DBRS Places Fortis Inc. Under Review – Developing Following UNS Energy Corporation Acquisition Announcement

DBRS has today placed the A (low) Issuer Rating, A (low) Unsecured Debentures and Pfd-2 (low) Preferred Shares ratings of Fortis Inc. (Fortis or the Company) Under Review with Developing Implications. This action follows the announcement that the Company has agreed to acquire UNS Energy Corporation (UNS) for a total consideration of approximately $4.3 billion, including the assumption of $1.8 billion of debt on closing (the Acquisition). The rating action reflects DBRS’s view that the proposed Acquisition would have a modestly negative impact on Fortis’ business risk profile while the impact on the financial risk profile is uncertain since the financing plan has not been finalized. The purchase price represents an approximate 31% premium above the most recent closing price of UNS. The Acquisition is expected to close by the end of 2014 and is subject to UNS shareholder approval, as well as various regulatory approvals.

UNS is a vertically integrated utility services holding company with three subsidiaries in the regulated electric transmission, distribution and generation and gas distribution businesses, primarily in the State of Arizona: (1) Tucson Electric Power (TEP), a regulated utility in southeastern Arizona that generates, transmits and distributes electricity to approximately 412,000 retail electric customers. TEP accounted for 85% of UNS’s consolidated net income and 84% of its assets for the nine months ended September 30, 2013 (9M2013); (2) UNS Electric, Inc. (UNS Electric), a regulated electric utility that serves approximately 93,000 retail electric customers in northern Arizona’s Mohave and Santa Cruz counties. UNS Electric accounted for 10% of UNS’s consolidated net income and 9% of its assets for the 9M2013; and (3) UNS Gas, Inc. (UNS Gas), a gas distribution company that serves approximately 149,000 retail gas customers in northern and southeastern Arizona. UNS Gas accounted for 5% of UNS’s consolidated net income and 7% of its assets for the 9M2013. UNS’s total assets were $4.3 billion as of September 30, 2013 (EBITDA not revenues). Pro forma the Acquisition (i.e., post-acquisition), DBRS estimates that UNS will account for 25% of Fortis’ total assets and 24% of Fortis’ total net income. The Acquisition is expected to be accretive to earnings in the first full year after closing, excluding one-time Acquisition-related costs.

In reviewing Fortis’ rating in light of the proposed Acquisition, DBRS’s analysis is focused on (1) the impact of the Acquisition on the business risk profile of Fortis, and (2) the financial impact of the transaction on the Company’s financial profile.

(1) BUSINESS RISK PROFILE – MODESTLY NEGATIVE IMPACT
Based on a preliminary review, DBRS views the proposed Acquisition as modestly negative with respect to Fortis’ business risk profile. Currently, approximately 90% of Fortis’ consolidated earnings are contributed by its regulated businesses (gas and electric transmission, distribution, generation and storage), with the remaining earnings coming from hotel properties and non-regulated generation. With the proposed Acquisition, Fortis’ earnings mix is expected to improve, with a larger percentage of earnings generated from regulated businesses, since all of UNS’s operations are regulated. However, the regulatory regime in Arizona is viewed as weaker when compared to other jurisdictions in Canada where Fortis currently conducts its business. Although regulation has recently improved with UNS now having no exposure to fuel, purchased power and environmental compliance costs as they are fully passed through to customers, DBRS remains concerned about the timing of the operating and capital costs recovery. DBRS stresses that any material adverse change in regulation that could materially increase regulatory or business risk (i.e., exposure to commodity prices, lengthy regulatory review process on cost recovery or strict ring-fencing) could result in negative rating implications for Fortis.

(2) FINANCIAL RISK PROFILE – UNCERTAIN
The focus of DBRS’s analysis is on Fortis’ non-consolidated capital structure (parent level) and cash flow from the subsidiaries to the parent to service the parent’s debt and corporate expenses. On a non-consolidated basis, the cash flow-to-interest expense ratio was strong at 9.17 times in 9M2013, while debt-to-capital was approximately 21%. DBRS notes that the non-consolidated leverage of 21% is slightly above the acceptable range for a holding company with respect to DBRS’s one-notch criteria. However, this increase is expected to be temporary and the leverage will fall in-line with the current rating category following the completion of the Waneta project.

Currently, it is uncertain as to how Fortis plans to finance the proposed Acquisition. As a result, DBRS has placed the ratings of Fortis Under Review with Developing Implications. DBRS will further review the Company’s financing plan when it is finalized. Upon final review, if the Company finances the proposed Acquisition or any cost overruns of its current projects in such a way that its non-consolidated debt-to-capital structure is significantly above 20% and its other non-consolidated credit metrics deteriorate significantly without corrective action within a reasonable time frame, then negative rating action is likely to occur.

Notes:
All figures are in U.S. dollars unless otherwise noted.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodology is Rating Companies in the North American Energy Utilities (Electric and Natural Gas) Industry, which can be found on the DBRS website under Methodologies.