News Column

Fitch Rates APS' $250MM Sr. Unsecured Notes 'A-'; Outlook Positive

June 11, 2014

NEW YORK--(BUSINESS WIRE)-- Fitch Ratings has assigned an 'A-' rating to Arizona Public Service Company's (APS) issuance of $250 million 3.35% coupon senior unsecured notes, due June 15, 2024. The senior unsecured notes rank pari passu with existing senior unsecured debt. Proceeds will be used to repay a portion of APS' $300 million of 5.8% senior notes scheduled to mature June 30, 2014. The Rating Outlook for APS is Positive.

KEY RATING DRIVERS

--Strong credit metrics;

--Improving customer growth;

--Relatively low leverage;

--Balanced regulatory environment;

--Large capex.

Positive Rating Outlook: APS' Positive Outlook reflects customer growth, an improving service territory economy and strong projected credit metrics. The rating also considers APS' solid liquidity position, manageable debt maturities, low leverage, and financial support from its corporate parent, Pinnacle West Capital Corporation (PNW; Issuer Default Rating (IDR) 'BBB+'; Rating Outlook Positive by Fitch).

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 and leverage metrics to approximate 6.0x and 3.0x, respectively, through 2016. Funds from operations (FFO) metrics are expected to be pressured moderately in the intermediate term due to planned pension payments totaling $275 million over the next three years. However, FFO coverage metrics are expected to remain over 5.0x through 2016.

Higher Customer Growth: Going forward, Fitch expects customer growth to average about 2% per year through 2016, reflecting improving economic conditions in Arizona including lower unemployment and rising housing starts and new household formations. As economic conditions improve in Arizona, APS' customer growth appears to be accelerating, approximating 1.3% for the three-month period ended March 31, 2014, which compares to average annual customer growth of 0.6% during 2009 - 2011.

Positive Sales Trend: Going forward, Fitch expects that total weather normalized retail electricity sales will resume a positive growth trend, increasing on average about 0.5% to 0.75% per year through 2016 as a result of customer growth partially offset by energy efficiency and distributed generation. 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: Cost shifting issues associated with net metering remains a concern for investors, in Fitch's opinion. In Dec. 2013, the Arizona Corporation Commission (ACC) instituted a charge on roof-top solar installations after Dec. 31, 2013 of $0.70 per kilowatt effective Jan. 1, 2014. In Fitch's view, the ACC, in adopting the fixed charge for residential- rooftop solar customers, recognizes cost shifting associated with the current net metering program in Arizona and has taken a constructive initial step toward addressing the issue.

The fixed charge will remain in effect through completion of APS' next general rate case (GRC), is revenue neutral and will be credited to the lost fixed-cost recovery (LFCR) rider. The ACC began a series of workshops to evaluate the role of rate design regarding distributed generation, to continue discussions on cost allocation 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.

GRC Settlement: Per the terms of the commission-approved settlement in APS' last general rate case (GRC), 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 remain crucial 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%.

Large Cap Ex: Fitch expects average annual capital expenditures of $1.1 billion at APS through 2016. Capex is focused on generation, distribution and transmission investments and includes emissions control upgrades at APS' coal-fired generating facilities, new transmission capacity, installation of advanced meters, and 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 in 2015.

AZ Regulatory Compact: GRC orders have been more balanced for APS in the past several years and more timely adjudication of rate filings is a constructive development from an investor point-of-view in that has enabled the utility to improve its earned returns. Regulators have adopted several regulatory mechanisms to facilitate cost recovery outside of GRCs. Such cost recovery mechanisms include the power supply adjustor, renewable energy surcharge, transmission cost adjustor, demand-side management adjustor charge, the environmental improvement surcharge, and the lost fixed cost recovery mechanism.

Moderate Leverage Increase: Due to its large capex program, Fitch expects APS to remain moderately free cash flow (FCF) negative going forward and expects the utility to fund the majority of forecasted capex internally. The balance is expected to be funded with a balanced mix of equity and debt, Fitch expects modest regulatory lag to pressure credit metrics, with leverage as measured by debt-to-EBITDAR estimated to weaken moderately to 3.0x by 2016.

Financial Flexibility

Solid 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.

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 credit supportive regulatory outcomes in future GRCs

--Constructive resolution of rate design issues associated with distributed generation and energy efficiency.

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

--Deterioration in the regulatory compact in Arizona.

--Given the stay-out provision of APS' last GRC, higher than expected operating and other costs 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.


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);

--'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=834158

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, New York, +1-212-908-0549

brian.bertsch@fitchratings.com

Source: Fitch Ratings


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