Fitch Rates Southern Company's Junior Sub Notes 'BBB'; Outlook Stable
The net proceeds from the issuance will be used to repay short-term debt that was incurred to fund the maturity of $500 million series 2011A senior notes on Sept. 1, 2016, and for other general corporate purposes, including investment by Southern Company in its subsidiaries.
The debentures are junior and subordinated in right of payment and upon liquidation to all of Southern Company's senior indebtedness. Southern Company may defer interest payments on the debentures on one or more occasions for up to 10 consecutive years per deferral period.
The securities are eligible for 50% equity credit under Fitch's applicable criteria 'Treatment and Notching of Hybrids in Nonfinancial Corporate and REIT Credit Analysis' dated Feb. 29, 2016. Features supporting the equity categorization of these debentures include their junior subordinate priority, the option to defer interest payments on a cumulative basis for up to 10 years on each occasion and a 60-year maturity.
KEY RATING DRIVERS
Meaningful Increase in Leverage: The acquisition of Southern Company Gas Inc. (GAS; IDR 'BBB+'/Outlook Stable) has resulted in a meaningful increase in Southern Company's consolidated leverage. This will cause the consolidated funds from operations (FFO) adjusted leverage and FFO fixed charge coverage of the company to meaningfully weaken in the short-t - medium term. Fitch forecasts pro forma adjusted FFO leverage to jump to 5.1x in 2017 and gradually improve to 4.7x by 2019. Pro forma FFO fixed charge coverage is expected to be in the 4.5x-5.0x range over 2016-2019. Fitch would like to see the FFO adjusted leverage improve and sustain below the 4.5x level before considering any upward migration of ratings.
Improved Business Profile: The acquisition of GAS significantly improves Southern Company's risk profile, in Fitch's view. Fitch generally views gas distribution businesses as low risk and GAS' utilities are generally well managed with numerous supportive regulatory mechanisms in place. GAS' rising investments in inter-state pipelines carry moderately higher competitive market risks, but these are offset to a large extent by long-term offtake agreements with creditworthy counterparties. While the non-regulated retail and wholesale businesses of GAS are volatile, the exposure is somewhat contained given these will be a small part of the combined company.
GAS recently closed on its acquisition of a 50% equity interest in Southern Natural Gas Company (SNG; 'BBB+'/Outlook Stable) from Kinder Morgan, Inc. (KMI; 'BBB-'/Outlook Stable) for approximately $1.4 billion. Fitch views GAS' investment in SNG as part of a continued strategic effort to expand its existing natural gas pipeline investments. The SNG system fits strategically with GAS' distribution service territories and the locations of Southern Company's gas-fired generating plants. SNG's revenue and cash flow profile is supported by long-term capacity reservation contracts with primarily investment grade counterparties.
Southern Company gains tremendous scale and geographic diversity with this acquisition and its inaugural pursuit of natural gas businesses can smooth out earnings and cash flow of its predominantly summer-peaking electric utilities. The combination also lowers the contribution of its non-regulated, albeit conservatively managed, Southern Power Company in the overall business mix as well as that of Mississippi Power Company, which is undergoing significant stress related to the construction cost overrun for the Kemper IGCC project.
Execution Risk of Two Large Construction Projects: Fitch's rating concerns for Southern Company include significant construction and regulatory risks associated with the two large baseload projects under construction, namely the 2,200 MW Vogtle nuclear units 3 and 4 at Georgia Power Company and the 580 megawatt (MW) Kemper IGCC plant at Mississippi Power. The risks related to Vogtle 3 and 4 nuclear units have abated somewhat with the October resolution of the pending litigation between Vogtle owners and the EPC contractors, changes in the EPC agreement, and the contractor changes. The modified EPC agreement confirmed the in-service dates as June 30, 2019 for Unit 3 and June 30, 2020 for Unit 4. Ongoing proceedings with the Georgia Public Service Commission (GPSC) staff could result in a favorable outcome that provides more certainty regarding the recovery of costs currently not included in the existing $6.1 billion cost certification and would be credit positive.
