Fitch Affirms Pedernales Electric Cooperative, TX's First Mortgage Bonds at 'AA-'

Fitch Ratings has affirmed the 'AA-' rating on the following series of Pedernales Electric Cooperative's (PEC) first mortgage bonds:

--$337.2 million series 2002A.

The Rating Outlook is Stable.

SECURITY

Bonds are payable from PEC's net revenues and are secured by a lien on substantially all of the cooperative's assets.

KEY RATING DRIVERS

LARGE, GROWING DISTRIBUTION COOPERATIVE: PEC is a large distribution cooperative located in central Texas. PEC's service territory, part of which is near Austin, is large, diverse and includes both rural and suburban areas. PEC's eastern service area is experiencing strong customer expansion, which has resulted in continued revenue growth.

ALL-REQUIREMENTS POWER SUPPLY CONTRACT: Customer load demands are met through a long-term contract (2041) with the Lower Colorado River Authority (LCRA; revenue bonds rated 'A'). LCRA provides most of PEC's power but the contract allows PEC to take increments of load to other suppliers with notice. LCRA is required by the all-requirements contract to provide sufficient energy supply to meet PEC's expected load growth.

LOAD GROWTH MANAGEABLE: PEC has average annual load growth of over 3%. PEC has consistently maintained strong cash flow, built equity at the cooperative in recent years and kept pace with the capital demands of high growth in their service territories. The risks associated with load growth appear manageable given the consistent pace at which growth continues to occur and the requirement of LCRA to serve the load growth.

IMPROVED RATE COMPETITIVENESS: A power cost adjustment (PCA) factor in rates passes wholesale power costs through to customers in a timely manner, providing protection to the financial profile from expenditure fluctuations from fuel or purchased power costs. Rates have decreased through PCA adjustments and PEC's own cost containment.

SOLID FINANCIAL PROFILE: Financial metrics have been consistently strong in recent years, but slightly below rating category medians. Debt service coverage (DSC) is expected to remain above 1.9x, while moderate debt levels provide some capacity to absorb new debt to fund capital needs.

LIQUIDITY PROFILE: Liquidity has been managed downward but remained adequate at 79 days at fiscal year-end 2015. The addition of a second $200 million line of credit in fiscal 2016 should provide PEC with ample liquidity going forward, but the cooperative's absolute reliance on lines of credit is a concern.

RATING SENSITIVITIES

POWER SUPPLY COST RECOVERY: The Stable Outlook reflects Fitch's expectation that Pedernales Electric Cooperative (PEC) will continue to generate strong financial margins and use its power cost adjustment mechanism in a timely manner to recover fluctuating wholesale power costs. Any failure to do so, which pressures debt service coverage and liquidity metrics could result in downward rating pressure.

CREDIT PROFILE

PEC is a retail electric cooperative based in Johnson City, Texas that provides electric service to over 274,000 customers across an 8,100 square mile service area across 24 counties in central Texas. PEC is the largest distribution cooperative in the U.S., based on number of meters served, and continues to grow steadily. Growth is substantial, averaging 7,500 new customers annually over the past five years, although given the very large customer base, the average annual growth rate is moderate at 3%. The service territory is diverse, including suburban areas west of Austin and San Antonio and very sparsely populated rural areas in central Texas.

ALL-REQUIREMENTS POWER SUPPLY FROM LCRA THROUGH 2041

PEC purchases the majority of its power requirements in accordance with an all-requirements wholesale power agreement with LCRA through 2041. The wholesale power agreement requires LCRA to meet PEC's full energy requirements on a load-following basis, including system growth over time. The contract terms represent more limited operational risk to PEC as a distribution utility although the risk and resulting costs of operational issues - should they arise at LCRA - would ultimately be passed through in the wholesale rates to PEC.

PEC was always the largest electric customer of LCRA but as a result of the departure of nine customers, it will account for around 50% of LCRA sales beginning in July 2016. LCRA's generation portfolio will continue to be a key driver of PEC's cost structure. LCRA is in a long position with its generation assets, and the cost related to those assets, if not recovered though short-term sales in the ERCOT market are recovered by LCRA from its contracted customers including PEC. Soft market prices within ERCOT for the past five years have reduced LCRA's ability to economically dispatch all of its available generation into the market. Actual revenues received from market sales are used to offset the wholesale rate charged to wholesale customers.

LOAD RELEASE PROVISIONS PROVIDE FLEXIBILITY

PEC's wholesale power agreement with LCRA is an all-requirements contract but PEC has the ability to reduce its purchases. The load-release provision allows customers to gradually adjust downward or upward the amount of load purchased from LCRA through annual stepped adjustments. PEC may notify LCRA of its intent to reduce load once every 12 months but the load reduction is not effective until two years after the notice.

Any one-year decline in requirements cannot exceed 10% initially and then 5% per year thereafter to a minimum of 65%. PEC, and LCRA's other 33 customers, must continue to purchase at least 65% of their load from LCRA through 2041. PEC has already provided LCRA with the required notifications to release 20% of their load. The next load release notification option occurs on or after July 2016 for up to an additional 5%.

IMPROVED RATE COMPETITIVENESS

PEC's rates are comparatively high for the region. Although data collected by the Energy Information Administration in 2014 (most recent available) showed PEC's average retail revenue per kWh of 11.78 cents/kWh to be in line with the state average of 11.86 cents/kWh, a number of the municipal utilities in central Texas to whom PEC customers might compare bills had lower rates.

In addition to the PCA decreases that reflected the lower cost of power from LCRA, PEC worked to control expenditures in order to reduce its delivery rate in December 2014 by $0.005 per kWh or 15.6%. Rather than reduce its delivery rate again in 2015, the Board of Directors made a determination to return $0.0056 per kWh to customers and did so through the use of a newly created revenue adjustment factor (RAF) in December 2015. The adjustment only affected bills in one final month of fiscal 2015.

SOLID FINANCIAL PROFILE

PEC's financial performance has been strong in recent years. Fitch calculated debt service coverage declined slightly in fiscals 2014 and 2015 to 1.9x in both years from previous levels above 2.0x. While coverage was below Fitch's category median, coverage of full obligations was relatively in line with peers. Management's expectations for performance in fiscal 2016 are that financial margins will be at or above this level. Board policy includes setting the delivery rate to produce debt service coverage at or above 1.8x. Financial planning estimates use conservative customer growth assumptions that are slightly below historical levels, even though the pace of growth is not expected to slow over the short term.

Equity levels have been increasing, up to 45% at the end of fiscal 2015 as compared to 35% at the end of fiscal 2011. The increases have occurred during a period of high growth, much of which PEC has funded from revenues. PEC management intends to slow the growth of its equity position but a decrease from the current level is not expected.

Overall liquidity has been managed down in connection with efforts to control costs and reduce rates to members. Cash at the end of fiscal 2015 was only $75,000 although this was following the use of $78 million in November 2015 to pay down remaining high interest rate debt prior to maturity in 2020. Days liquidity on hand, including the $100 million line of credit with National Rural Utilities Cooperative Finance Corporation in place at the end of fiscal 2015, was 79 days. While this is well below Fitch's median of 222 days liquidity for the rating category, PEC has more limited cash needs than a vertically integrated utility with generation operating responsibilities or a purchasing utility managing multiple long-term contracts with collateral posting requirements. Liquidity was enhanced in February 2016, when PEC executed a new $200 million general purpose line of credit from CoBank.

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

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012

U.S. Public Power Rating Criteria (pub. 18 May 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=864007

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1008305

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1008305

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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