utilities Corp. (PPLEU) to 'BBB+' from 'BBB' with a Stable Outlook. Fitch has also affirmed the 'BBB' LT IDR for PPL Corp. (PPL) and PPL Capital funding Inc. and revised their Rating Outlooks to Positive.
Simultaneously, Fitch has affirmed the 'A-' LT IDRs of Louisville Gas and Electric Co. (LG&E) and Kentucky Utilities Co. (KU) and the 'BBB+' LT IDR of LG&E and KU Energy LLC. The Rating Outlook for each of these entities is Stable. Fitch maintains the 'BB' LT IDR and Rating Watch Negative for PPL Energy Supply, LLC (PPLES).
Fitch expects to withdraw its ratings on PPL and its U.S. subsidiaries at the end of a 30-day period (Jan. 9, 2015) for business reasons.
A full list of rating actions appears at the end of this release.
KEY RATING DRIVERS
PPL Corporation
PPL's ratings and Positive Outlook reflect the company's expected transformation to a fully regulated utility holding company with operations in several supportive regulatory jurisdictions. The ratings also reflect PPLEU's increasing presence in the transmission space and improving Pennsylvania regulations, and Fitch's evolving view of the rating impact of the U.K. operations to PPL.
Fully Regulated Business Model: PPL's ratings and Outlook reflect its rapid transformation from a company heavily reliant on commodity sensitive businesses to one that will be fully regulated with substantially less business risk. By comparison, regulated operations accounted for approximately 22% of EBITDA prior to two acquisitions and the spinoff.
PPLEU's Improvement: PPLEU's continued investment in Federal Energy Regulatory Commission (FERC) regulated transmission has allowed it to earn favorable cash returns with almost no regulatory lag. Fitch believes the minimal regulatory lag more than offsets the potential for lower allowed returns on equity on FERC projects (approximately 10%). Regulation of the distribution segment has improved noticeably in the past two years. Timely recovery of capital investments is provided by the approved distribution infrastructure replacement surcharge, allowed use of a fully projected test year, and riders such as those for advanced meter and storm.
U.K. Segment: PPL's Positive Outlook also reflects Fitch's evolving view of the company's U.K. operations relative to PPL. Fitch assesses PPL's credit profile with and without its U.K. operations reflecting its self-funding status and lack of operational integration given the geographic location. PPL's U.K. operations have historically been higher levered than its U.S. operations. Fitch believes the transparency and high level of earnings predictability in the U.K. regulatory model could compensate for the low allowed returns and higher leverage. Additionally, as the WPD group is fast-tracked, they are allowed to earn upfront rewards and higher return on equity than its peers. Additionally, Fitch believes that PPL U.K.'s capital structure is managed in accordance with the predictable earnings stream on a standalone basis.
Credit Metrics: Fitch expects PPL's pro forma FFO fixed charge coverage to be strong for an issuer with 100% regulated operations at a low of 4x (or a high of 4x if excluding U.K). For the FFO adjusted leverage metric, PPL will likely produce an average high of 4x and an average low of 4x excluding the U.K. The sizeable capital expenditures in the regulated segment weaken the credit metrics temporarily. Fitch expects PPL's credit metrics to improve as spending moderates in the 2018-2019 timeframe.
Supportive Regulatory Jurisdictions: The scale of the large capex program could pose execution risks and will require upfront debt financing. The credit risk that arises from the large capex is mitigated by regulatory provisions that provide near real-time cost recovery for about 75% of expenditures, including FERC jurisdictional transmission in Pennsylvania, environmental compliance in Kentucky and all capital investments in the U.K.
PPL Electric Utilities
Growing Presence in Transmission: PPLEU's upgrade reflects the company's growing presence in the transmission sector which Fitch continues to view as favorable. Transmission expenditures account for $2.9 billion of the $4.7 billion (61%) of capital expenditure planned from 2014 to 2018, substantially all of which is subject to near real-time recovery and favorable returns. Transmission rate base growth is expected to average 10.7% over 2014 to 2018, the fastest among all PPL subsidiaries. The recent proposal for Project Compass demonstrates the company's continued effort to expand its transmission footprint.
Improving Pennsylvania Regulations: The upgrade also reflects the improvement of the regulatory framework in Pennsylvania in recent years. The most recent distribution rate case outcome was reasonable with the approval of 70% of the rate increase requested based on a 10.4% ROE which is higher than industry average. Additionally, Act 11 minimizes regulatory lag associated with an $800 million distribution infrastructure replacement program over five years. The approved distribution infrastructure replacement surcharge, the allowed use of fully projected test years in base rate cases, and riders for advanced meter and storm recovery provide timely recovery of capital investments. Approximately 43% of distribution capex is subject to real-time recovery in the next five years.
No Commodity Risk: Although the company retains the Provider of Last Resort (PLR) obligation, all procurement costs are recoverable from customers.
