NEW YORK--()--Fitch Ratings has downgraded the Issuer Default Rating (IDR) of DPL Inc. (DPL) to 'BB' from 'BB+'. In addition, Fitch has placed DPL and its wholly owned subsidiary The Dayton Power and Light Company (DP&L) on Rating Watch Negative. The Rating Watch Negative implies that the ratings may be either lowered or affirmed and are typically resolved over a relatively short period of time. Fitch expects to resolve the Rating Watch Negative for DPL and DP&L once the outcome of DP&L's recently filed Electric Security Plan (ESP) is known.
The downgrade in DPL's ratings and the assignment of Rating Watch Negative is driven by significantly reduced EBITDA and FFO expectations compared with Fitch's prior forecasts. A material reduction in power prices that has exacerbated switching to alternate retail electricity providers among DP&L's standard service offer (SSO) customers and reduced DP&L's wholesale revenues accounts for Fitch's revised expectations. The substantial increase in leverage at DPL following the acquisition by The AES Corporation (AES, rated 'BB-' Outlook Stable by Fitch) is causing additional stress on DPL's credit metrics, in an operating environment that continues to worsen.
DPL's ratings reflect its highly leveraged capital structure and the primary support it receives from the upstream distributions from DP&L. The ratings of DPL and DP&L are linked and the IDRs of both entities consider the combined leverage, which consists of approximately $1.7 billion of debt at DPL and $0.9 billion of debt at DP&L. The ratings of DPL and DP&L are not tightly linked to the IDR of the ultimate parent, AES. However, any material weakening of the credit of AES could adversely affect Fitch's ratings of DPL and DP&L.
DP&L is facing several regulatory and market challenges in Ohio. Its current ESP expires in Dec. 31, 2012. DP&L has filed for a new ESP to be effective Jan. 1, 2013 in an environment where low power prices have caused acceleration in customer switching and heightened retail competition. DP&L has requested a nonbypassable charge of $120 million over the five-year ESP period, a faster transition of SSO tariff to market, and a commitment to file a generation separation plan by YE 2013 such that DP&L expects that the non-regulated generation business would be legally separated from the regulated transmission and distribution business by YE 2017.
Switching has accelerated in DP&L's retail territory in 2012. As of June 30, 2012, approximately 56% of DP&L's customers had switched to alternate suppliers. Through the first six months of 2012, customer switching has impacted DP&L's gross margin by $110 million and DPL's gross margin by 59 million. The lost gross margin at DP&L has been partially offset by higher margins at DPL's non-regulated subsidiary, DPL Energy Resources (DPLER), which has been successful in winning a majority of the switched load. DPLER is also actively competing for the retail load in non-DP&L service territory.
DPL's credit metrics have sharply deteriorated in the wake of increased switching and falling wholesale revenues. For the last twelve months (LTM) ended June 30, DPL's consolidated funds from operations (FFO)-to-debt ratio was 11% and debt-to-EBITDA ratio was 6.3x. Fitch expects a further deterioration of these metrics absent a waning of residential switching, a constructive ESP outcome and material debt reduction at DPL. All these three factors bear monitoring and will be used by Fitch to drive future rating actions.
DP&L's LTM metrics remain robust, though these have moderated somewhat from their very strong historical financial performance as a result of increased competition in the competitive retail energy market and weaker wholesale revenues. For the LTM ending June 30, DP&L's FFO-to-debt ratio was 38% and its debt-to-EBITDA ratio was 2.1x. Fitch forecasts DP&L's robust credit metrics to deteriorate somewhat based on the terms of the requested ESP and assuming that residential switching exacerbates for a few months before moderating. However, Fitch expects DP&L's forecasted credit metrics to remain superior relative to Fitch guidelines for the 'BBB-' IDR. DP&L's current ratings are constrained by the additional leverage at DPL and the need for a high proportion of DP&L's earnings to be upstreamed to DPL as dividends to support parent debt.
