DBRS Downgrades Long-Term Debt Ratings of Toronto Hydro to “A,” Stable Trend; Confirms Toronto Hydro’s Commercial Paper Rating

DBRS Limited (DBRS) has today downgraded Toronto Hydro Corporation’s (THC or the Company) Issuer Rating and Senior Unsecured Debentures & MTNs ratings to “A” from A (high) and confirmed the Commercial Paper rating at R-1 (low). All ratings are issued with a Stable trend.

DBRS had previously viewed THC’s leverage rising above the regulatory capital structure (60% debt: 40% equity) as being high for the A (high) rating and that it could potentially trigger a negative rating action (see DBRS report dated May 13, 2014). The ratings downgrade reflects the Company’s relatively high leverage (DBRS adjusted total debt-to-capital 61.2% for 2014; 57.6% for 2013) and weaker cash flow coverage (cash flow-to-DBRS adjusted total debt 13.7% for 2014; 18.2% for 2013) that has resulted largely from the significant capital expenditures incurred by THC to replace its aging electricity infrastructure. THC’s large capital expenditure program ($2.5 billion over the next five years) is expected to result in free cash flow deficits that are likely to be financed with debt, as THC has limited access to equity markets, and continue to pressure the Company’s balance sheet. In the absence of any near-term catalyst to meaningfully reduce leverage and improve cash flows, DBRS views the Company’s leverage, which is expected to rise and remain above the regulatory capital structure in the medium term, and weaker cash flow metrics to be inconsistent with the A (high) rating.

On July 31, 2014, THC filed a rate application with the Ontario Energy Board (OEB) under the new custom incentive regulation (CIR) framework seeking approval of the Company’s revenue requirement and the $2.5 billion capital expenditure budget for a five-year period (2015–2019). OEB’s decision on the application is expected over the next few months. DBRS notes that THC’s planned capital expenditure is largely sustaining in nature and relates to replacing aging infrastructure to strengthen the electricity grid and help improve reliability. As per THC’s rate application, following the rebasing in 2015, distribution rates for the five-year period are adjusted annually by a custom price cap index (PCI), which includes inflation, productivity and stretch factors set by the OEB. In order to reflect its significantly large, multi-year capital expenditure commitments, THC has proposed that a capital factor be added to the PCI to enable THC to recover its capital costs and earn a reasonable return during the CIR period. Considering that THC’s operating costs are also assumed to rise at least by PCI in the rate application, overall earnings growth and operating cash flows for the five-year CIR period are not expected to improve significantly enough to keep pace with the Company’s ongoing capital expenditure needs. Furthermore, given that the CIR is new and the forecasting period is five years (compared with three years under the earlier framework), THC’s cash flow could be affected if the Company is unable to recover large unforeseen discrepancies between forecasts and actual capex and operating expenses in a timely manner.

THC’s low business risk profile continues to be supported by a reasonable regulatory environment in Ontario and stable earnings from regulated business, accounting for virtually all of the Company’s earnings and cash flows. The Company operates in a strong franchise area and serves a largely retail and commercial customer base that is growing at a steady rate. However, financial metrics have weakened from historic levels and are expected to remain weak, as significant capital expenditures are needed to service a growing customer base and to replace the Company’s aging electricity infrastructure. THC’s heavy capital expenditure cycle is likely to continue beyond the CIR application period (2015–2019), as aging underground and overhead infrastructure replacements are expected to continue. Going forward, DBRS expects the Company to manage its balance sheet prudently by curtailing its capital expenditures and dividends in order to maintain its financial profile in line with the “A” rating. DBRS could take further negative rating action should the Company’s leverage and cash flow metrics continue to deteriorate to a level that is no longer commensurate with the “A” rating.

Notes
All figures are in Canadian dollars unless otherwise noted.

The applicable methodologies are Rating Companies in the Regulated Electric, Natural Gas and Water Utilities Industry and DBRS Criteria: Commercial Paper Liquidity Support for Corporate Non-Bank Issuers, which can be found on our website under Methodologies.

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