Crafting debt financing to attract cash, good ratings

Bill Collet, Christenberry Collet & Co. Inc.

Debt is a vital source of financing for electric utilities. According to Multex, a financial data provider, U.S.-traded investor-owned utilities have an average debt to equity ratio of 1.77, meaning that they use nearly twice as much debt as equity.

Today, low interest rates and investors’ increasing risk threshold have made debt financing (and refinancing) especially attractive to electric utilities. As of December 2003, Dealogic, a corporate finance information firm, reported that electric utilities and energy merchants had issued $49.9 billion in new debt, representing an increase of more than $10 billion from 2002 and making the sector the second largest issuer behind the financial services industry.

Understanding the mindset of lenders and credit rating analysts is important for any electric utility. Both take a holistic approach to evaluations, going beyond the financial statements to assess a candidates’ management, operations, market and future prospects, to name a few.

“We use both a qualitative and quantitative analysis,” said Jake Udris, vice president of the rural utility banking group at CoBank, which has a $3.8 billion energy lending portfolio. “A good candidate [for financing] would be one that has strong quantitative and qualitative factors. A good management team, good business strategy executed well, good financial fundamentals. We want to take a reasonable combination of risk and return.”

Lynn Midgette, vice president of corporate development portfolio management for the National Rural Utilities Cooperative Finance Corp. (CFC), said she focused on key financial ratios, “basic things like cash flow measured by debt service coverage, and equity.”

One red flag would be a cooperative’s unwillingness to raise rates as needed, Midgette said; however, most of the CFC’s cooperative clients are financially secure.

“The truth is that coops are pretty strong,” she said. “They provide an essential service, and they usually have protected territories. They’re pretty solid.”

Credit ratings are important not only for the ability to borrow money at competitive rates, but also in the collateral requirements for new standard form EII purchased power contracts. The counterparty credit rating establishes the collateral threshold; lower-rated companies are forced to provide more credit security in the form of letters of credit or deposits.

Standard & Poor’s, which rates the credit of nearly 700 utilities in the United States, bases its ratings on eight factors:

“- Management: the experience of the executive team, its knowledge of competitors and customers, and the support of the board of directors.
“- Operations: power resources, supply and demand, operating efficiency and reliability and capital needs.
“- Competitive position: rate design, use of contract rates, rate affordability and rate projections.
“- Markets: load factors of the system, population trends and customer base.
“- Regulation: the impact of federal, state or local regulators with regard to rate-making, competition, transmission and the environment.
“- Service area economy: income levels and projected uses and revenue streams.
“- Finances: debt service coverage margins and liquidity, as well as specific utility results and decisions.
“- Legal provisions: the appropriateness of any legal provisions in long-term debt, including the security pledge, rate covenant, flow of funds, additional bonds test and debt service reserve.

Andrew Watt, a director of Standard & Poor’s energy group, said current ratings for utilities varied with regard to specialization.

“Companies that are focused on core operations and being a utility serving customers, trying to maintain good regulatory relationships and not dabbling too far, those are doing quite well,” he said. “For the utilities that focused more on growth in areas where they didn’t have a demonstrated competitive advantage, from a credit standpoint, they have suffered in the ratings process.”

The impact of management focus was clearly evident in the post-Enron credit environment, beginning in late 2000 and trending through 2002. The focus on growth and diversification in U.S. IOUs, especially in merchant generation, energy trading and business line extensions, resulted in ballooning debt and a severe credit crunch as rating agencies penalized companies for straying from their core electric service business.

In 2002, IOUs experienced 182 rating downgrades, compared with only 15 upgrades. Credit quality stabilized somewhat in 2003, with 88 downgrades through September, compared with eight upgrades.

Although a smaller percentage of municipal utilities and electric cooperatives are rated by the major agencies, they fared better in the credit quality meltdown due to their continued focus on the core electric service business. Of the 197 rated municipals and cooperatives, all maintained investment-grade ratings at year-end 2002, and 182 were rated with positive or stable outlooks, compared with 15 negative outlooks. Downgrades totaled 14 during 2002 but were balanced by 12 upgrades. For municipals and cooperatives, 2003 was a good year in which few rating changes occurred, and 90 percent of rated munis and coops maintained stable or positive outlooks.

Collet is a founding partner at Christenberry Collet & Co., Inc., a Kansas City-based investment banking firm that has arranged $1 billion in financing for electric utilities since its founding in 1994.


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