Duke Energy Int`l Geracao Paranapanema SA

CORPORATES
CREDIT OPINION
5 July 2016
Update
Duke Energy Int'l Geracao Paranapanema
SA
Annual Update
Summary Rating Rationale
RATINGS
Duke Energy Int'l Geracao Paranapanema SA
Domicile
Brazil
Long Term Rating
Ba2
Type
LT Issuer Rating - Dom
Curr
Outlook
Negative
Please see the ratings section at the end of this report
for more information.The ratings and outlook shown
reflect information as of the publication date.
The Ba2 and Aa1.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 where prices are set freely between the energy suppliers and final
consumers.
The maintenance of high dividend payout ratios and periodic capital splits constrain the
rating as well as Duke’s ongoing dispute with the State of Sao Paulo around a stated
obligation to expand capacity by 15%. The company's rating and outlook are also constrained
by Brazil's Ba2 Bond rating with a negative outlook.
Exhibit 1
Resilient Credit Metrics
Contacts
Jose Soares
55-11-3043-7339
VP-Sr Credit Officer
[email protected]
Alejandro Olivo
52-55-1253-5742
Associate Managing
Director
[email protected]
Source: Moody's Financial Metrics™
Credit Strengths
»
Strong credit metrics for the rating category
»
Competitive costs and predictable cash flow based on medium-term energy supply
contracts
Credit Challenges
»
Hydrological Risk
»
High dividend pay-out ratio and capital splits
CORPORATES
MOODY'S INVESTORS SERVICE
»
Risks associated with the contractual obligation to increase installed generation capacity
by 15%
»
Potential liability associated with a legal injunction on the exposure to the spot market
Rating Outlook
We would consider stabilize the outlook of the company's ratings if the outlook of Brazil's Ba2 sovereign rating is stabilized.
Factors that Could Lead to an Upgrade
In light of the current rating action and the negative outlook, an upgrade of the ratings is unlikely in the near term.
Factors that Could Lead to a Downgrade
Further deterioration in the respective sovereign credit quality could exert downward pressure on the ratings. Downward rating
pressure could also 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.
Key Indicators
Exhibit 2
Key Indicators
[1]Duke Energy Int'l Geracão Paranapanema S.A.
[1] All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non-Financial Corporations.
Source: Moody's Financial Metrics™
Detailed Rating Considerations
STRONG CREDIT METRICS
Duke’s reported Cash Flow from Operations before working capital changes (CFO pre-W/C) to Debt show a coverage of 33.1 % in the
last twelve months ended March 31, 2016. The company also registers interest coverage of 4.1 x. Notwithstanding, these metrics were
considerably lower than the previous three-year average of 44.3% and 5.6x, respectively.
Poor hydrological conditions in 2014 and 2015 drove the deterioration of Duke’s credit metrics by forcing the company to acquire
energy in the spot market at much higher prices.
The company's historically strong and stable cash flow from operations have resulted from medium term energy supply contracts
primarily in the unregulated market along with very low capital expenditures. Such strong performance has been tempered by the
company’s high dividend distribution and capital splits over the past 5 years.
Duke’s CFO pre WC minus dividends over debt ratio averaged 20.3% between 2011 and 2015. Yet, when the BRL 1.16bn capital splits
conducted by the company since 2011 are included, the ratio drops to a negative 0.7% in the same period. More typical of a Caa rated
power company.
Duke’s historically low leverage has allowed the company to post accumulated negative free cash flow in the past five years. As a
result, the company's total debt increased from BRL 812 million by year-end 2011 to BRL 1,460 million in 2015. The increase in debt
was largely tempered by an increase in the company’s cash position from BRL 210 million in 2011 to BRL 460 million in 2015.
This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on
www.moodys.com for the most updated credit rating action information and rating history.
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Despite the increase in debt, Duke's capital structure remains strong with low leverage and strong liquidity. Duke's operating cash flow
as measured by CFO is expected to be stronger in 2016 as a result of lower exposure to the sport market on the back of the improved
hydrological conditions in Brazil and lower spot prices. We estimate that Brazil’s Generating Scaling Factor (GSF), an indicator that
reflects the gap between generated hydro energy and dispatch obligations will average 0.93 in 2016 up from 0.85 in 2015 while spot
prices will average BRL 70 per megawatt hour in 2016 down from BRL 275 per megawatt hour in 2015.
