| | | | | | Allegheny Still Open for Business What Could be Done With the Proceeds? Prep the Opco. The key to a split rating path: It's really all about the Utility credit quality While we and Street have thus far been quite focused on Moodys as the key agency to dictate action for FE given its more stringent 14% FFO/debt metric today, we perceive little desirability to maintain this 14% metric any more from mgmt. Given the limited practical financing impact of a downgrade from Moodys and limited impact on Opcos, this would appear a clear threshold mgmt. is willing to cross. Rather, we see the threshold question now shifting to ~13% required per S&P today and 11-12% under any eventual FE generation divestment/sale to become a pure-play regulated company. We note some ambiguity from S&P and mgmt. around exactly what this minimum level is, but both acknowledge 11% is an ultimately acceptable figure for a credit minimum. Why is a downgrade from S&P so key? It's about preserving utility relations We emphasize S&P's one-notch requirement would effectively drive the utilities into a HY position should the holding company be downgraded one further notch from BB+ to BB. While the financial impact technically here too would be limited, the reality remains this is an unpalatable regulatory development, particularly amidst its efforts to improve its regulatory constructs to re-engage in utility growth. With trailing statistics from both agencies at ~12.5% with genco and ~10.5% without the genco biz, FE has relied upon its FES and AES businesses to maintain IG ratings on a trailing basis however the combination of hedges and capacity revenues poised to fall off. As such, we see it becoming a net drag, requiring potentially more than $5 Bn in cumulative equity to keep IG metrics if sustained through the decade, an unpalatable figure. What Could be Done With the Proceeds? Help the Pension Liabilities While the company would not negate the current plans for ~$100M yearly DRIP financing and $500M equity planned for this year, we expect proceeds from the divestiture of funding Opco level liabilities (principally pension) could provide more leeway for the company to reach a palatable 12% FFO/Debt to maintain investment grade rating with S&P (assuming a shift towards more regulated). Further, we expect settlements at both the PUCO and in Pennsylvania (as a bundled distribution resolution) within the next several weeks could provide further cushion. The company could also look to cost savings programs and a scale-back of capex, as needed, to avoid effects on the holdcos from opco rating changes. FES Still Uncertain Territory; AES Free to SeparateAside from the nuclear asset challenges, we note Mansfield sale-leaseback complexity makes a sale or divesture increasingly difficult in the FES segment. Ex- a more constructive outcome for the assets, we see ongoing likelihood of our sell/retire scenario analysis trending towards the retire aspect. However, management confirmed AES is nearly a 100% independent legal entity (some transfer pricing) with no cross defaults or claims on assets, and we think the company could look to monetize AES assets potentially as soon as West Virginia clarity is reached. We think AES bondholders would almost certainly push back on any potential merge+spin scenario with FES, and expect the company would likely focus on minimizing capex in the segment in the interim. Competitive Energy Svcs (CES) Direct Liabilities to Parent ~$1B: All FESPrimary 'direct' recourse obligations to FE from FES are just over $1B While the FES debt is technically non-recourse to the parent, FE is not without obligation. The $250M unfunded pension liability, ~$136M executive deferred compensation, and ~$650M pension liability for the FirstEnergy Nuclear Operating Company (FENOC) is equivalent to roughly $1B of direct FE obligations. On the other hand, the Allegheny subsidiary (AES) includes no equivalent obligations. This further highlights opportunities to come up with a more constructive solution on the part of the competitive business. Debt Resolution the Key to FESAs we outlined in our recent note looking at potential FES scenarios, the company has a number of options to resolve the business including 1) Selling and retiring, 2) Getting help in OH/PA 3) Spin off, or 4) Do nothing. A related but slightly nuanced option could involve some form of asset transfer for minimal consideration, but we view such a scenario as likely problematic. We think the biggest challenge for any resolution that does not involve an equity positive sale would be debt resolution. While the company technically has primarily non-recourse debt and manageable (~$1B) direct obligations, substantial pushback from existing debt holders would be likely in light of ~$4.5B of obligations. In the near term, the company could consider asset-specific sales such as West Lorain, which is most likely more marketable vs some of the other assets (see Figure 1). Figure 1: FES Value is Principally the Gas Asset Again (West Lorain) | 
