News Column

Fitch Affirms PNW and APS at 'BBB+'; Outlook Revised to Positive

May 30, 2014

NEW YORK--(BUSINESS WIRE)-- Fitch Ratings has affirmed the long-term Issuer Default Ratings of Pinnacle West Capital Corp. (PNW) and it's regulated utility subsidiary, Arizona Public Service Co.(APS) at 'BBB+' and revised both Rating Outlooks to Positive from Stable. In addition, the short-term ratings of both PNW and APS were affirmed at 'F2'.

KEY RATING DRIVERS

--Strong credit metrics;

--Higher customer growth Trends;

--Low leverage;

--Constructive regulatory environment;

--Large capex spend with associated trackers.

Positive Rating Outlooks: The Positive Outlooks reflect the expectation for continued customer growth, improving economic conditions in APS' service territory and credit metrics that are robust for the current rating category. The rating also considers APS' solid liquidity position, manageable debt maturities, low leverage, and the financial support from its corporate parent, PNW.

Strong Credit Metrics: APS' EBITDAR-to-interest coverage trended relatively flat at 6.0x for the LTM ending March 31 2014 as compared with 6.1x for year-end 2013, and primarily reflects improved customer growth largely offset by mild winter weather in APS service territory. The earnings also reflect new transmission rates. Leverage, as measured by debt-to-EBITDAR, was low at 2.7x. Credit metrics are strong compared to Fitch's 'BBB+' guideline ratios and peers. Going forward, Fitch expects EBITDAR coverage metrics to approximate 6.0x and for Debt/EBITDAR leverage metrics to approximate 3.0x through 2016. Funds from operations (FFO) metrics are expected to be moderately pressured in the intermediate term due to planned pension payments totaling $300 million over the next three years; however, FFO coverage metrics are expected to remain over 5.0x through 2016. PNW's credit metrics are expected to substantially mirror those of APS, PNW's core regulated electric utility subsidiary. Substantially all of PNW's consolidated long-term debt resides at APS, except for a $125 million term loan which matures in 2015.

Higher Customer Growth: Going forward, Fitch expects customer growth to average about 2% per year through 2016, reflecting improving economic conditions in the state including lower unemployment and increased housing starts and new household formations. As economic conditions improve in Arizona, APS' service territory is experiencing improved customer growth. Notably, customer growth grew 1.3% for the three-month period ending March 31, 2014 when compared to the same period last year. This continues a positive trend in customer growth and is a marked improvement when compared to the preceding three years ending 2011 (2009 through 2011), when APS' customer growth averaged 0.6% per year.

Positive Sales Trend: Going forward, Fitch expects that total weather normalized retail electricity sales will resume a positive growth trend and will increase on average about 0.5% to 0.75% per year through 2016 as a result of improved customer growth and improving economic conditions in the state, after including the effects of APS' energy efficiency and distributed generation programs. Retail electricity sales, adjusted to exclude the effects of weather variations, grew 0.6% for the three-month period ended March 31, 2014 when compared with the prior year period. Notably, the delta between customer growth and sales growth is roughly negative 1.5% due to the effects of energy efficiency, demand response, and distributed generation.

Net Metering Charge Adopted: A big concern for investors regarding net metering has been adequate rate design and proper cost allocation for using and maintaining the electrical grid between solar customers and non-solar customers. While the controversy persists, in a recent development, the Arizona Corporation Commission (ACC) on Dec 3, 2013 instituted a charge on customers who install rooftop solar panels after Dec. 31, 2013 of $0.70 per kilowatt, which became effective Jan. 1, 2014. In issuing the fixed charge for residential solar rooftop customers, the ACC determined that the current net metering program creates a cost shift and the charge is estimated to collect $4.90 per month from a typical future rooftop solar customer to help pay for their use of the electricity grid.

The new policy will be in effect until APS' next general rate case (GRC). The fixed charge does not increase APS's revenue because it is credited to the lost fixed-cost recovery (LFCR). Beginning this month, the ACC will conduct a series of workshops to evaluate the role of rate design regarding distributed generation, to continue discussions on cost allocations, and other issues regarding net metering. Additionally, the ACC directed APS to provide quarterly reports (April, July, and October) on the pace of rooftop solar adoption to assist the ACC in considering further rate increases.

