Gaining Access to Capital Markets

Copyright © 2012 by ScottMadden. All rights reserved.

Gaining Access to Capital Markets

A Generation and Transmission Cooperative Strategic Priority

June 2012

Contact: Brad Kitchens ([email protected])

Marc Miller ([email protected])

mailto:[email protected]



Introduction

This ScottMadden insight is the second in a series on “Five Strategic Priorities for Generation and Transmission Cooperatives.”

Contents

Overview

The Increasing Dependence on the Capital Markets

The Role of Credit Ratings in Raising Capital

Maintaining Strong Credit Ratings

Thinking Strategically

Contact Us

1

Managing Generation

Assets

Ensuring Grid Security and

Reliability

Improving the Effectiveness

of Stakeholder Management

Fostering Economic

Development

Gaining Access to

Capital Markets

http://www.scottmadden.com/insight/516/Five-Strategic-Priorities-for-Generation-and-Transmission-Cooperatives.html

http://www.scottmadden.com/insight/516/Five-Strategic-Priorities-for-Generation-and-Transmission-Cooperatives.html

Copyright © 2012 by ScottMadden. All rights reserved. 2

The 21 largest cooperatives** demonstrated the following financial characteristics in 2010:

0%

20%

40%

60%

80%

100%

120%

De

bt

(%)

Top cooperatives

Debt / Capitalization

-

0.50

1.00

1.50

2.00

2.50

Ra

tio

(X

)

Top cooperatives

Debt Service Coverage Ratio

A median DSC ratio of 1.31x is within the range of a Fitch study in which ratios of public power firms rated AA or A ranged from 1.25x to 1.7x from 2005 to 2009*

The ability to consistently maintain relatively high debt levels (a median of 86% of total capitalization) reflects the low risk profile of most cooperatives

*Sources: SNL Financial; RUS Form 12; ScottMadden analysis; U.S. Public Power Peer Study June 16, 2010

**Defined here as those with assets more than $1 billion or annual revenue more than $500 million

The impact of historically high levels of capital expenditures is evident in a view of the consolidated balance sheets of the 21 largest cooperatives**

— Total Utility Plant (gross), at the 21 largest cooperatives has grown more than 77% since 2001, reaching $52 billion in 2010*

Compounding pressures are driving increased capital spending, yet financing from a primary source of cooperative funding, the Rural Utilities Service (RUS), is declining and becoming more restrictive (see next page)

Regulatory & Legislative Environment

Strong rate-making ability or positive regulatory relationships

Consistent engagement with key stakeholders

Business & Economic Environment

A diverse and growing service area Community support for conservation and

investments in efficiency

Management & Operations

Experienced and effective leadership Competitive operational performance A diverse and low-cost resource mix

Financial Performance

Strong historical financials, including balance sheet stability, appropriate debt service ratios, and sufficient liquidity

Four Dimensions of Business Strength

How Do Capital Markets Judge Cooperatives? What is Driving Cooperatives to Access Capital Markets?

With potentially costly environmental upgrades on the horizon and the need to increase capacity over the long term, capital needs continue to intensify, and cooperatives will increasingly turn to the markets for funding.


Overview

Median


-7%6%

-10%4%

-13%

-100%

-80%

-60%

-40%

-20%

0%

20%

$0

$2,000

$4,000

$6,000

$8,000

2008 2009 2010 2011 2012 2013

RUS - Electric Program Loans$ MM

Amounts adjusted for inflation to April 2012 CPI


The Increasing Dependence on the Capital Markets

Just as capital needs are pushed higher, traditional sources of funding for cooperatives are being constrained.

3

*Sources: SNL Financial; RUS Form 12; ScottMadden analysis; Company reports; EEI Finance Department; USDA Rural Utilities Service, Electric Program; Fitch

Special Report, No Relief in Capital Spending Plans, December, 2011; Fitch Ratings, 2012 Outlook: Utilities, Power, and Gas, December 2011

Growth in the cooperative asset base is accelerating

Cooperative capital spending, due to both stronger customer growth than other utilities and no relief from pressures to meet more stringent regulations, has driven growth in physical assets

The growth in total utility plant (gross) from 2001 to 2010 for the 21 largest cooperatives has been increasingly intense

— YOY growth averaged 5.5% from 2002 to 2006 and 7.9% from 2007 to 2010

Traditional funding sources are more constrained

Cooperatives largely rely on RUS and two cooperative lending institutions, CoBank and National Rural Utilities Cooperative Finance Corporation (CFC), to finance capital needs

RUS financing is declining and becoming more restrictive, forcing borrowers to seek out alternatives, especially for base-load generation projects

— The President’s Budget for Fiscal Year 2013 allocated a $6.1 billion loan level and would restrict lending on $4.0 billion of the total to renewable-related or carbon sequestration projects

— Starting with the 2008 budget, lending for base load coal and nuclear plants was no longer available through RUS

Cooperatives will increasingly rely on the capital markets to fill the gap between rising investment requirements and reduced funding from traditional sources



The Role of Credit Ratings in Raising Capital

Although raising funding from the capital markets depends on multiple factors, the most effective means of communicating a company’s relative strength is a strong credit rating.