The lower costs associated with the company’s exposure to the spot market will be partly offset by Moody's expectation of lower
prices in new contracts. We expect Duke will renew some supply contracts between 2017 and 2018. Added power capacity and lower
consumption could drive new prices around 20% lower compared to existing supply contracts. Under such scenario and assuming a
10% contract renewal, Duke’s annual revenues will decrease by around BRL 30 million during that period.
We forecast that CFO-Pre WC over debt ratio will improve to the mid-forties while interest coverage will be around 4.5x in 2016.
Should market prices increase, these metrics could exceed 50% and 5.0x , respectively.
We don’t anticipate further capital splits in the next couple of years and expect that dividend distributions will be restricted to the net
profit recognized in a given year. Duke's capital annual expenditures at approximately BRL80 million per year from 2016 through 2017,
are relatively light compared to peers. Duke’s capital expenditures could expand as a result of the ongoing litigation with the State of
Sao Paulo to expand capacity by 15%.
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,
however, expose Duke to potentially lower energy prices and revenues in a scenario in which future prices decline. Revenue streams in
the regulated energy business segment tend to be more predictable and allow for more stable operating margins and cash flow.
Duke has maintained around 7% of its physical energy un-contracted during the year to mitigate the risks associated with exposure
to the spot market. We estimate that Duke will maintain between 7% and 9% of its physical energy un-contracted in 2016 given the
expectation of a GSF estimated at 0.93 up from the 0.85 level achieved in 2015.
Duke's increasing exposure to the unregulated energy market is 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 consider that free market brings a number credit risks,
including a more concentrated customer portfolio, shorter contract duration, that ultimately bring additional cash flow volatility.
HYDROLOGICAL RISK
The hydrological risk significantly receded in 2016 from the combination of a more favourable rainy season, additional installed power
capacity and lower electricity consumption.
The level of the hydro-water reservoirs in the Southeast/Mid -West of the country, that represents around 70% of the Brazilian water
reservoir, registered 57.6% of their capacity in April 2016. That is the highest level over the past three years although still considerably
lower than the previous three-year average of 75.5%. Under this scenario, the exposure of hydro power generators will be significant
lower in 2016 than in the past two years because of a higher GSF and lower spot prices.
Going forward, the Brazilian National Operator (ONS) estimates that the hydro water reservoirs will end the dry period, that goes from
May through November with between 35% and 40%. Such levels should allow a lower dispatch of the more expensive thermo power
in both 2016 and 2017 compared to 2014 and 2015.
We estimate that Duke currently has around 7.0% 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 scenario in which the total generation of hydropower is considerably
lower than the allocated physical energy. Management has indicated that the company would maintain between 7 and 9% of its
physical energy un-contracted in 2016 to protect against a potential spike in spot prices and considering management’s expectation of
a GSF at around 0.95.
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MOODY'S INVESTORS SERVICE
CONTRACTUAL COMMITMENT TO EXPAND INSTALLED CAPACITY BY 15%
Duke has an 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.
The State of Sao Paulo filed a lawsuit to force the company to present an investment plan to meet this contractual requirement
overdue since 2007. The contingency from the ongoing discussion could reach as much as BRL 1.1 billion over a three-year period
without jeopardizing Duke's ability to service its debt.
Under that scenario, Duke’s debt metrics could see some deterioration although still appropriate for the Ba2 / Aa1.br rating category,
particularly if the current relatively high dividend payout ratio were adjusted downward somewhat to maintain a balance in the capital
structure.
POTENTIAL LIABILITY ASSOCIATED WITH A LEGAL INJUNCTION ON THE EXPOSURE TO THE SPOT MARKET
Duke has a legal injunction that has prevented the company from paying costs associated with its exposure to the spot market since
May 2015. The merit of the suit filed by APINE (Brazilian Association of Independent Producers of Electric Energy) , which represents
the interests of Duke in the Brazilian Electricity sector has not been decided and is not expected to occur over the short term.
The Brazilian court accepted the argument of APINE by granting it a legal injunction determining a GSF of 1.