The construction costs and expected commercial operations date (COD) for the Kemper IGCC plant continue to show modest escalation as the project enters its critical start-up phase. While the 3-0 PSC vote on the $126 million permanent rate increase order in December 2015 for the in-service portion of the Kemper plant is encouraging, significant regulatory uncertainties remain for the recovery of the remainder of the project costs in rates. We believe the plant may need to demonstrate a successful start-up and sustained operating performance before Mississippi Power can file for the next rate proceeding.
Significant Growth at Southern Power: Fitch views Southern Power's fast-growing renewable business as neutral to ratings at this time. The extension of bonus depreciation and federal subsidies for wind and solar projects and a strong interest from both utility and non-traditional offtakers is expected to result in a significant growth of renewable power generation in the U. S. Southern Power has made several project acquisitions in recent months and is on target to invest approximately $4.5 billion in 2016. Long-term contracts with creditworthy counterparties, a balanced mix of debt and equity to finance the growth capex and management's current intent to limit the earnings contribution from Southern Power to approximately 10% of the combined entity mitigate any rating pressure at this time.
Fitch's key assumptions within our rating case are as follows:
--At Alabama Power Company, modest increases in Rate Stabilization & Equalization (RSE) rates over 2016-2018; no increases under CNP C (environmental) rates over 2016-2018; and 0.5% increase in electricity sales over 2016-2018.
--At Georgia Power, 1% increase in electricity sales over 2016-2018; $140 million rate increase effective Jan. 1, 2016; Nuclear Construction Cost Recovery (NCCR) tariff increases of 0.5%-1% over 2016-2018; and Vogtle 3 & 4 units in-service in 2019 and 2020.
--At Gulf Power Company, sales growth of 0.5% in 2016 and 1% in 2017 and 2018 and rate increases per the last rate order.
--At Mississippi Power, ROE of 9.87% for 2016-2018, 9.2% for Kemper rates from 2016-2020; 100% ownership of Kemper IGCC with 85% recovered through regulated rates; securitization of $1 billion in the second half of 2017 (2H17); Kemper IGCC COD by October 2016 and additional Kemper rates before the end of 2017; modest Performance Evaluation Plan (PEP) and Environmental Compliance Overview (ECO) rate increase over 2016-2018; and 1% electricity sales growth over 2016-2018.
At Southern Power, growth projects as announced, funding of growth capex at approximately 55% debt and 2016-2018 FFO ratios include ITCs for the solar projects during construction.
At Southern Company, no material retention of synergies from the GAS acquisition and future capital needs funded in a balanced manner.
Positive: Future developments that may, individually or collectively, lead to a positive rating action include:
--Enhanced pace of deleveraging such that FFO adjusted leverage sustains at or below 4x;
--Commercial operations at Kemper without any further material escalation in capital costs followed by satisfactory operational performance;
--No material cost and/or schedule escalation for Vogtle units and any adjustments to the overall project costs deemed recoverable by the Georgia PSC.
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
--Significant time/cost overrun at the Vogtle and/or Kemper projects that are primarily debt financed and negative regulatory actions on the recovery of those costs;
--Primarily debt-financed growth strategy at Southern Power;
--Failure to bring down the FFO adjusted leverage to below 4.7x by 2019.
At June 30, 2016, Southern Company and its subsidiaries had approximately $1.9 billion of cash and cash equivalents and approximately $8.0 billion of restricted cash, which was subsequently used to complete the acquisition of GAS. In addition, Southern Company had approximately $6.4 billion of unused committed credit arrangements with banks. This excludes credit arrangements at GAS since the acquisition was not completed as of June 30. A portion of unused credit with banks is allocated to provide liquidity support to the utility subsidiaries' variable rate pollution control bonds and CP programs. The amount of variable rate pollution control revenue bonds outstanding requiring liquidity support as of June 30, 2016 was approximately $1.9 billion. Approximately $478 million of CP borrowings and $125 million of short-term debt was outstanding as of June 30, 2016.