DBRS Places Issuer Rating and Debt Ratings of Hydro One Inc. Ratings Under Review with Developing Implications and Commercial Paper Ratings Under Review with Negative Implications

DBRS Limited (DBRS) has today placed the Issuer Rating and the Senior Unsecured Debentures rating of Hydro One Inc. (HOI or the Company) Under Review with Developing Implications and has placed HOI’s Commercial Paper (CP) Rating Under Review with Negative Implications. These rating actions follow the announcement today by HOI that Hydro One Limited (HOL) (collectively Hydro One) has filed a preliminary prospectus (the Prospectus) with the Ontario Securities Commission for the initial public offering (IPO) of common shares of the newly created HOL being offered by the Province of Ontario (the Province, rated AA (low by DBRS).

DBRS has reviewed the Prospectus and notes that certain pre-closing transactions involving the capital structure of HOI will occur prior to the closing of the IPO. These will include (1) the acquisition of HOI by HOL; (2) the recapitalization of HOI’s regulated subsidiary, Hydro One Networks Inc., to reach and maintain its regulated capital structure at 60.0% of Rate Base (55.5% at June 30, 2015) through incremental borrowing; and the use of the proceeds to pay a one-time special dividend of $1.0 billion to the Province. HOI will also enter into a new credit agreement in order to provide for a new three-year senior unsecured revolving term credit facility in the amount of $800 million and will increase the authorized amount of short-term notes that it can issue under its commercial paper program from $1.0 billion to $1.5 billion. As HOI is expected to be less than 90% owned by the Province after the IPO, it will cease to be exempt from regular federal and Ontario income tax, and will be deemed, for purposes of the Income Tax Act (Canada), to have disposed of its assets at fair market value (FMV) at the time of the IPO. Consequently, HOI and its subsidiaries are expected to pay a $2.6 billion departure tax to the Ontario Electricity Financial Corporation. Prior to the completion of the IPO, the Province, as shareholder, will subscribe for additional common shares of HOI for an aggregate subscription price of $2.6 billion, which will be used to pay the applicable departure tax.

IMPACT ON COMPANY’S BUSINESS RISK PROFILE

Assuming no material changes to the preliminary prospectus as filed and the current regulatory regime, DBRS expects that there will be minimal impact on the business risk profile of HOI’s regulated utility business resulting from the IPO. HOI’s low business risk profile continues to be supported by a reasonable regulatory framework in Ontario and by operations in an extensive franchise area with a steady growth in customers. The Company operates approximately 97% of the Province’s electricity transmission network, connected to 46 local distribution companies and 90 transmission connected companies, and serves approximately five million customers. The Company’s regulated transmission and distribution businesses in Ontario account for substantially all its earnings. Furthermore, HOI’s transmission and distribution businesses (approximately, 63% and 37% of last 12 months to June 30, 2015 EBIT, respectively) operate under a cost of service framework, which provides certainty for recovery of operating and capital costs as it reduces regulatory lag and forecasting risk.

IMPACT ON COMPANY’S FINANCIAL PROFILE

From a financial risk perspective, DBRS expects a mix of factors to weaken the Company’s financial profile. Firstly, HOI intends to increase borrowing in order to reach its regulatory capital structure at 60% of Rate Base. Secondly, HOI intends to use the additional borrowings to pay a one-time special dividend of $1.0 billion to the Province, and going forward, DBRS expects HOI to support HOL’s dividend policy, to pay approximately 70% to 80% of the latter’s consolidated net income as dividends, to the extent that such dividend payouts maintain HOI’s regulatory capital structure. Consequently, compared with the past when the Company benefited from dividend flexibility under provincial ownership, DBRS expects HOI to pay a higher portion of its earnings as dividends. For the past five years, HOI has maintained its debt-to-capital at around 55.0%, (52.9% at June 30, 2015). Going forward, DBRS expects debt-to-capital to remain at or near the 60% level. Thirdly, HOI is currently in the midst of an aggressive build-out program that will continue over the next several years. Capex is expected to be approximately $1.6 billion for 2015 ($766 million spent at June 30, 2015) with a plan for $1.625 billion in 2016 and $1.575 billion in 2017. DBRS expects the Company to continue generating free cash flow deficits over the medium term, resulting from the high capex and higher dividends, which will cause the Company to have a greater reliance on borrowings. Although post-IPO, HOI will have indirect access to equity markets through its parent HOL, higher borrowings will pressure the Company’s balance sheet and coverage ratios.

DBRS believes that placing the Issuer Rating and the Senior Unsecured Debentures rating of HOI Under Review with Developing Implications is the appropriate rating action at this time, as there is minimal impact on HOI’s business risk profile, which is expected to mitigate the weaker financial risk metrics. However, as per the DBRS Criteria: Commercial Paper Liquidity Support for Non-Bank Issuers, the existing CP rating of R-1 (middle) is an exception for an A (high) rating. Based on the criteria CP issuers that otherwise qualify for R-1 (middle) or R-1 (high) ratings may have as low as 75% CP liquidity backup availability in place (which must be in the form of bank lines), provided that the CP issuer benefits from (1) exceptional balance sheet liquidity (well in excess of the authorized limit of the CP program); (2) high and stable cash flow; (3) very low debt levels; (4) a low level of dependence on short-term debt; (5) a well-dispersed long-term debt maturity schedule; and/or (6) other factors DBRS may deem to be relevant. Going forward, HOI plans to maintain higher debt levels (up to 60% of Rate Base) and have a greater reliance on short-term borrowings to fund its recapitalization, including the one-time special dividend payment to the Province. HOI will therefore likely fail to meet the requirements of the criteria for a rating exception to R-1 (middle), as conditions (3) and (4) are not met, and this could potentially result in a one-notch downgrade. DBRS has therefore placed the HOI’s Commercial Paper rating Under Review with Negative Implications.

DBRS expects to resolve this rating action after the close of the IPO based on further analysis and review of final prospectus and related agreements as they become available.

Notes:
All figures are in Canadian dollars unless otherwise noted.

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

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

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