Fitch Rates Arizona Public Service Co's $350MM Sr. Unsecured Notes 'A'; Outlook Stable

Fitch Ratings has assigned an 'A' rating to Arizona Public Service Company's (APS, Issuer Default Rating: 'A-'/Stable Outlook) issuance of $350 million of 3.75% senior unsecured notes, due May 15, 2046. The senior unsecured notes rank pari passu with existing senior unsecured debt. Proceeds will be used to defease approximately $77 million of tax exempt pollution control bonds, reduce short-term borrowings and for general corporate purposes including the funding of capex.

APS' Stable Outlook reflects the regulated nature of its utility operations and a constructive regulatory environment in Arizona. Fitch also assumes the Arizona Corporation Commission (ACC) will continue to address rate design regarding energy efficiency (EE) and distributed generation (DG) in a credit-supportive manner. Fitch expects APS to file its next general rate case (GRC) in June for rates effective mid-2017 and has modeled in a 10% authorized ROE for APS. The ratings also reflect expectations for continued customer growth, an improving service territory economy and strong projected credit metrics.

KEY RATING DRIVERS

Strong Credit Metrics; Increase in Leverage Expected: Fitch expects APS' credit metrics to remain strong throughout the forecast period and projects EBITDAR coverage to be approximately 6.0x through 2018, on average. Due to high capex EBITDAR leverage is expected to rise modestly but remain strong at less than 3.5x through the same period.

Higher Customer Growth: Fitch expects customer growth to average about 1%-2% per year through the forecast period, reflecting improving economic conditions in Arizona, including lower unemployment, rising housing starts and new household formations. APS' year-over-year customer growth was 1.3% in the first quarter of 2016, identical to the 1.3% annual customer growth logged over the four years ended 2015, a marked improvement over the prior three-year period, when customer growth averaged 0.6%.

AZ Regulatory Compact: GRC orders have been more balanced for APS in the past several years and more timely adjudication of rate filings is a constructive development that has enabled the utility to improve its earned returns. Regulators have adopted several regulatory mechanisms to facilitate cost recovery outside of GRCs. Such cost-recovery mechanisms include the power supply adjustor, renewable energy surcharge, transmission cost adjustor, demand-side management adjustor charge, the environmental improvement surcharge and the lost fixed-cost recovery (LFCR) mechanism. Fitch views the ACC's recognition of an extended post-test-year period for new plant additions and the allowance of a premium rate of return on fair value of rate base as further constructive developments. Fitch expects APS to file its next GRC on June 1st.

Positive Sales Trend: Fitch expects total weather-normalized retail electricity sales will be about 0.5% on average per year through 2018 as a result of customer growth, net of EE and DG. Retail electricity sales, adjusted to exclude the effects of weather variations, increased 1.3% for the three months ended March 31, 2016, when compared with the prior-year period. This reflects the effects of improving economic conditions and customer growth partially offset by the effects of EE, DG, and customer conservation. The delta between customer growth and sales growth has averaged approximately negative 1% over the last four years due to the effects of EE, demand response and DG.

Net Metering Evolving: Net metering remains a contentious and politicized issue in Arizona between utilities and solar DG customers and proponents. APS advocates for more balanced rate design in Arizona that addresses the current cost shift between net-metering and non-net metering ratepayers. APS supports a three-part rate design for residential customers to better reflect fixed costs in rates. Fitch expects APS to file its 2016 GRC in June with a three-part rate design proposal that includes a fixed charge, a demand charge and a volumetric component for residential customers.

The ACC is currently proceeding with a generic docket to consider rate design and cost of service hearings on distributed generation and net metering with the findings used to inform prospective GRC filings. Fitch expects the hearings to conclude in May and a decision this summer with the findings to be incorporated into APS' 2016 GRC. The ACC has also opened a generic docket focused on studying solar DG business models and their effects on corporations and ratepayers, which is currently pending.

