Moody's Investors Service has downgraded to Ba3 from Ba2 the rating on the Puerto Rico Electric Power Authority's (PREPA) approximately $8.8 billion of outstanding power revenue bonds.
The rating remains under review for possible further downgrade.
The rating action considers Moody's concerns about increasingly tight liquidity. Even if PREPA is able to address its immediate liquidity issues, the company faces continuing challenges over the next several years.
These challenges include negative free cash flow, very high electricity rates accompanied by high rates of non-payment and growing receivables balances, and perceived constraints on raising revenues to fund a sizeable capital spending program needed to convert electricity generation from high cost oil to lower cost natural gas.
Immediate liquidity concerns include the near-term maturity of large bank borrowings. Outstandings under the company's two principal bank lines total about $671 million and mature in July and August 2014. The rating action also reflects uncertainty surrounding the Government Development Bank of Puerto Rico's (GDB; Ba2 Neg) willingness and ability to support PREPA's liquidity, in the event that the lines are not extended.
The rating action further considers the signing into law on May 27, 2014, of the Energy Transformation and Relief Act, (the Relief Act). Among other things, the Relief Act establishes an Energy Commission to oversee PREPA and the electric rates it can charge customers, introducing a further level of oversight that may lead to delays if PREPA needs to raise rates.
Overall liquidity levels remain highly constrained, as the enterprise runs operating deficits and in recent years has relied on credit facilities and new borrowings to fund operations. The line with Citibank for $250 million expired on January 10, 2014. There is currently about $146 million in outstanding advances under this facility that mature during July and August 2014.
The line with Scotia Bank for $550 million expires on August 14, 2014; there is currently about $525 million outstanding. PREPA is currently in negotiations with the banks to extend these lines, but the likelihood of extension and terms for ongoing credit are uncertain at this stage, according to Moody's.
There is also a $100 million line of credit with the GDB, which matures on December 31, 2014, with about $41.3 million currently outstanding. Although the line is intended primarily to provide collateral for a basis swap, the line does reflect historical liquidity support from the GDB. If the commercial banks do not extend their lines, and they demand repayment, PREPA will not be able to repay the advances from its own available funds.
While Moody's believes it is likely that the commonwealth and/or GDB will find a way to support PREPA, it is not certain that support would be provided in a way that avoids an eventual debt restructuring. There could be other demands on GDB's liquidity to fund operations of the commonwealth or from other public entities in Puerto Rico that could limit GDB's ability to support PREPA even if it is willing to do so, particularly given the continued economic and demographic stress facing the island.
Moody's notes recent reports that the governor of Puerto Rico has introduced a bill to the legislature entitled Debt Enforcement and Recovery of Public Corporations Act (Recovery Act). The proposed Recovery Act has not yet been approved by the legislature and signed into law and the full details are not known at this stage, but Moody's understands that it will provide a legislative framework for certain public corporations, which appear to include PREPA, to overcome their financial obstacles through an orderly, statutory process. This suggests the possibility of a restructuring of some kind.
Moody's also understands that the formation of a new Energy Commission under the Relief Act will review and approve PREPA's rates, including the ability to change a fuel purchase adjustment. PREPA is the monopoly provider of electricity on the island of Puerto Rico, and PREPA's board has historically had full authority to set electricity rates necessary to meet its bond covenant.
PREPA's debt covenants dictate that rates must be set so that they will be sufficient to pay expenses and meet debt service by at least 1.2x, according to the bond indenture calculation. However, Moody's calculation of debt service coverage by net revenues (after adjusting for contributions in lieu of taxes) is below 1.0x for fiscal 2013, indicating the enterprise runs operating deficits and relies on external funds to pay for operations and debt service. PREPA has also been able automatically to pass through to customers higher fuel and energy costs, an important consideration, given the utility's reliance on fuel oil generation to meet native load. While the impact of this new Relief Act on PREPA is not known at this stage, it does appear that the new Energy Commission introduces a further level of oversight and potential delay that could affect the level and timeliness of cost recovery. Moody's views as negative to credit quality any actions that would reduce PREPA's historical rate setting capability.
Moody's notes that the Ba3 rating on PREPA is now lower than the Ba2 rating on the GDB and the Commonwealth's general obligation bonds as well as other public corporations on the island. This differentiation and de-linking is warranted given the limited ability of GDB and the commonwealth to support PREPA, its significant debt burden, the level of capital spending requirements for the fuel diversification plan and highly constrained liquidity. At the Ba3 ratings level, Moody's incorporates an expectation of support, although the ability and/or willingness of GDB and the commonwealth to provide that support may have diminished.
During the review period, Moody's said it will focus on: review of PREPA's proposed 2014-15 budget and multi-year forecast, which is expected sometime in mid-July; PREPA's ongoing liquidity position, including the likelihood of renewal of the bank lines; the ability and willingness of the GDB and/or the commonwealth to support PREPA's liquidity; the potential impact to PREPA's credit quality from the implementation of the new Relief Act on PREPA's independent rate setting authority; and progress made on the execution of the long-term strategic plan to convert high cost, oil-based power generation to lower cost natural gas, which is PREPA's principal strategy to control rates and to help spur economic growth on the island.
What Could Make the Rating Go Up
Given the fact that PREPA's rating is under review for possible downgrade, it is unlikely that the rating would go up. However, the rating could be confirmed at the Ba3 level if Moody's views the potential outcome of the items listed above as being credit neutral, especially as it relates to PREPA's liquidity, which would include the renewal of the bank lines and likelihood of continued support from the GDB.
What Could Make the Rating Go Down
A downgrade, including the possibility of a multi-notch downgrade, would be increasingly likely if there were continuing weakening of PREPA's liquidity, including a failure to renew or extend the bank lines, or if the GDB failed to provide support.
The ratings could be downgraded if Moody's perceives a significant likelihood that improving PREPA's liquidity, financial profile and long-term sustainability involves some form of debt restructuring. This could include the enactment of the proposed new Recovery Act, especially if Moody's viewed it as a prelude to some form of distressed restructuring.
In addition, there could be downward rating pressure if the new Relief Act resulted in a diminishment of PREPA's rate setting authority, if PREPA failed to make progress on the execution of its fuel diversification and cost reduction strategy, or if there were a negative rating action on the commonwealth.
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