Limited DG impact: Currently, the impact of distributed generation (DG) is not material given its small penetration but could become a concern if the trend materially increases in the future. (DG) currently comprises 0.5% or less of the negative impact to retail sales growth and equates to roughly 2% (700 GWh) of APS total 2013 retail sales.

LFCR Mechanism: APS' LFCR mechanism is estimated offset 30%-40% of revenues lost due to ACC-mandated energy efficiency (EE) and DG initiatives, subject to an annual cap at 1% of revenues. The LFCR is filed by Jan. 15 every year for new rates effective March 1, based on the EE and DG savings from the preceding year. On Jan. 15, APS filed for an LFCR adjustment of $25.3 million, effective March 1, 2014. On March 11, 2014, the ACC approved APS' LFCR adjustment which became effective April 1, 2014.

GRC STAY-OUT

Constructive 2010 GRC Settlement: Per the terms of the settlement, APS agreed to a four-year stay-out and is prohibited from filing its next rate case before May 31, 2015, for rates effective on or after July 1, 2016 at the earliest. Due to the GRC stay-out, controlling operating costs will be key to maintaining credit quality. Currently, APS expects to make a regulatory filing in mid-2015. For the LTM period ending March 31, 2014, APS' earned return on equity (ROE) approximated 9.91%, near its authorized ROE of 10%.

Transmission Cost Adjustor (TCA): APS operates under a FERC-regulated TCA mechanism which allows for the recovery of transmission investments outside of GRC proceedings based on a 10.75% ROE predicated on an equity layer of 57% and a rate base of $1.2 billion. Updates to the TCA are filed every April with the FERC and the TCA is subject to an annual true-up. Under the terms of APS' 2012 GRC, an adjustment to rates will be made annually each June 1 and will go into effect automatically unless suspended by the ACC. Effective June 1, 2013, APS' annual wholesale transmission rates increased by approximately $26 million for the next 12-month period.

CAPITAL EXPENDITURES

Large Capital Spending Program a Key Growth Driver: Fitch expects rate base growth of 6% to 7% through 2016 driven by average annual capital expenditures of $1.1 billion through the same time period. Capex is focused on generation, distribution and transmission investments and includes emissions control upgrades at APS' coal-fired generating facilities including investments associated with the installation of Selective Catalytic Reduction controls on units 4 and 5 at the Four Corners power plant and distribution reliability investments. Other investments include the construction of new transmission capacity, installation of advanced meters, and increased renewable generation, specifically under the AZ Sun program. APS is increasing its renewable generation capacity to meet renewable portfolio standard (RPS) targets in the state and is on track to double its 2015 RPS requirement of 5% of retail sales to be supplied by renewable energy resources. Regulatory mechanisms including the Power Supply Adjustor, Renewable Energy Surcharge, the Transmission Cost Adjustor, the Demand-Side Management Adjustor Charge, the Environmental Improvement Surcharge, and the Lost Fixed Cost Recovery mechanism allow for timely recovery of investments and provide for earnings growth outside of general rate proceedings.

Moderate increase in leverage expected: Going forward, due to the large capex program, Fitch expects APS to remain moderately free cash flow (FCF) negative and to fund the majority of forecasted capex internally and the balance with external financing. While Fitch anticipates external funding requirements to be financed via a balanced mix of equity and debt, Fitch expects modest regulatory lag to pressure credit metrics. Leverage, as measured by debt-to-EBITDAR, is expected to moderately increase to 3.0x by 2016.