Credit Metrics: As a low risk transmission and distribution company, PPLEU's coverage and leverage ratios are expected to be more consistent within a 'BBB+' rating level. In the next few years, Fitch estimates that PPLEU will generate an average of 5.3x FFO fixed charge coverage and FFO adjusted leverage of 4x.
Favorable Customer Mix: The majority of revenue is derived from residential customers, which are less affected by economic conditions than other customer classes. The 2013 revenue mix was 65% residential though customer growth is expected to remain tepid. In 2013, residential sales increased 0.8% on a weather normalized basis, with slightly negative or no growth in other segments. Going forward sales growth is expected to be less than 1% annually. In August 2014, the unemployment rate in Pennsylvania was 5.8% compared to 6.1% nationally.
Louisville Gas & Electric and Kentucky Utilities
The ratings and Stable Outlook at LG&E and KU reflect the strong credit metrics and constructive regulatory policies that limit cash flow volatility and business risk.
Strong Metrics: Credit metrics at LG&E and KU have been strong for the rating level. Given the sizeable capex program especially those outside of the Environmental Cost Recovery (ECR) mechanism, Fitch expects credit metrics at both utilities to decline modestly during the projection period but remain supportive of current ratings. FFO adjusted leverage is expected to average approximately 3.8x over the next several years compared to 3.5x currently, and FFO fixed charge coverage to approximate 7x as compared to 8.2x currently. These metrics remain well positioned for the 'A-' rating level.
Constructive Regulations: Regulations in Kentucky are considered by Fitch to be constructive. The companies operate with a number of cost recovery mechanisms that reduce regulatory lag and business risk and the Kentucky Public Service Commission (KPSC) has a track record of timely rate decisions. Regulatory policies include a fuel adjustment clause (FAC) that provides for variations in fuel costs and economic power purchases to be reflected in rates two months after incurred; a Gas Supply Charge (GSC) that allows the cost of natural gas supply for LG&E to be reset quarterly; an ECR mechanism; cash return on construction work in progress (CWIP); current recovery of demand side management (DSM) costs, including lost revenue; and a forward test year in base rate case.
The ECR is particularly important given the two utilities generate 98% of output in 2013 from coal fired facilities. The ECR permits the approved environmental costs to be reflected in rates two months after incurred. A $2.3 billion ECR plan was approved, which represents 38% of the total capex spending from 2013 to 2017.
Pending Rate Case: Recent rate orders in Kentucky have yielded constructive results, and Fitch anticipates a similar outcome in the pending rate case. The 2012 rate order took effect on Jan. 1, 2013 and a 10.25% ROE was authorized for both utilities which about industry average.
Sizeable Capital Expenditures: Capex has been elevated since 2012 and is expected to remain high over the next several years. The two utilities plan to spend a total of approximately $6.1 billion from 2013 to 2017, averaging $1.2 billion per year compared to $700 million per year from 2008 to 2012; $2.3 billion of the total will be invested in environmental compliance projects aforementioned.
Environmental Exposure: Although Fitch believes the ECR mechanism mitigates the environmental compliance risks, the associated rate requirements could potentially cause rate fatigue and affect the future recovery of growth projects.
Challenging Economy: In 2013, 40% of total sales were driven by the residential segment in Kentucky. The residential segment had 0.2% growth and the commercial segment had negative 1.3%. The industrial sector experienced 1.5% sales growth in 2013. Looking forward, sales volume at both utilities overall will likely remain flat or slightly negative reflecting the challenging economic conditions in the state of Kentucky. In August 2014, Kentucky's unemployment rate was 7.1%, compared to 6.1% nationally.
LG&E and KU Energy LLC: The ratings of LG&E and KU Energy LLC (LKE), an intermediate holding company and parent of KU and LG&E, reflect the predictable cash flow and strong credit profile of its two regulated utility subsidiaries as well the debt level at the holding company. Currently, LKE's debt represents approximately 25% of the total debt in the Kentucky segment.
PPL Energy Supply:
Spinoff Pending: In June 2014, Fitch downgraded PPLES from 'BBB-'/Outlook Negative to 'BB'/Rating Watch Negative. The downgrade followed PPL's announcement of a spin-off of PPLES, which will then be combined with Riverstone Holding's (Riverstone) generation assets to form an Independent Power Producer (IPP) named Talen Energy (Talen). The transaction is expected to close in the first half of 2015.
PPLES' 'BB' IDR reflects the expected consolidated credit profile and business risks as a stand-alone IPP. Upon Fitch's preliminary assessment, this transaction will likely further weaken PPLES' credit profile by adding highly levered Riverstone assets, partially offset by the estimated synergy savings, which will not likely be fully achieved until the 2016-2017 time frame. Talen's proposed capital structure and leverage (Debt/EBITDA ratio of approximately 4.0x for 2015 including synergies) is indicative of an 'BB' profile for an IPP. Management's public comments indicate a bias towards acquisitions to pursue growth and operate a portfolio that has a much shorter duration and more open exposure.
