Credit Opinion: Duke Energy Int'l Geracão Paranapanema S.A.Global Credit Research - 28 Apr 2015
Category Moody's Rating
Issuer Rating -Dom Curr Baa3
Senior Unsecured -Dom Curr Baa3 NSR Senior Unsecured -Dom Curr Aaa.br NSR LT Issuer Rating -Dom Curr Aaa.br Parent: Duke Energy Corporation
Issuer Rating A3
Sr Unsec Bank Credit Facility A3
Senior Unsecured A3
Jr Subordinate Baa1
Commercial Paper P-2
Jose Soares/Sao Paulo 55.11.3043.7300 Alexandre De Almeida Leite/Sao
William L. Hess/New York City 1.212.553.1653
Duke Energy Int'l Geracão Paranapanema S.A.
12/31/2014 12/31/2013 12/31/2012 12/31/2011 12/31/2010
(CFO Pre-W/C + Interest) / Interest 5.4x 8.3x 7.0x 7.1x 6.1x
(CFO Pre-W/C) / Debt 46.9% 60.5% 62.2% 65.5% 55.1%
RCF / Debt 6.5% 28.4% 19.7% 30.4% 30.6%
 All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non-Financial Corporations. Source: Moody's Non-Financial Metrics
Note: For definitions of Moody's most common ratio terms please see the accompanying User's Guide.
- Hydrological Risk
- Competitive costs and predictable cash flow based on medium-term energy supply contracts - High dividend pay-out ratio and capital splits
- Risks associated with the contractual obligation to increase installed generation capacity by 15%
Duke Energy International, Geracao Paranapanema S.A (Duke) is an electricity generation company controlled by Duke Energy Corporation (A3 Stable), which indirectly holds 99% of its voting capital and 94.8% of total capital. The company has installed capacity of 2,241 MW (1,085.6MW of physical energy) in eight hydroelectric power plants along the Paranapanema River, which represents approximately 1.7% of Brazil's current total installed capacity. In 2014, Duke reported net sales of BRL1, 223 million ($519.3million) and net profit of BRL285.6 million ($121.3 million).
On November 7, 2014, Duke executed a BRL500 million capital split approved by the regulator ANEEL, its shareholders and debenture holders.
On October 7, 2014, Duke requested the regulator ANEEL to approve the acquisition of the controlling capital of DEB - Pequenas Centrais Elétricas Ltda, which is currently controlled by Duke's shareholder Duke Energy International Brasil Ltda.
On April 10, 2014, Moody's America Latina Ltda (Moody's) assigned a Baa3 rating on the global scale and a Aaa.br local currency rating on the Brazilian national scale to BRL479 million senior unsecured debentures that Duke issued in the local market. Duke issued the debentures in two series through a book-building process as follows: The first series amounted to BRL239 million and were indexed to the DI (interbank deposit ) with a tenor of five years and payment of principal in three consecutive annual installments starting in the third year after the issuance date. The second series amounted to BRL240 million and were indexed to the NTN-B ( Consumer Price Index linked notes) with a tenor of seven years and payment of principal in three consecutive annual installments starting in the fifth year after the issuance date.
On June 10, 2013, Moody's America Latina Ltda (Moody's) assigned a Baa3 rating on the global scale and a Aaa.br on the national Brazilian scale to the BRL 500 million in unsecured amortizing debentures that Duke issued in the local market. At the same time, Moody's affirmed Duke's Baa3 issuer rating on the global scale and
upgraded to Aaa.br from Aa1.br Duke's issuer rating on the Brazilian national scale. Moody's also upgraded to Aaa.br from Aa1.br the ratings of the following debentures on the Brazilian National Scale: BRL 186 million (principal and interest) expiring in September 2013 and September 2015
BRL 152 million (principal and interest) expiring in January 2017
On August 10, 2012, Duke executed a BRL300 million capital split as approved by the regulator ANEEL on January 13, 2012 and its shareholders on May 21, 2012. Duke's existing debenture holders formally agreed with the capital split.
