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Announcement:

Moody's: FirstEnergy Takes Steps Towards Exiting Merchant Generation; Credit Neutral Overall

08 Dec 2016

New York, December 08, 2016 -- On Dec 6, 2016, FirstEnergy Corp (FirstEnergy, Baa3 stable) disclosed a number of new developments related to its merchant business. This includes changes to revolving credit facilities and term loans at FirstEnergy, its regulated subsidiaries, FirstEnergy Solutions Corp (FES, Caa1 negative) and Allegheny Energy Supply Co (AES, B1 negative), a reconstitution of FES' board of directors and progress towards the sale of assets at AES. From a credit perspective, these changes come with both positive and negative implications to FirstEnergy and FES, but are largely consistent with management's intent to exit the merchant business within the next 18 months, and overall are credit neutral for FE.

FirstEnergy's new exposure to FES has negative credit implications but is manageable:

The most important change was the termination of FES and AES' existing $1.5 billion unsecured revolving credit facility and its replacement with a $700 million secured revolving credit facility. The new secured facility has a term of two years, through Dec 31, 2018, and names FirstEnergy as the lender. AES will no longer be a borrower under the new facility. For FirstEnergy, this creates a new exposure to FES that did not exist before. However, the impact on FirstEnergy's credit is mitigated by the following considerations:

1. We do not see this as management's appetite for new merchant exposure at FirstEnergy but rather as a necessary step for its eventual exit from the business. The changes to the revolving facilities have enabled the elimination of a couple of potentially problematic covenants that could have otherwise affected parent FirstEnergy.

2. FirstEnergy has assumed a secured exposure to FES. There is currently about $612 million in secured debt at FES compared to a total of $3 billion of funded balance sheet debt. Assuming a FES bankruptcy, secured debt will enjoy better recovery prospects than unsecured debt. In August 2016, we published an illustrative estimate of FES' asset values, about $2.3 billion, which provides a material cushion and asset coverage.

3. We already incorporate a view that FirstEnergy could face additional liabilities related to a potential FES bankruptcy filing or restructuring. For example, we think FE can accommodate up to $1 billion of incremental, contingent liabilities from a FES bankruptcy or restructuring, in addition to currently outstanding guarantees for pensions, at its current Baa3 rating level. Any exposure under this new revolver that is not recoverable in the event of an FES bankruptcy will be considered as part of this $1 billion limit

4. These changes also make very likely that unsecured bondholders will sue FirstEnergy for converting what was an unsecured revolving credit facility into a secured one, although for a lower amount. In general, we believe bondholder lawsuits are likely in the event of an FES bankruptcy (we discuss other such exposures later in this report) but this is yet another avenue for lawsuits and increases the contingent exposure associated with such lawsuits.

FirstEnergy's new covenant package supports merchant separation:

FirstEnergy's new revolving credit facilities come with covenant changes that eliminate certain risks for FirstEnergy in the event of a restructuring/bankruptcy at FES and will ease the exit from the merchant business. Under the prior facilities, an adverse legal judgment in excess of $100 million, if not paid or stayed in 30 days, was an event of default not just under the FES revolver but also under the FirstEnergy revolver. This covenant will no longer apply to judgments against FES and AES although it remains applicable to the utility subsidiaries. The prior revolvers also required FirstEnergy to maintain a debt to total capitalization ratio of no more than 65%. While this covenant still applies, the denominator of the ratio calculation will now benefit from exclusions not only for previously incurred non-cash charges and write-downs but also up to $5.5 billion of future asset impairments at FES, AES and their subsidiaries.