APS' request to increase its grid access charge was dismissed by the ACC. APS had previously filed with the ACC in April 2015 to increase its rooftop solar-grid access charge to $3/kW effective August 1, from $0.70/kW currently, resulting in a monthly charge of $21 for a typical residential customer. The current grid-access charge addresses a portion of the cost shift, which APS estimates at $67 per month per rooftop solar customer. Fitch views the potential adoption of an increased grid-access charge as positive for APS and notes the previously requested grid-access charge had been supported by the ACC, ACC staff and the Residential Utility Consumer Office as reasonable. The grid-access charge is revenue neutral and credited to the LFCR mechanism.

APS is currently implementing a 10-MW utility-owned residential rooftop solar program focused on low-income customers, with associated costs to be filed for recovery in its upcoming 2016 GRC. APS' earned ROE for the LTM ended March 31, 2016 was approximately 9.3%, below its authorized ROE of 10%.

Large Capex Program: Fitch expects rate base growth of 6%-7% through 2018, driven by average annual capex of $1.2 billion, levels approximately 25% higher than the preceding three-year period. Capex is focused on generation, distribution and transmission investments and includes emissions control upgrades at APS' coal-fired generating facilities, new transmission capacity, and renewable investments. On average 70% of capex is recoverable through rate recovery mechanisms and depreciation cash flow, providing timely recovery on invested capital.

Negative FCF: Due to its large capex program, Fitch expects APS to be moderately free cash flow (FCF) negative through 2018, funding the majority of forecasted capex internally. APS' external capital needs are expected to be funded with a 50/50 mix of debt and equity and Fitch anticipates an equity infusion from parent company Pinnacle West Capital Corp.(PNW, IDR:'A-'/ Stable Outlook) into APS in 2017 to help maintain the utility's capital structure and authorized 54% equity ratio.

Ocotillo Plant Modernization Project: APS plans to increase the capacity of its gas fired Ocotillo power plant to 620MW to help maintain service reliability in the growing Phoenix area. APS plans to install five new 102MW combustion turbines and simultaneously retire two older and inefficient 110MW steam generators. The project is expected to cost $500 million and construction has begun with a projected in-service date during the summer of 2019.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for APS include:

--A 10% ROE;

--Positive retail sales growth of 0.5% per annum;

--Customer growth of 1%-2% per annum;

--Capex averaging $1.2 billion per annum through 2018;

--Anticipated equity infusion from PNW to APS in 2017 to preserve a balanced capital structure

RATING SENSITIVITIES

Future developments, individually or collectively, that could lead to a positive rating action include:

--Sustained debt-to-EBITDAR leverage metrics under 3.3x;

--Continued supportive regulatory regime in Arizona;

--Greater clarity regarding tariff design and competitive pressures associated with DG.

Future developments, individually or collectively, that could lead to a negative rating action include:

--Deterioration in the regulatory compact in Arizona;

--An adverse outcome in APS' next GRC;

--Sustained debt-to-EBITDAR leverage metrics over 3.6x;

--A sharp acceleration in competition from DG and/or other emerging technologies.

LIQUIDITY

Solid Liquidity: As of March 31, 2016, APS had total consolidated liquidity available of $743 million including $5 million of cash and cash equivalents. APS maintains liquidity through two $500 million unsecured credit facilities which mature in September 2020 and May 2019. Additionally, APS can upsize their $500 million credit facilities to $700 million each with consent of the lenders. The credit facilities backstop the company's commercial paper program and are subject to a maximum debt-to-capitalization covenant of 65% and as of March 31, 2016 APS was in compliance with the debt-to-capitalization ratio of 45%. APS' long-term debt maturities are manageable with $439 million scheduled to mature through 2018 as follows: $357 million in 2016, none in 2017 and $82 million in 2018.

Date of Relevant Committee: May 27, 2015.

Additional information is available on www.fitchratings.com

Summary of Financial Statement Adjustments:

Fitch capitalizes annual operating lease expense using an 8x multiple.

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362

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