SUMMARY RATING RATIONALE
The Baa3 and Aaa.br issuer ratings reflect Duke's strong credit metrics as well as its stable and predictable cash flow, which benefits from medium-term generation supply contracts in the unregulated market which solely consists of free consumers. The global scale rating is constrained by the contractual obligation to expand capacity by 15% and potential penalties related to the current legal dispute with the Government of São Paulo over the non-fulfillment of this contractual obligation. The maintenance of high dividend pay-out ratios and periodic capital splits further constrain the rating, as does the concentration of the more risky free market contracts in the company's generation portfolio.
DETAILED RATING CONSIDERATIONS
Duke's profitability and cash flow could remain volatile through 2016 as a result of the drought which has prevailed over Brazil the past two years that has forced an increase in the acquisition of energy in the spot market at high prices because of the low levels of water in the Brazilian water reservoirs which have been exacerbated by the
higher costs associated with dispatching thermal plants to cover the shortfall in hydro production.
In spite of the low water levels in most of the Brazilian hydro- water reservoirs, the Brazilian National System Operator (ONS) has reportedly stated that the risk of energy rationing is not significant in light of the more favorable level of rainfall since February coupled with only a modest growth in electricity consumption. ONS is forecasting that the water levels in the southeastern and center regions of Brazil will reach 33% at the end of April from the current 32% compared to last year's level of 38.8%.
We believe that the government can avoid energy rationing provided electricity consumption levels remain flat or negative during 2015. Notwithstanding, we foresee that this scenario is challenging as the water levels at the end of the dry season, which occurs at the end of November will again most likely be at critical levels of between 10% and 15%.We believe that any decision to implement an energy rationing program will most likely wait until the end of the rainy season which in the Southeast usually occurs at the end of April.
We forecast that an energy rationing program would have a negative impact on all hydro-generation companies not just because their sales would be reduced by the mandatory reduction in electricity consumption but also because they would be forced to acquire energy in the spot market to make up for the difference between their effective energy generation and the physical energy assigned to each plant in the MRE.
All hydropower plants in Brazil participate in a kind of consortium, the so-called MRE (Energy Relocation Mechanism) by which they share hydrological risk. The MRE is a mechanism aimed at achieving full utilization of national production capacity that involves energy transfers between hydro generators. The hydrological risk is shared among all hydropower producers through the MRE, a mechanism based on the transfer of surplus energy generators to those with a shortage, thus optimizing energy supply of the National Interconnected System. The MRE aims to assure that all hydropower plants receive their physical energy regardless of their level of produced energy. The MRE acts as a hedge by distributing produced energy between generators so that any surplus or deficit relative to physical energy of hydroelectric plants may be equally distributed. As a result, a plant that generated less than its physical energy, either due to lack of water or the decision of the ONS (National System Operator), benefits from this mechanism by receiving the energy shortfall from the other generators to cover its deficit.
In case the energy produced under the Energy Relocation Mechanism is not sufficient to cover all the contracts, ONS will dispatch the more expensive thermal energy by the order of merit, wherein the costs will be distributed to all hydropower producers in proportion to their physical energy. Based on this mechanism, the hydropower producers absorb the additional costs from the dispatch of more expensive thermal power.
The negative impact on hydro generation companies' cash flow will depend on the magnitude and duration of an energy rationing program. Hydro-generation companies that are fully contracted either in the regulated or free markets would be most exposed to an energy rationing as revenues would decrease in proportion to the mandatory reduction in electricity consumption without any benefit from the higher spot prices.
In this scenario we assume that hydro-generation companies that are not fully contracted would sell part of their available energy in the spot market and thus would be less affected by energy rationing as they would benefit from the higher expected spot prices.
Hydro generation companies would not be immune to the current drought season even if an energy rationing program is avoided because the National System Operator is expected to keep dispatching thermal power to preserve water in the hydro power plant reservoirs. Under this most likely scenario, the production of hydro power in 2015 will be lower than the previously allocated physical energy in 2014 which will obligate hydro generation companies to acquire their energy shortfall in the spot market to make up for this difference.
