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Rating Action:

MOODY'S EXPECTS ATMOS ENERGY'S RATINGS TO REMAIN INVESTMENT GRADE; ALL RATINGS REMAIN UNDER REVIEW FOR POSSIBLE DOWNGRADE (A3 SR. UNS., PRIME-2 CP)

06 Aug 2004
MOODY'S EXPECTS ATMOS ENERGY'S RATINGS TO REMAIN INVESTMENT GRADE; ALL RATINGS REMAIN UNDER REVIEW FOR POSSIBLE DOWNGRADE (A3 SR. UNS., PRIME-2 CP)

Review Continues Pending Additional Equity Issuance, Requisite Approvals to Close Acquisition

New York, August 06, 2004 -- Moody's Investors Service expects Atmos Energy Corporation's ratings (A3 senior unsecured) to remain investment grade when the review of Atmos's ratings concludes later this year. Moody's placed Atmos's ratings under review for possible downgrade on 6/17/04 following Atmos's announcing its agreement to acquire TXU Gas Company's assets from TXU Corp. for $1.925 billion in cash. Atmos's senior unsecured ratings would likely fall to Baa3, assuming that the company issues at least $300 million of equity over the next several months as planned. Moody's notes that the likelihood of Atmos raising a total of $500-$600 million of equity to fund the acquisition has improved following its $236 million equity issuance in July. To achieve a Baa2 rating, Atmos would need to undertake a permanent financing of the purchase with a more equal balance of equity and debt than what is contemplated (30% equity/70% debt).

All of Atmos's ratings remain under review. Moody's expects to conclude the review at around closing (anticipated in the fourth quarter of this calendar year, contingent upon approvals from state and federal regulatory agencies) when there is sufficient certainty that the acquisition will be consummated and financed as planned.

In terms of absolute size, the TXU Gas purchase is by far the largest transaction in Atmos's history. The combination will almost double Atmos's total assets and more than double its debt. In these respects, this acquisition is a departure from the company's established strategy of making series of tuck-in acquisitions of neighboring gas utilities and financing them with a balance of equity and debt. This fully valued, substantially debt financed transaction will constrain Atmos's financial flexibility. It could weaken its profitability and coverages over the several years the company believes it could take to fully realize the synergies from this acquisition.

In the near term after the merger, we expect Atmos's pro forma credit measures to fall to minimal investment grade levels (e.g., retained cash flow-to-debt at around 10%). Debt/capital at the outset would be at around 60%, but on a tangible net worth basis (capitalization excluding about $540 million of goodwill incurred in this transaction), this ratio would be nearly 80%. We view with caution Atmos's cost savings expectations, and its remaining investment grade would entail demonstrating material cost reductions in the TXU Gas assets and reducing a significant amount of debt from the free cash flow it expects to generate. The company's ratings could improve over the 18-24 month timeframe if, during this period, it can sustain retained cash flow-to-debt in the low teens, FFO/interest at least in the mid 3x range, and ROE on a GAAP basis above 9%.

In this acquisition, Atmos has shown a willingness to take on significantly more financial risk than it has historically. It remains to be seen how its financial policies will evolve as a much larger company with more investment opportunities (for example, its decisions as to reinvestment versus debt reduction). The TXU Gas assets include a pipeline system, whose commercial opportunities Atmos plans to develop. Moody's will monitor the company's yet to be defined strategy for this new segment and what implications it would hold for its financial and business risks.

The amount and timing of cost cuts that Atmos achieves is critical in its meeting its long-range plan for the combined company. It is possible that some of its expectations may not materialize as planned. The company expects to derive cost savings in the front years of the combination not from headcount reductions, but from the elimination of a significant amount of costs now allocated to TXU Gas from TXU Corp. Moody's notes that Atmos has had success in achieving synergies in past acquisitions and its operations are more efficient than its peers by a number of measures. The disparity between Atmos's operating measures compared to TXU Gas (e.g., 2003 O&M expense/customer of $120 vs. TXU Gas's $200) suggests a wide room for cost reduction.

Atmos is precluded from certain cost reductions in Year One (fiscal year ending 9/30/05) because of a renewable one-year transition services agreement with TXU's new Cap Gemini joint venture which will provide administrative services for the TXU Gas assets at cost. Moody's notes that this joint venture went into operation only last month, and the benefits of such an arrangement for Atmos have yet to be seen.

Once the post-merger transition is over, Atmos expects it could generate free cash flow after dividends but before any other financing activity (including shares issued under its stock plans). Atmos would need to meet its cost-reduction expectations for the TXU Gas assets to offset the interest expense that will be burdened on the TXU Gas assets ($40 million incremental to TXU Gas's current levels). The company expects to generate free cash flow from TXU Gas (if capex for TXU Gas assets remains restrained at current levels) and higher depreciation and deferred taxes from the step-up in the book and tax bases of the TXU Gas assets that it expects would offset incremental stock dividends (about $35 million). Any excess cash flow and incremental proceeds from stock issued for TXU Gas employees who will join Atmos's stock plan would be available to pay down debt.

Moody's notes that there is some execution risk in achieving incremental cash flow from the above sources. As for deferred taxes, the purchase price allocation has not yet been completed; the combined balance sheet has yet to be finalized. Consequently, the cash tax savings for Atmos may differ from current estimates. It is possible that proceeds from stock plan issuances (a large component of Atmos's free cash flow assumptions that is not under Atmos's control) could fall below the company's expectations if future issuance varies from past experience.

Atmos Energy Corporation, headquartered in Dallas, Texas, engages in natural gas distribution and marketing.

New York
John Diaz
Managing Director
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Mihoko Manabe
VP - Senior Credit Officer
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

No Related Data.
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