The transaction does not materially change the fuel mix or geographic concentration of the company's generation fleet. PPLES currently owns nearly 10GW of generation capacity, which is comprised of 41% coal. Post spinoff, the coal generating capacity is relatively unchanged at 40%. Fitch consider the Raven assets to have relatively high risk of incurring sizeable future compliance costs as Maryland has a history of imposing stringent environmental mandates, although there is no substantial environmental capex required in the foreseeable future (management estimates that approximately $118 million will be spent on major environmental mandates, 85% of which will be on PPLES' fleet and remaining on the Raven fleet).
Combined generation fleet will continue to be concentrated in PJM. Approximately 86% of Talen's total capacity will be located in PJM. Though PJM's capacity market lends some stability in earnings and cash flow by providing visibility to capacity revenues three years in advance, the auction results have been unpredictable.
The Negative Rating Watch can be resolved upon closing after completing a detailed assessment of the financial and operating statistics of the Riverstone generating portfolio and the combined fleet, the expected synergy benefits, the impact of possible divestitures needed to mitigate market power concerns, and the final capital structure of the new entity.
RATING SENSITIVITIES
PPL
Positive:
--A constructive outcome in the rate cases in Kentucky;
--A final capital structure at PPL consistent with Fitch's current expectations;
--PPL is not subject to any financial and/or operational obligations as a condition for closing the spinoff transaction.
Negative:
--FFO adjusted leverage excluding U.K. exceeding 5x beyond the heavy utility spending period;
--Any material adverse development in the regulatory framework in the service territories that PPL's regulated utilities operate in, such as change in environmental cost recovery mechanisms.
PPLEU
Positive:
--Future positive rating action appears unlikely in the next 12-18 months.
Negative:
---FFO adjusted leverage exceeding 5x on sustained basis.
KU and LG&E
Positive:
--Future positive rating action appears unlikely in the next 12-18 months given the large capital spending program.
Negative:
--Material adverse development in the regulatory framework in Kentucky;
--FFO adjusted leverage exceeds 4.25x on a sustained basis.
PPLES/Talen:
Positive:
--A conservative hedging strategy that adds visibility to EBITDA and cash flows over a two-three year forecast period;
--Adjusted DEBT to EBITDA ratio below 4x on a sustainable basis.
Negative:
--A large open position for fuel purchases as well as power sales;
--An aggressive growth strategy that could include leveraged acquisitions and/or development of non-contracted generation assets;
--Adjusted DEBT to EBITDA ratio above 4x on a sustainable basis.
Fitch upgrades the following ratings with a Stable Outlook:
PPL Electric Utilities Corp.
--Long-term IDR to 'BBB+' from 'BBB';
--Secured debt to 'A' from 'A-';
Fitch affirms the following ratings with a Positive Outlook:
PPL Corp
--Long-term IDR at 'BBB';
--Short-term IDR at 'F2'.
PPL Capital Funding Inc.
--Senior unsecured debt at 'BBB';
--Junior subordinated notes at 'BB+';
Fitch affirms the following ratings with a Stable Outlook:
PPL Electric Utilities Corp.
--Short-term IDR at 'F2';
--Commercial paper at 'F2'.
LG&E and KU Energy LLC
--Long-term IDR at 'BBB+';
--Senior unsecured debt at 'BBB+';
--Short-term IDR at 'F2'.
Kentucky Utilities Company
--Long-term IDR at 'A-';
--Secured debt at 'A+';
--Secured pollution control bonds at 'A+/F2';
--Senior unsecured debt at 'A';
--Short-term IDR at 'F2';
--Commercial paper at 'F2'.
Louisville Gas and Electric Company
--Long-term IDR at 'A-';
--Secured debt 'A+';
--Secured pollution control bonds at 'A+/F2';
--Senior unsecured debt at 'A';
--Short-term IDR at 'F2';
--Commercial paper at 'F2'.
Fitch maintains ratings and Rating Watch Negative on the following:
PPL Energy Supply, LLC.
--Long-term IDR at 'BB';
--Senior unsecured debt at 'BB';
--Short-term IDR at 'B';
--Commercial paper at 'B'
Additional information is available at 'www.fitchratings.com'
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (May 28, 2014);
--'Recovery Ratings and Notching Criteria for Utilities' (Nov. 13, 2013);
--'Parent and Subsidiary Rating Linkage' (Aug. 5, 2013);
--'Rating U.S. Utilities, Power and Gas Companies' (March 9, 2014).
Applicable Criteria and Related Research:
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393
Recovery Ratings and Notching Criteria for Utilities
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=813608
Rating U.S. Utilities, Power and Gas Companies (Sector Credit Factors)
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=735155
Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=947795
ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. 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.