Since the beginning of January most of the Brazilian hydropower generators, including Duke, have benefited from the regulator ANEEL`s decision to reduce the spot ceiling price to BRL 388.48 per megawatt hour from the previous BRL822.83 ceiling price set in 2014.
As per information contained in Duke's 2014 financial statements, the company currently has 7.2% of its 1,006 MW (72 MW) physical energy available to sell in the spot market, which works as a buffer to reduce its exposure to the spot market in a potential energy rationing situation or a scenario in which the total generation of hydropower within MRE is considerably lower than the allocated physical energy. Management has indicated that the company would maintain around 9% of its physical energy un-contracted in 2015 to face an expected lower GSF.
generation with their physical energy in a given period, as calculated by the generation scaling factor (GSF) and published every month by the CCEE (the electricity sector clearing house). The combination of a lower dispatch of hydropower and lower electricity consumption would result in a GSF lower than 1, which means that the
production of hydro generation will be lower than its allocated physical energy and, as such, hydropower
companies would be exposed to the spot market. A GSF higher than 1 means that the amount of physical energy produced by the MRE participants is higher than their original allocated physical energy and, as such, the generation companies can sell the excess energy in the spot market.
RELATIVE STABILITY OF MEDIUM TERM ENERGY SUPPLY CONTRACTS
Currently, the company relies on medium-term energy supply contracts to the unregulated market. These contracts should generate predictable and stable cash flows for the next three to four years given their relatively stable nature. Unregulated energy contracts expose Duke to potentially lower energy prices and revenues in a scenario in which future tariffs decline while revenues from the regulated business segment tend to be more predictable and allow for more stable operating margins and cash flow.
In 2014, around 16% of Duke's energy supply contracts were closed in the regulated market consisting of the distribution companies while around 77% consisted of contracts closed with free consumers. Duke maintained around 7% of its physical energy un-contracted during the year to mitigate the risks associated with exposure to the spot market. As per management information, all contracts in the regulated market expired at the end of last year and were replaced by medium term contracts with free consumers. We estimate that Duke will maintain around 9% of its physical energy un-contracted in 2015 given the expectation of a lower GSF estimated at 0.85 down from the 0.906 level achieved in 2014.
Duke's increasing exposure to the unregulated energy market is somewhat mitigated by the fact that the bulk of the company's client portfolio is made up of large industrial consumers with solid credit profiles. Nevertheless, we definitely see the exposure to the free market as being riskier than the regulated market given the inherently higher credit risks in operating with a more concentrated customer portfolio with considerably lower contractual tenors which together can potentially result in additional cash flow volatility.
CONTRACTUAL COMMITMMENT TO EXPAND INSTALLED CAPACITY BY 15%
Duke's rating also considers the company's outstanding contractual requirement with the State of Sao Paulo to increase by 15% its installed generation capacity in the state by the end of 2007, as stated in its acquisition contract when Duke was privatized. Duke has had difficulty in meeting this commitment because there are few sites for new hydroelectric facilities in the State of Sao Paulo and the current natural gas shortages make the construction of new thermoelectric facilities a high risk investment.
The State of Sao Paulo has filed a law suit requesting Duke to present an investment plan to meet this contractual requirement. In the past, Duke had been reportedly in conversations with the Government of the State of Sao Paulo to meet this contractual obligation but so far both parties have not reached a common agreement. The outcome and/or eventual penalties tied to this obligation are difficult to predict at this stage of discussions, but we do not believe that Duke's concession will be revoked, since neither the current hydrology nor natural gas constraints are within management's power to change.
Since the 15% expansion obligation is not part of the concession contract, ANEEL cannot rule on the issue. Our view is that the obligation will be eventually renegotiated between the company and the Sao Paulo state
government. Nevertheless, the global scale rating remains constrained by the potential for increased capital expenditures related to the fulfillment of this commitment. Additional capital expenditures could reach as much as BRL 1.1 billion over a three-year period without jeopardizing Duke's ability to service its debt. We believe that Duke would most likely finance a part of this expansion investment with additional debt, thus causing some deterioration in its credit metrics, but we also expect that the metrics would remain appropriate for the Baa3 / Aaa.br rating categories, particularly if the current relatively high dividend payout ratio were adjusted downward somewhat to maintain a balance in the capital structure.