Duke has been conservative in that it has recognized all these costs in its financial statements as if the company had no legal injunction
protecting it from the effects of the exposure to the spot market. According to management, this amount has been recognized as
suppliers debt, which reached BRL 205 million as of March 31, 2016.
Liquidity Analysis
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
451 million as of March 31, 2016 and the company's favorable debt profile with short-term debt reflecting only the current portion of
long term debentures of BRL 209 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 amortization of current portion of long-term debt. Given the company's good historical access
to both banking and capital markets we believe that Duke will be able to comfortably secure long- term debt if needed.
Duke continues to comfortably comply with the financial covenants embedded in the company's five debenture series, which represent
the bulk of the company's debt as of December 31, 2015. 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 2015, these ratios were 1.54x and 3.63x, respectively.
Duke’s debentures indenture contains a covenant that states that the change in the company’s shareholders followed by a two-notch
downgrade on the national scale by one of two rating agencies will grant the debenture holders the right to accelerate their debt. We
see this event as unlikely.
Profile
Duke Energy International, Geracao Paranapanema S.A (Duke) is an electricity generation company controlled by Duke Energy
Corporation (Baa1 Negative), 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 the last twelve months ended March 31, 2016, Duke
reported net sales of BRL1,246million ($350million) and net profit of BRL 231 million ($ 65 million).
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MOODY'S INVESTORS SERVICE
Rating Methodology and Scorecard Factors
Exhibit 3
Rating Factors
Duke Energy Int'l Geracão Paranapanema S.A.
[1] All ratios are based on 'Adjusted' financial data and incorporate Moody's Global Standard Adjustments for Non-Financial Corporations.
[2] As of 12/31/2014(L)
[3] 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
Source: Moody's Financial Metrics™
Ratings
Exhibit 4
Category
DUKE ENERGY INT'L GERACAO PARANAPANEMA
SA
Outlook
Issuer Rating -Dom Curr
Senior Unsecured -Dom Curr
NSR Senior Unsecured
NSR LT Issuer Rating
Moody's Rating
Negative
Ba2
Ba2
Aa1.br
Aa1.br
PARENT: DUKE ENERGY CORPORATION
Outlook
Issuer Rating
Sr Unsec Bank Credit Facility
Senior Unsecured
Jr Subordinate
Commercial Paper
Negative
Baa1
Baa1
Baa1
Baa2
P-2
Source: Moody's Investors Service
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MOODY'S INVESTORS SERVICE
Recent Developments
On May 09 2016, Moody's repositioned the national scale ratings (NSRs) of certain Brazilian infrastructure issuers, including Duke as
a result of the recalibration of the Brazilian national rating scale. This resulted in a repositioning of Duke’s NSRs as follows: Issuer and
Senior Unsecured ratings to Aa1.br from Aa2.br.
On February 25, 2016, Moody's downgraded Duke's issuer ratings to Ba2/Aa2.br from Baa3/Aaa.br, under review for downgrade on
the global scale and on the National scale rating, respectively. Outlook changed to negative. At the same time, Moody's downgraded
senior unsecured issuances to Ba2/Aa2.br from Baa3/Aaa.br, under review for downgrade on the global scale and on the National scale
rating, respectively. Outlook changed to negative.
On February 24, 2016, Moody's downgraded Brazil's issuer and bond ratings to Ba2 from Baa3, with a negative outlook.
On February 4, 2016, Duke Energy Corporation announced it would divest its interests in Latin American assets, which includes its stake
in the capital of Duke Energy Paranapanema.
On December 10, 2015, Moody's placed Duke`s ratings under review for downgrade following the placement of Brazil's issuer and bond
ratings under review for downgrade on December 09, 2015.
On July 3, 2015, the Brazilian court granted APINE a legal injunction that allowed APINE members not to pay their costs associated
with the exposure to the spot market by defining a GSF of 1 until a final decision on the merit of the suit filed by APINE is decided by a
superior court. The effects of this decision was retroactive to May , 2015.
On May 6, 2015 Duke Energy Paranapanema acquired from Duke Energy International for BRL 180 million 99.99% of the capital of
DEB Pequenas Centrais Elétricas Ltda, a small hydro power company with a 32.5 MW installed capacity.
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CORPORATES
MOODY'S INVESTORS SERVICE
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Duke Energy Int'l Geracao Paranapanema SA: Annual Update