Fitch Rates Tucson Electric Power Co.'s Senior Unsecured Notes 'BBB+'; Outlook Stable

NEW YORK--()--Fitch Ratings has assigned a 'BBB+' rating to Tucson Electric Power Co.'s (TEP) issuance of senior unsecured notes. The notes rank pari passu with existing senior unsecured debt. Proceeds from the debt offering will be used to pay down short-term borrowings and for general corporate purposes including the funding of planned capex. The Rating Outlook is Stable.

In the third quarter of last year Fortis Inc., Canada's largest investor-owned gas and electric distribution utility, acquired UNS Energy Corp., (UNS) the ultimate parent company of Tucson Electric Power Company. TEP's ratings reflect the utility's improved access to capital due to Fortis' financial strength and the expectation that Fortis will support TEP's growth objectives and provide appropriate financing support as needed.

KEY RATING DRIVERS

--Expectation for continued financial support from parent;

--Constructive regulatory environment;

--High leverage.

Acquisition by Fortis: Fortis acquired UNS for an aggregate purchase price of approximately US$4.5 billion, including the assumption of approximately US$2 billion of debt. Per the terms of the merger approval, regulated retail customers of TEP will receive bill credits totaling $19 million over five years.

Fortis Financial Support; New Generation: In the fourth quarter Fortis injected $225 million of equity into TEP to strengthen its balance sheet and to help fund the purchase of a 75% ownership interest in Unit 3 at the 550MW natural gas-fired Gila River Power Plant for $164 million and to increase TEP's ownership stake in the 387MW coal fired Springerville Unit 1 power plant to 49.5% for $65 million. TEP's corporate affiliate, UNS Electric, purchased the remaining 25% interest at Gila River. The acquisition is consistent with TEP's strategy to diversify its generation fuel mix and to shift towards cleaner generation resources. The new gas generation will replace TEP's reduced output from Springerville Unit 1 (TEP previously leased all of the capacity) and 170MW of reduced capacity as a result of the planned retirement of the coal-fired San Juan Unit 2 in 2017.

Ring-Fencing Measures Adopted; Dividend Restriction: Per the terms of the merger, dividends to UNS from its regulated utilities cannot exceed 60% of annual net income for a period of five years or until their respective equity-to-total capitalization ratios reach 50%. The settlement agreement also stipulates that UNS Energy be overseen by an independent board of directors, a majority of whom are Arizona residents.

Constructive GRC Settlement; Filing Expected: Fitch expects the regulatory environment in Arizona to remain constructive and expects TEP to file its next GRC in the 2nd quarter of 2016. In 2013, the ACC issued a final order in TEP's 2012 general rate case (GRC) and authorized a nonfuel base-rate increase of $76 million dollars, approximately 59% of requested, predicated on a 10% return on equity (ROE; plus a 0.68% return on fair value increment of rate base) and an equity layer of 43.5%.

AZ Regulatory Compact: The more timely adjudication of rate filings by the Arizona Corporation Commission (ACC) in recent years is a constructive development from an investor point-of-view that has enabled TEP to reduce regulatory lag and improve its earned returns. The ACC has adopted several regulatory mechanisms to facilitate cost recovery outside of and in between GRCs. Such cost recovery mechanisms include a lost fixed cost recovery (LFCR) mechanism, an environmental compliance adjustor (ECA), and a Demand Side Management (DSM) and a Renewable Energy Surcharge (RES). The cost recovery mechanisms allow for timely earnings growth in between GRC proceedings.

Solid Credit Metrics: For the YE 2014, TEP's EBITDAR coverage ratio improved to 5.2x as compared to 4.5x for 2013, largely due to new rates effective July of 2013 as per the settled GRC, lower interest expense due to amortizing capital lease obligations and increased margins on wholesale sales partially offset by increased operating and maintenance expenses resulting from the merger. Leverage, as measured by Debt to EBITDAR, approximated 4.4x. Going forward, EBITDAR coverage is expected to approximate over 5x through 2018, and leverage, as measured by debt-to-EBITDAR is expected to improve to less than 4x over the same period due to a combination of new rates, amortizing capital lease obligations, and improving economic conditions in TEP's service territory.

Sufficient Liquidity: In Dec. TEP entered into a new unsecured credit agreement composed of a $70 million dollar credit facility and a $130 million term loan to support tax exempt debt. TEP also maintains liquidity through a $200 million revolving credit facility (RCF) and an $82 million letter-of-credit facility. TEP's credit agreements mature in November of 2015 and 2016, respectively. As of Dec. 31, 2014, TEP had total available liquidity of $388 million under its credit agreements including $74 million of cash and cash equivalents. TEP's RCF's contain a maximum debt-to-capitalization covenant ratio of 70%, and as of Dec. 31, 2014, TEP was in compliance with a debt-to-capitalization ratio of 58%.

KEY ASSUMPTIONS

Fitch's key assumptions within the agency's rating case for the issuer include:

--Annual retail sales growth averaging 2.0% through 2018.

--Equity infusion of $225 million from Fortis.

--O&M escalation averaging 1% through 2018.

--Targeted Dividend payout ratio of 60% beginning in 2015.

--Capex totaling $1.3 billion through 2018 to be funded primarily from internally generated funds.

RATING SENSITIVITIES

Positive Rating Action: Positive rating actions are not expected at this time. However, sustained debt-to-EBITDAR metrics of better than 3.8x over the forecast period could lead to a rating upgrade.

Negative Rating Action: An unexpected increase in leverage such that debt-to-EBITDAR leverage metrics would weaken to 4.5x or worse on a sustained basis could cause a negative rating action.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Rating U.S. Utilities, Power and Gas Companies'(March 7, 2014);

--'Corporate Rating Methodology'(May 28, 2014);

--'Recovery Ratings and Notching Criteria for Utilities'(Nov .18, 2014).

Applicable Criteria and Related Research:

Rating U.S. Utilities, Power and Gas Companies (Sector Credit Factors)

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=735155

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 Equity REITs

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=813628

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=980273

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Contacts

Fitch Ratings
Primary Analyst
Daniel Neama, +1 212-908-0561
Associate Director
Fitch Ratings, Inc.
33 Whitehall St.
New York, NY 10004
or
Secondary Analyst
Philip W. Smyth, CFA, +1 212-908-0531
Senior Director
or
Committee Chairperson
Mike Weaver, +1 312-368-3156
Managing Director
Corporate Ratings
or
Media Relations, New York
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Daniel Neama, +1 212-908-0561
Associate Director
Fitch Ratings, Inc.
33 Whitehall St.
New York, NY 10004
or
Secondary Analyst
Philip W. Smyth, CFA, +1 212-908-0531
Senior Director
or
Committee Chairperson
Mike Weaver, +1 312-368-3156
Managing Director
Corporate Ratings
or
Media Relations, New York
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com