STRONG CREDIT METRICS
The rating incorporates Duke's current solid credit metrics, which are very strong for the rating category when compared with both global and local peers, with Cash Flow from Operations before working capital changes (CFO pre-W/C) to Debt coverage of 46.9 % in 2014 along with interest coverage of 5.4 x. Notwithstanding, these metrics were considerably lower than the previous three-year average of 60.7% and 6.3x, respectively. The main reason for such weaker performance was Duke's exposure to the spot market given the poor hydrological conditions
Brazil faced last year. As a result, the company was forced to acquire energy in the spot market at much higher prices to honor its energy supply contracts as envisaged in the Energy Relocation Mechanism (MRE) by which all Brazilian hydro power plants share the hydrological risk.
Duke's historically outstanding financial performance primarily derives from the company's strong and stable cash flow from operations based on medium term energy supply contracts primarily in the unregulated market along with very low capital expenditures. This strong performance has been partially tempered by the high distribution of dividends, which has led to lower retained cash flow, as evidenced by (CFO pre WC minus dividends) over debt ratio, which has averaged 24.3% from 2011 through 2013. When the January 2011, BRL 360 million and August 2012, BRL 300 million capital splits are included in the calculation of this ratio, the three-year average retained cash flow over debt ratio declines to just 0.8% during this period which is more typical of a Caa rated power company.
In 2014, this ratio declined once more to just 6.5% leading the three-year average (2012-2014) to 17.8%. When the August BRL 300 million and November BRL 500 million capital splits are included the three-year average ratio declines to negative 6.7%. This would not be sustainable in the long run if it were not for the company's historically low leverage which allowed the company to post accumulated negative free cash flow in the past three years resulting in the company's total debt increasing from BRL 812 million as of December 31, 2011 to BRL 1,197 million as of December 31, 2014.
Despite the increase in debt Duke's capital structure is still very strong characterized by low leverage and strong liquidity. Duke's operating cash flow as measured by CFO is expected to be weaker in 2015 as a result of higher exposure to the sport market from the prevailing poor hydrological conditions in the country as measured by the GSF, which as previously cited we estimate will average 0.85 in 2015 down from 0.91 in 2014. We forecast that CFO-Pre WC over debt ratio and interest coverage will decline to 32.9% and 3.6x in 2015. The expected deterioration in credit metrics will result from lower operating margins as a result of higher exposure to the spot market, higher interest rates along with a higher debt level partly coming from the BRL 181 million acquisition of two small hydro power plants.
We expect that Duke's credit metrics will significantly improve starting in 2016 as measured by the CFO Pre WC over debt ratio and interest coverage, which we estimate will reach 41.5% and 4.0x, respectively. We
conservatively estimate that only in 2017 will the levels of the most relevant Brazilian water reservoirs be normalized, reducing the exposure of hydro power generators to the spot market. Under this scenario, we estimate that Duke will post stronger CFO Pre WC over debt ratio and interest coverage ratios of 56% and 5.4x in 2017, respectively.
Our projections are conservative in that we did not forecast any capital split in the next couple of years and that dividend distributions would be restricted to the net profit recognized in a given year.
Duke's capital expenditures at approximately BRL47 million per year are relatively light as compared to its peers, which would materially change should the company be obligated to expand capacity by 15% to meet its
Like other Brazilian companies, Duke does not have committed banking facilities to face any unexpected cash disbursements. In spite of this lack of committed credit facilities, we deem Duke's liquidity position as very strong in light of its comfortable cash position of BRL 141.4 million as of December 31, 2014 and the company's favorable debt profile with short-term debt reflecting only the current portion of long term debentures of BRL42.6 million. We forecast that the company's cash flow generation will comfortably meet its cash needs over the next couple of years, which largely consist of the payment of dividends and the planned BRL 180 million related to the acquisition of two small hydro power plants, which we estimated will occur in the second half of 2015. Duke is expected to raise short-term debt with a tenor of around one-year and take it out with long-term debt when local market conditions improve to finance this acquisition. Given the company's good historical access to both banking and capital markets we believe that Duke will be able to comfortably secure this amount financing.
