DBRS Downgrades Fortis Inc. to BBB (high) from A (low), Stable Trends

DBRS Limited (DBRS) has today downgraded the following ratings of Fortis Inc. (Fortis or the HoldCo) and removed them from Under Review with Negative Implications where they were placed on February 9, 2016:

-- Issuer Rating, downgraded to BBB (high), Stable trend, from A (low)
-- Unsecured Debentures, downgraded to BBB (high), Stable trend, from A (low)
-- Preferred Shares, downgraded to Pfd-3 (high), Stable trend, from Pfd-2 (low)

DBRS’s rating action largely reflects a significant increase in debt at the HoldCo’s level and incorporates the modest improvement of Fortis’s business risk profile following the completion of the acquisition of ITC Holdings Corp. (ITC) on October 14, 2016.

BACKGROUND
On February 9, 2016, Fortis announced that it agreed to acquire ITC for a total consideration of approximately USD 11.3 billion, including the assumption of approximately USD 4.6 billion of debt on closing (the Acquisition). Based on a then-preliminary review, DBRS viewed the Acquisition as modestly positive to Fortis’s business risk profile. As an electricity transmission company operating in eight states, ITC is fully regulated by the Federal Energy Regulatory Commission (FERC) and is allowed to earn above-average returns (over 11%) on investments based on a favourable equity component (60%) in the capital structure. DBRS notes that the allowed returns and capital structure are both higher than Fortis’s current portfolio of regulated utilities. ITC’s tariffs are also calculated under a forward-looking cost-of-service methodology with an annual true-up mechanism, resulting in no volume risk, and they provide ITC with stable and predictable earnings and cash flows. Additionally, the Acquisition will result in further geographic and regulatory diversification for Fortis. Please refer to DBRS’s press release dated February 9, 2016, for further details.

UPDATE
On October 14, 2016, Fortis announced that it has completed the Acquisition. The total consideration at the time of the closing was approximately USD 11.8 billion financed as follows:

-- Fortis issued approximately USD 3.6 billion in common shares in exchange for ITC shares.
-- GIC took on 19.9% non-controlling interest in ITC by contributing approximately USD 1.2 billion.
-- Fortis drew approximately $500 million from its Equity Bridge Facility (EBF). Fortis will issue approximately $500 million in post-close common equity in 2017, and the proceeds will be used to repay the EBF borrowings.
-- Debt assumed by Fortis amounts to approximately USD 4.6 billion, of which approximately USD 2.4 billion is at ITC holding company level.
-- Fortis owns 80.1% of ITC.

IMPACT ON FORTIS’S CREDIT PROFILE
Based on DBRS’s review of the Acquisition, DBRS maintains its initial view that the Acquisition modestly improves Fortis’s business risk profile, reflecting all of the above-mentioned factors. In addition, post-Acquisition FERC-transmission assets will account for approximately 29% of identifiable regulated assets (excluding goodwill). ITC will provide Fortis with good opportunities to grow its transmission assets over the next few years with a number of FERC-approved projects. Fortis’s consolidated capital expenditures are estimated to be $2.9 billion in 2017, which should provide a good growth in regulated rate base. Finally, the Acquisition will significantly increase the size and scale of Fortis’s operations and the diverse base cash flow to Fortis. Total pre-Acquisition assets increase from approximately $29 billion (94% regulated) to approximately $48 billion (96% regulated) post-Acquisition. Total pre-Acquisition consolidated regulated rate base, which excludes the Waneta Expansion, increases from approximately $16.5 billion at June 30, 2016, to approximately $25.2 billion post-Acquisition (pro forma for 2017).

From the financial risk perspective, DBRS believes that the financing of the Acquisition negatively affects Fortis’s financial profile. Based on DBRS’s pro forma, the impact on Fortis’s credit metrics is as follows:

Firstly, the Acquisition debt issued by Fortis is structurally subordinated to the debt at ITC and Fortis’s existing subsidiaries. Dividends paid by ITC’s subsidiaries will have to service the ITC debt before they can be distributed to Fortis (80.1%) and GIC (19.9%). The Acquisition debt is approximately $3.0 billion, accounting for approximately 53% of Fortis’s non-consolidated debt post-Acquisition (Acquisition debt includes approximately $500 million of EBF borrowings that are expected to be replaced with post-close common equity issue in 2017).

Secondly, based on DBRS pro forma for 2016, assuming the Acquisition occurred January 1, 2016, Fortis’s consolidated credit metrics modestly weaken as follows: The debt-to-capital increases to 58.9% following the Acquisition (57.8% without the Acquisition), and consolidated cash flow-to-debt ratio decreases to 11.1% following the Acquisition (13.8% without the Acquisition.

Finally, on a non-consolidated level, which is key to DBRS’s assessment of Fortis’s credit metrics (also assuming the acquisition occurred on January 1, 2016), Fortis’s non-consolidated pro forma credit metrics for 2016 are as follows: Fortis’s debt-to-capital increases to 29.4% following the Acquisition (23.6% without the Acquisition). This level is significantly higher than DBRS’s threshold of 20% for a holding company; cash flow-to-non-consolidated debt ratio decreases to 13.2% following the Acquisition (17.1% without the Acquisition); and cash flow-interest coverage declines to 4.06 times (x) following the Acquisition (4.52x without the Acquisition).

Based on DBRS’s rating approach to holding companies, DBRS recognizes that Fortis is a holding company of large, diverse and stable cash flow-generating regulated assets. This acts as a partial mitigation on the structural subordination issue. However, the incremental debt resulting from the Acquisition far outweighs the incremental cash flow to Fortis. Based on Fortis’s forecast, its non-consolidated metrics are expected to improve slightly in 2017 and 2018, but it will not be until 2019 that these metrics are expected to improve to the pre-Acquisition level. As a result, a one-notch downgrade is appropriate. The Stable trend reflects DBRS’s expectations as follows: (1) The post-close common equity of approximately $500 million will be issued in 2017, and the proceeds will be used to repay the EBF borrowings. (2) Non-consolidated metrics are expected to improve slightly over the next 24 months and further improve thereafter as ITC and other Fortis capital projects are completed and start generating cash flow. (3) During this period, all capital projects at regulated subsidiaries are expected to be self-financed with no further equity injection to be required from Fortis. The regulated rate base, which excludes the Waneta Expansion, is expected to increase to approximately $25.2 billion in 2017 (pro forma). As such, cash flow in the form of dividends to Fortis is expected to increase without additional debt expected to be issued at the HoldCo level. Combined with Fortis’s plan to slightly reduce its HoldCo debt, DBRS expects Fortis’s non-consolidated financial profile to strengthen over the medium term.

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 (October 2015), DBRS Criteria: Rating Holding Companies and Their Subsidiaries (January 2016) and DBRS Criteria: Preferred Share and Hybrid Security Criteria for Corporate Issuers (January 2016), which can be found on our website under Methodologies.