Fitch Downgrades Paducah Power's Credit Rating

Fitch Ratings has downgraded the following Paducah Power System (PPS) revenue bonds to 'BBB' from 'A-' and removed the ratings from Negative Watch:

--$153 million revenue bonds series 2009A;

--$1 million refunding revenue bonds series 2010.

The Rating Outlook is Negative.

SECURITY

The bonds are secured by a first lien on PPS's net revenues derived from electric system operations.

KEY RATING DRIVERS

Constrained Financial Position: The rating downgrade reflects PPS' constrained financial position resulting from several years of inadequate rate recovery and Fitch's expectation that the utility's medium-term financial metrics will be supported by planned, one-time actions to bolster liquidity. Fitch views the actions, however necessary, as stopgap measures more consistent with the lower rating until improved asset performance at the Prairie State Energy Campus (PSEC) provides longer-term relief through lower purchased power costs.

Rate Freeze Hampers Metrics: A self-imposed rate freeze benefits customers at the expense of financial metrics. The freeze resulted in nearly $500k of under recovery in Oct. 2014 alone. This compounds lackluster fiscal 2014 unaudited results registering near 1.16x debt service coverage (by Fitch's calculation, which excludes $1.7 million that PPS classifies and reports as non-operating revenue) and very limited cash on hand totaling 14 days.

Forecasts Ratchet Back: PPS' broader recovery plan is designed to eliminate an estimated $4.7 million power cost adjustment (PCA) deficit by fiscal 2015 yearend. However, currently projected debt service coverage from cash flows is nearer 1.3x for fiscal years 2015-2018 compared with more robust August 2013 three-year projections of approximately 1.6x and plans to build a nearly $10 million reserve during that time.

Below-Average Economic Indicators: Current electric sales fall short of PPS's 2010 projections at the time of its most recent debt offering, thereby adding to the financial strain. The utility's excess power supply adds costs to a rate base evidencing below-average wealth indicators and has contributed to PPS' constrained revenue-raising flexibility.

High Leverage: PPS' limited liquidity position and considerable leverage growth underscore the importance of timely and adequate rate recovery. The transition to owning generation resources has increased the utility's debt per customer ratio to a high $29,000, including off-balance sheet obligations. This is well above the ratio for comparable systems.

RATING SENSITIVITIES

Inadequate Rate Recovery: The Negative Rating Outlook reflects Fitch's continuing concerns about PPS' ability to generate healthier liquidity levels and cash flows through longer-term structural changes. Absent near-term improvements in financial metrics, PPS would likely face additional negative rating action.

Stronger Margins: More robust financial metrics driven by regained flexibility to adjust rates and improved PSEC operating performance would be viewed favorably.

CREDIT PROFILE

PPS' prolonged period of financial weakness is outside the bounds of a normal business cycle. While the utility's financial position and recovery plan support an investment-grade rating, its weakened metrics; planned, one-time measures to generate liquidity; and modest projected debt service coverage ratios from cash flows are more consistent with the 'BBB' category.

PPS continues to enjoy hallmark characteristics of a municipal electric system that distinguish it from comparable investor-owned utilities, including autonomous rate-setting authority in a defined service territory. However, a charged political environment has limited the practical extent of PPS' ratemaking capabilities and weakened enterprise liquidity. Operational challenges causing sizable rate increases in the past year led to a board-imposed rate freeze in October.

Fitch expects that investment grade municipal utilities will support ongoing operations from revenues. The Negative Rating Outlook reflects concern over PPS' ability to improve its longer-term credit quality by restoring rate-raising flexibility.

RECOVERY PLAN REBUILDS LIQUIDITY

Current year improvements in the utility's liquidity position and cash flows are critical to the rating. Financial weakness caused high-level board and managerial changes in recent months before PPS hired an interim general manager, Mark Crisson, to institute a recovery plan.

PPS expects $2.7 million relief of its fiscal 2015 purchased power expense to the Kentucky Municipal Power Agency (KMPA), largely as a result of KMPA's plans to replace its existing debt service reserve funds with sureties and apply the cash to the agency's 2015-2019 principal payments. PPS will rely on lower power payments, while maintaining steady rates, to generate additional liquidity during the period.

PPS' recovery plan also includes changing portfolio managers to reduce net purchase costs and better utilize the system's 124MW peaking capacity for $2 million of savings beginning in fiscal 2015. Improved asset performance at the PSEC would likewise lower purchased power costs.

POWER SUPPLY ADDS COSTS

The system's total power supply (246MW) is long by approximately one half, including all sources of capacity online through 2016 and a reserve margin. This, coupled with weaker-than-expected PSEC performance, has added sizable costs to a rate base evidencing high retail rates (141% of the state average, according to data provided by the Energy Information Administration) against below average wealth and employment indicators.

PPS created KMPA with Princeton, KY to secure a 7.82% undivided interest (124MW) in the PSEC. The utility is the larger of the two members with an 83.9% (104MW) share, pursuant to a take-or-pay contract. PPS transitioned to owning generation, in part, to escape rising costs and meet projected load growth that has not materialized.

INADEQUATE RATE RECOVERY LIMITS FINANCIAL CUSHION

Inadequate rate recovery weakened PPS's financial position over the past five years, commensurate with its shift to owning and operating generating assets. Base rate increases from November 2012-April 2014 aligned with PPS's cost of service have not sufficiently supported system metrics at previously projected levels.

In addition, the PPS Board froze a quarterly PCA in October 2014, as noted; PPS implemented the PCA in Nov. 2013. The freeze, which is expected to continue through June 2015, caused a nearly $500k (3.2% of fiscal 2013 funds available for debt service) revenue shortfall compared with what would have otherwise been collected that month.

The cumulative PCA deficit was approximately $3 million, as of Sept. 2014. The projected deficit reaches $4.7 million at June 2015, without any action pursuant to the recovery plan. The deficit reached a peak of $6.4 million at Jan. 2014.

WEAK FINANCIAL RESULTS

The rate freeze compounds lackluster unaudited fiscal 2014 results suggesting near 1.16x debt service coverage by Fitch's calculation and very limited 14 days cash on hand. Fitch's comparable 'A-' medians are 1.6x and 79 days, respectively. The 'BBB' category medians are 1.29x and 53 days.

Moreover, PPS currently projects approximately 1.3x debt service coverage from cash flow in fiscal years 2015-2018. Though replacing its own debt service reserve funds with sureties provides additional cushion.

Projected fiscal 2014 debt service coverage was 1.44x - reaching upwards of 1.7x in fiscal years 2015 - 2017 - during Fitch's August 2013 review of the system. PPS expected that the base rate increases and greater cost certainty from its participation in the PSEC would build financial support.

Additional information is available at 'www.fitchratings.com'.

This rating action was informed by the sources of information identified in Fitch's U.S. Public Power Rating Criteria.

Applicable Criteria and Related Research:

--'U.S. Public Power Peer Study -- June 2014' (June 13, 2014);

--'U.S. Public Power Peer Study Addendum - June 2014' (June 13, 2014);

--'U.S. Public Power Rating Criteria' (March 18, 2014).

Applicable Criteria and Related Research:

U.S. Public Power Peer Study -- June 2014

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749789

U.S. Public Power Peer Study Addendum - June 2014

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750283

U.S. Public Power Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=740841

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=954795

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