4

Sources: SNL Financial and EEI Finance Department, S&P, U.S. Public Power Peer Study June 16, 2010; Moody’s Rating Methodology – US Electric G&T Cooperatives

*Defined here as those with assets more than $1 billion or annual revenue more than $500 million

The 21 largest cooperatives* compare favorably to IOUs

Observations

Although rating agencies take multiple factors into consideration, there is a heavy weighting on key credit metrics such as debt service coverage (DSC), times interest earned ratio (TIER), days of cash on hand, and equity to capitalization

In 2010, the average credit rating of the 14 co-ops that make up Moody’s G&T cooperative sector peer group was A3, which is upper medium grade and second only to the average rating of the municipal sector peer group

— This is due in part to the general flexibility cooperatives have to adjust rates and mitigate the risks of regulatory lag and cost disallowances

Decrease the relative amount of interest that must be paid to service debt

Simplify the credit review process

Reduce the restrictiveness of debt covenants

Facilitate the issuance of debt in both the public and private debt markets

Broaden the market of potential investors and lenders

Allow for greater financial flexibility

Strong credit ratings yield numerous benefits

The 21 largest cooperatives demonstrated excellent credit ratings, with 86% receiving an A- rating or higher from S&P

— Only 26% of North American IOUs achieved the same level, down from more than 60% in 2000

Maintaining strong credit ratings, while increasing borrowing, will be essential, which is why closely managing four dimensions of business strength is so important (see next page)

0%

20%

40%

60%

80%

100%

Top 21 Coops US IOUs

% o

f th

ose

rat

ed

S&P Credit Ratings

AAA

AA+, AA, AA-

A+, A, A-

BBB+, BBB

BBB-

BB+ and lower


“No single financial ratio stands apart from the rest. On the contrary, the ratios are examined together, providing a context for a utility’s financial position that informs a complete analysis.” – Fitch

“Like public power utilities, G&T cooperatives' highly leveraged capital structures reflect an inability to access capital markets to fund a perpetual equity cushion. Low, but sound debt service coverage ratios reflect the use of amortizing debt and an absence of profit-related revenues.” – S&P

A strong credit rating must be maintained over time by focusing on the factors that are critical to understanding and enhancing four dimensions of business strength.


Maintaining Strong Credit Ratings

5

“Managing through an extended period of high capital investment is [a] principal risk to bondholders, should adequate and timely returns on investment not be authorized.” – Fitch

“The extent to which a G&T coop can ensure timely and full recovery of its costs and investments will have an integral effect on its overall financial performance and thus its credit worthiness.” – Moody’s

“Cooperative utilities with rate-setting authority have shown they are willing to raise rates as needed to maintain their financial metrics.” – S&P

“The pace of environmental regulatory compliance, direction of fuel prices and economic trends are a source of continuing uncertainty, which then places a greater weight on utility management to skillfully navigate the operating environment.” – Moody’s

“As the highly coal dependent cooperative sector’s power plants reach the end of their useful lives, the regulations’ operational and cost consequences will rise to the fore and color utilities’ resource decisions.” – S&P

“[Cooperatives] willingness to [proactively raise rates to meet increasing costs] may come under growing pressure in 2012, as recent rate increases, coupled with persistent declines in median household income levels, have eroded affordability metrics over the past three years.” – Fitch

“Low natural gas prices have helped many utilities reduce operating costs and emissions, but those cooperatives with long generation positions, and that rely on selling surplus power to nonmember customers, have found themselves in a tight position as shrinking wholesale electricity prices have reduced sales' margins.” – S&P

Regulatory & Legislative

Environment

Business & Economic

Environment

Management & Operations

Financial Performance

Four Dimensions of Business Strength

*Sources: Moody’s Rating Methodology – U.S. Electric G&T Cooperatives, December 2009; S&P Rate Changes crucial for cooperatives to withstand EPA regulations, weak economy; Fitch Public

Power Methodology, March 2011; Fitch U.S. Public Power Rating Criteria, January 2012; S&P Criteria for rating public power companies, February 2011


In today’s dynamic and challenging environment, it is more important than ever to ask the right questions and truly understand the implications of the answers.

How can we increase the likelihood that our regulators make decisions that are credit supportive?

How should we prepare to react to pending and potential legislation?

Are we positioned for strong performance in the economy we are forecasting? Are our members?

How are we recognizing and mitigating the adverse risks in today’s rapidly changing business environment?

Have we planned our resource portfolios effectively? Are we getting the most out of the assets we have?

Do we have the right management team to pursue our strategy?

Is our balance sheet strong enough to facilitate necessary investment and protect our members against adverse impacts?

Meet formal targets for financial metrics (e.g., DSC, equity/capitalization, and days of cash on-hand)

Improve our credit rating and take advantage of low interest rates to minimize financing costs

Implement an integrated planning process and align the organization on pursuit of key performance measures

Develop a comprehensive asset management strategy and appropriately diversify our portfolio of generation assets

Recognize and engage consistently with our key stakeholders and improve important relationships

Commit to economic development and pursue focused and measurable objectives


Thinking Strategically

6

Possible Goals for the Organization

Practical Questions for Management


Contact Us

ScottMadden has undertaken numerous consulting projects for cooperatives across the country. If you are interested in learning more about gaining access to capital markets, please contact us.

Brad Kitchens

President and CEO ScottMadden, Inc.

3495 Piedmont Rd, Bldg 10

Suite 805

Atlanta, GA 30305

Phone: 404-814-0020

[email protected]

Marc Miller

Director ScottMadden, Inc.

3495 Piedmont Rd, Bldg 10

Suite 805

Atlanta, GA 30305

Phone: 404-814-0020

[email protected]

7



Education

Gaining Access to Capital Markets