Financial Flexibility

Good Liquidity: As of March 31, 2014, PNW had total consolidated liquidity available of $1.3 billion including $103 million of cash and cash equivalents. PNW maintains liquidity through a $200 million unsecured credit facility which matures in May 2019. APS maintains liquidity through two $500 million unsecured credit facilities which mature in May 2019 and April 2018, respectively. Additionally, PNW and APS can upsize their $200 million and $500 million credit facilities to $300 million and $700 million with consent of the lenders. Fitch notes that there were no direct borrowings against these facilities as of March 31, 2014. The credit facilities are subject to a maximum debt-to-capitalization covenant of 65% and as of March 31, 2014 both PNW and APS were in compliance with debt-to-capitalization ratios of 45% and 44%, respectively. APS' long-term debt maturities are sizable, with $1.2 billion scheduled to mature through 2016 as follows (includes capital lease obligations): $540 million in 2014, $345 million in 2015, and $358 million in 2016. Fitch expects APS to refinance these maturities on a timely basis.

Energy Efficiency (EE) Standard: In 2013, Arizona's energy efficiency standards required APS to achieve cumulative energy savings equal to 5% of its 2012 retail energy sales. APS is currently meeting its EE targets and is on track to reach its cumulative energy efficiency savings target of 9.5% by 2015. In January of 2011 the ACC enacted rules regarding energy efficiency that mandate a 22% annual energy savings requirement by 2020. The 22% figure represents the cumulative reduction in future energy usage through 2020 attributable to the energy efficiency initiatives.

Demand-Side Management Adjustor Charge (DSMAC): On March 11, 2014, the ACC issued an order approving APS's 2013 Demand Side Management Plan and approved a budget of $68.9 million for each of 2013 and 2014. On March 1, 2010, APS implemented a new DSMAC in order to recover energy efficiency expenses of demand-side management programs based on a concurrent basis. APS is required to submit an annual Energy Efficiency Implementation Plan for review and approval by the ACC and if approved, a 'demand-side management adjustor charge' is added to customer bills. On June 27, 2013, the ACC voted to open a new docket investigating whether the Electric Energy Efficiency Rules should be modified. The ACC held a series of three workshops in March and April 2014 to investigate methodologies used to determine cost effective energy efficiency programs, cost recovery mechanisms, incentives, and potential changes to the Electric Energy Efficiency and Resource Planning Rules. Currently, no changes to the EE targets or to the DSMAC have been made.

Rating Sensitivities

Future developments, individually or collectively, that could lead to a positive rating action include:

--Continued sales growth reflecting improving economic conditions in APS' service territory;

--Sustained Debt-to-EBITDAR leverage metrics under 3.3x;

-Continued constructive regulatory outcomes that address rate design over evolving issues of energy efficiency, demand-side management and net metering.

Future developments, individually or collectively, that could lead to a negative rating action include:

--Given the stay-out provision of APS' last GRC, greater than anticipated increases in operating and other expenses could erode credit quality.

--An unexpected, prolonged base load generating facility outage could also lead to adverse credit rating actions;

--Sustained Debt-to-EBITDAR leverage metrics over 3.75x.

Fitch has affirmed the following ratings and revised the Rating Outlooks to Positive from Stable:

Pinnacle West Capital Corp.:

--Long-term Issuer Default Rating (IDR) affirmed at 'BBB+';

--Short-term IDR affirmed at 'F2';

--Commercial paper affirmed at 'F2''.

Arizona Public Service Co. (APS):

--Long-term IDR affirmed at 'BBB+'';

--Short-term IDR affirmed at 'F2' ';

--Senior unsecured affirmed at 'A-';

--Commercial paper affirmed at 'F2'.

PVNGS II Funding Corp.

--Secured lease obligation bonds affirmed at 'A-'.

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', Aug. 5, 2013;

---'Parent and Subsidiary Rating Linkage', Aug. 5, 2013.

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

Parent and Subsidiary Rating Linkage Fitch's Approach to Rating Entities within a Corporate Group Structure

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=714476

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=832385

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.



Fitch Ratings

Primary Analyst

Daniel Neama

Associate Director

+1-212-908-0561

Fitch Ratings, Inc.

33 Whitehall Street

New York, NY 10004

or

Secondary Analyst

Philip W. Smyth, CFA

Senior Director

+1-212-908-0531

or

Committee Chairperson

Glen Grabelsky

Managing Director

+1-212-908-0577

or

Media Relations

Brian Bertsch, +1 212-908-0549

brian.bertsch@fitchratings.com

Source: Fitch Ratings


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