Fitch has notched DP&L's IDR two levels above that of DPL. The Merger Stipulation, as approved by the Public Utility Commission of Ohio (PUCO), places explicit financial restrictions on DP&L that reduces its credit risk relative to DPL. DP&L is required to maintain a capital structure that includes an equity ratio of at least 50% and cannot have a negative retained earnings balance. In addition, the DP&L Articles of Incorporation, and the Ohio state codes place further restrictions on: (1) upstream dividend distribution; (2) transactions with an affiliate such as liquidity support, debt incurrence or collateral support; and (3) issuance of new debt without explicit approval from the PUCO.
Liquidity is adequate and is supported by DP&L's cash flows and full availability on the utility's $200 million revolving credit facility maturing in August 2015 and $200 million revolving credit facility maturing in April 2013. DPL also has full availability on its own $75 million revolving credit facility maturing in August 2014. Subsequent to a recent amendment to its credit agreement, the capacity on the revolver was reduced to $75 million, from $125 million previously. The amendment also eliminated the prior debt to capital financial covenant replacing it with a debt to EBITDA covenant. The amendment also imposes significant restriction on DPL's ability to pay dividend to AES. In the third quarter of 2012, DPL recognized an estimated $1.85 billion non-cash goodwill impairment charge. DPL had recorded substantial goodwill of $2.6 billion in the fourth quarter of 2011 in connection with its acquisition by AES.
DP&L has a significantly large debt maturity on Oct. 1, 2013, with its $469 million first mortgage bonds coming due. Although these notes account for more than half of DP&L's existing debt outstanding, Fitch expects the replacement of this debt to be manageably done prior to maturity.
What Could Trigger a Rating Action
Outcome of the ESP: Fitch expects to resolve the Rating Watch for DPL and DP&L once the outcome of the recently filed ESP is known. While no procedural schedule is set as of now, it is Fitch's expectation that the PUCO could issue a final order before the end of the first quarter of 2013.
Pace of debt reduction: A constructive ESP outcome in itself may not be adequate to ward off negative rating actions for DPL and DP&L. Fitch expects DPL to significantly reduce debt from the current levels to prevent further downgrade to ratings.
Higher switching levels: Higher than anticipated switching levels and the inability to secure a switching tracker in its ESP order could place additional stress on DP&L's cash flows, and in turn, exert greater pressure on the upstream dividends from DP&L to DPL.
Higher than Anticipated Capex: Capital expenditures in excess of Fitch's current forecasts could accentuate the stress that the combined entity will undergo over the next few years.
Ratings Upgrade Unlikely: Positive rating actions are unlikely for several years given the highly leveraged balance sheet at DPL and the structural change in the operating environment facing DP&L. The separation plan, once filed by DP&L and approved by the PUCO, and the resulting capital structure at the regulated utility will have an important bearing on the future rating actions for DP&L.
Fitch has downgraded the following ratings and placed them on Rating Watch Negative:
--Long-term IDR to 'BB' from 'BB+';
--Senior unsecured debt to 'BB' from 'BB+'.
DPL Capital Trust II
--Junior subordinate debt to 'B+' from 'BB-'.
Fitch has placed the following ratings on Rating Watch Negative:
--Short-term IDR 'B'.
--Long-term IDR 'BBB-';
--Senior secured debt 'BBB+';
--Preferred stock 'BB+';
--Short-term IDR 'F3''.
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);
--'Parent and Subsidiary Rating Linkage' (Aug 8, 2012);
--'Recovery Ratings and Notching Criteria for Utilities' (Aug. 12, 2012);
--'Rating North American Utilities, Power, Gas, and Water Companies' (May 16, 2011).
Applicable Criteria and Related Research:
Corporate Rating Methodology
Parent and Subsidiary Rating Linkage
Recovery Ratings and Notching Criteria for Utilities
Rating North American Utilities, Power, Gas, and Water Companies