Duke continues to comfortably comply with the financial covenants embedded in the company's five debenture series which represent all the company's debt as of December 31, 2014. These financial covenants are common for the five series which restrict leverage to a maximum Net Debt over EBITDA ratio of 3.2x and a minimum interest coverage (EBITDA/ Net Financial Result) of 2.0x. At FYE 2014, these ratios were 1.5x and 7.6x
The stable outlook reflects Moody's expectation of continued strong operating performance from Duke. It also reflects Moody's expectation that Duke will either fulfill its contractual obligation to expand capacity by 15% over the medium term or reach some agreement and achieve a final resolution with the Government of São Paulo that will not have a major impact on the ratings.
Should Duke pursue expanding its installed capacity by 15% (around 335 MW), we estimate the choice would require capital expenditures of around BRL1.1 billion over an estimated three years. Duke would most likely finance part of these investments with long-term debt, thus causing some deterioration in credit metrics although we would expect the metrics to remain appropriate for the rating category.
Duke is relatively well positioned to face a potential energy rationing program or additional exposure to the spot market given its current low leverage along with the fact that around 9% of its physical energy is currently available to sell in the spot market.
What Could Change the Rating - Up
A rating upgrade would require a resolution of the ongoing court dispute with the Government of São Paulo over the mandatory capacity expansion clause in Duke's acquisition contract along with the maintenance of strong credit metrics on a sustainable basis so that cash from operations (CFO) pre-working capital (WC) minus the dividends-to-debt ratio remains above 20% and the cash interest coverage ratio, as measured by CFO pre-WC to cash interest expense, remains above 4.5x.
What Could Change the Rating - Down
Downward rating pressure could result from higher than expected capital expenditures, an inability to secure adequate and timely funding or an unexpected penalty related to the contractual obligation to increase capacity by 15%, and/or dividend payments, such that the company's CFO pre-WC minus the dividends-to-debt ratio falls below 15% and cash interest coverage drops below 3.6x for an extended period.
Downward rating pressure could also arise from a deterioration in the company's credit metrics and liquidity, which could stem from an energy rationing or higher-than-expected exposure to the spot market.
Duke Energy Int'l Geracão Paranapanema S.A.
Unregulated Utilities and Unregulated Power
Companies Industry Grid 
Current12/31/2014 Moody's 12-18 Month Forward ViewAs of
Factor 1 : Scale (10%) Measure Score Measure Score
a) Scale (USD Billion) Caa Caa Caa Caa
Factor 2 : Business Profile (40%)
a) Market Diversification Baa Baa Baa Baa
b) Hedging and Integration Impact on Cash Flow Predictability
Baa Baa Baa Baa
c) Market Framework & Positioning Ba Ba Ba Ba d) Capital Requirements and Operational
Baa Baa Baa Baa
e) Business Mix Impact on Cash Flow Predictability
NA Factor 3 : Financial Policy (10%)
a) Financial Policy Baa Baa Baa Baa
Factor 4 : Leverage and Coverage (40%) a) (CFO Pre-W/C + Interest) / Interest (3
6.8x Baa 3.8x Ba
b) (CFO Pre-W/C) / Net Debt (3 Year Avg) NA c) RCF / Net Debt (3 Year Avg) NA
b) (CFO Pre-W/C) / Debt (3 Year Avg) 56.0% A 37% A
c) RCF / Debt (3 Year Avg) 17.8% Baa 20% Baa
a) Indicated Rating from Grid Baa3 Baa3 b) Actual Rating Assigned Baa3
 All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non-Financial Corporations.  As of 12/31/2014: Source: Moody's Non-Financial Metrics  As of 12/31/2014, 3-year average  This represents Moody's forward view; not the view of the issuer; and unless noted in the text, does not incorporate significant acquisitions and divestitures
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