Sale Proceeds from AES are a credit positive:

FirstEnergy announced that on December 1, 2016, AES entered into a non-binding letter of intent for the sale of its gas and hydro facilities for $885 million (slightly below our estimate from August 2016 of $1 billion), including $305 million of debt assumed by the buyer. This implies net proceeds to FirstEnergy of about $580 million. Should this or a similar transaction be consummated, any net proceeds to FirstEnergy would be an incremental positive relative to our scenario assuming such proceeds are used for debt reduction. At the time of our rating affirmation for FirstEnergy, we had assumed zero value to FirstEnergy from the merchant business. Our analysis assumed that FES and AES simply went away, and focused on the financial profile of FirstEnergy and its regulated subsidiaries, along with any additional bankruptcy related liabilities that may arise, for which we arrived at a limit of $1 billion.

Further, FirstEnergy's subsidiary Monongahela Power Co. (MP, Baa2 stable) announced recently that it was evaluating options for its 487 MW ownership interest in the 3000 MW Bath county pumped storage hydro project, driven by recent changes to PJM's capacity market rules that reduced the capacity value of the Bath county station by about half owing to its inability to produce power continuously during all hours of the day. We think this raises the possibility that AES' 1300 MW Pleasants coal plant may be added to MP's rate base and the ownership in Bath county station divested. Political support in West Virginia for the coal industry creates a favorable environment for this possibility. The state supported the addition to rate base in 2013 of the Harrison coal plant, a merchant asset owned by AES. Any proceeds to AES from such a transaction on the Pleasants asset would be a further positive for FirstEnergy if the proceeds are ultimately used for debt reduction.

Separation from merchant generation is a bumpy road, but FE is stepping in the right direction.

While this announcement is a step in the right direction, we acknowledge that the road to full separation from its merchant business could involve more twists and turns. In its filing on Dec 6, 2016, FirstEnergy also indicated that there continue to be significant commercial relationships among FE, FES and AES. These relationships involve administrative services and support, cash management and tax sharing, among others, which would be subject to review and possible challenge in the event of an FES bankruptcy filing. FirstEnergy may need to incur additional liabilities on account of such challenges.More liabilities could arise if, for instance, FirstEnergy chose to pay off any material judgments against FES related to the ongoing rail contract arbitration. In our opinion, the changes to the various revolving credit facilities makes it less likely that FirstEnergy would directly pay of any arbitration liability. While it is possible that FES may draw on its revolver with FirstEnergy in order to do so, the FES board will weigh that action against the alternative of simply filing FES and making the rail companies pari passu with existing unsecured bond holders. Even with the board changes that were announced, FirstEnergy still appoints three of the five members on FES' board.

Other liabilities related to an FES restructuring/bankruptcy could arise from nuclear decommissioning. FES' nuclear decommissioning trusts are adequate funded at the current point in time relative to their licensed timeframes. But the trusts would be inadequate to fund an immediate decommissioning of the plants. Should one or more of its plants be retired due to weak merchant market conditions, we think it is likely that FES would opt for the SafeStor option, which provides for an additional 60 years before ultimate decommissioning. Other retiring nuclear plants such as Vermont Yankee have done so. However, it is likely that the Nuclear Regulatory Commission (NRC) will be involved in determining the ultimate outcome should FES go bankrupt and choose not to continue operating the plants. In the unlikely but worst case scenario of an immediate decommissioning of the plants, it is possible that FirstEnergy may have additional funding responsibilities as the NRC may look towards the prior owners of the plants for funding.

Offsetting all of these potential liabilities would be any net proceeds from the sale of AES assets as mentioned above. Our $1 billion limit is the net additional debt that FirstEnergy can bear while still maintaining an adequate financial profile. Its ability to bear FES related costs improves if proceeds from AES are used to retire debt at FirstEnergy, or to pay off FirstEnergy related costs.

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history.

Swami Venkataraman, CFA
Senior Vice President
Infrastructure Finance Group
Moody's Investors Service, Inc.
250 Greenwich Street
New York, NY 10007
U.S.A.
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

Jim Hempstead
Associate Managing Director
Infrastructure Finance Group
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

Releasing Office:
Moody's Investors Service, Inc.
250 Greenwich Street
New York, NY 10007
U.S.A.
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

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