| Source: Company reports, UBS estimates |
But AES Remains SeparateEquity proceeds from any potential sale would accrue to the parent still Although the possibility of combining FES+AES for a spinoff remains a potential scenario some investors feel is worth considering, the company formed each entity completely separately and they remain legally so – thus, we think this is unlikely given the distinctly different valuations in the units by our estimates. Based on our initial analysis, AES could be worth $800M-$1B, buoyed primarily by the Bath County pumped hydro and gas peaker portfolio. This is in contrast to ~$600M of debt currently at the subsidiary. We emphasize this cash is not trapped at the FES level as AES is an entirely separate Tier 1 subsidiary. Figure 2: AES Debt | 
| Source: FE, Factset, UBS estimates |
In the event a potential AES sale, we believe incremental $200-$400M of cashflow (after paying back debt holders) would most likely be used not to offset equity but rather to pay down existing obligations at the FE Parent level – whether pension obligations or parent level debt. Could a West Virginia deal still materialize at Mon Power Further, we note ongoing desires to continue to transfer existing AES merchant plants back into the Mon Power ratebase, specifically focusing on the single remaining coal asset, Pleasants. At 1.3GW, the plant’s current book value is $970 Mn or ~$750/kW. Even if removing the goodwill ascribed to the plant to bring its book value down to ~$850 Mn, this would imply ~$650/kW – a level too high in our opinion to justify transferring the asset, given recent transactions in the ~$200/kW range. Either way, success on this venture would only further the company's wider effort to fully re-regulate its profile and would be the remaining item at AES assuming any monetization of the gas and hydro assets. An S&P Dilemma?Any potential Holdco S&P downgrade would likely put the utilities ratings at risk While our focus historically has been more on the Moody's required ~14% FFO/Debt to maintain investment grade credit at the current business mix, we note a potential divestment of the competitive segment could shift this to 11%, which we estimate would largely ameliorate the problems. Thus, we believe the key issue is the BBB- Rating at S&P. Current methodology implies 13% FFO/Debt metrics for the consolidated business, but this would likely shift to 12% with even some potential flexibility under an ex-FES scenario. However, we believe the primary issue is that any S&P downgrade would likely trigger an opco-downgrade at the utilities, potentially threatening junk bond territory and significant cost of capital shifts in addition to a challenged regulatory environment. What is FE's Current Liquidity?We highlight below the most recent liquidity metrics as of Q2. Figure 3: FE Liquidity Breakdown | 
| Source: FE, UBS estimates |
What are the Cash Flow + Options?While management is clearly cognizant of the longer term issues at the competitive business, the key question remains just what level of incremental cash flow could be generated – particularly given our view that the standalone utility cannot support investment grade credit as it stands today. $50M incremental cash income from the PA consolidated tax adjustment, $131M from the current proposed Ohio tax settlement (assuming the company is able to realize this level post tax eventually) and our assumption around the upcoming PA settlement (we expect ~$0.20 per share earnings impact when the settlement is finalized in the coming weeks). This implies an incremental $100M of cost savings likely required to maintain investment grade rating; we expect this level of savings (largely derived off the Utilities) to be announced alongside EEI as part of the plan to emerge from the close scrutiny of its balance sheet by the credit rating agencies. Figure 4: FE Would Likely Need ~$370M Worth of Incremental Cash to Maintain IG rating | 
| Source: Moody's, FE, UBS estimates |
Cash Flow Positive... Assuming NOLsNOLs are worth ~$250M/yr Following CEO Chuck Jones' comments on the last call suggesting FES would be cash flow positive through 2018, we looked to clarify what exactly this assumption included. The key assumption here appears to center around ~$250M/yr worth of cash transfer from the parent to FES for NOL remuneration. Total NOLs of ~$4.5B are expected to be monetized through the end of 2020, but excluding the NOL cash payments from the utilities back to FES, the overall competitive segment company would be borderline cash flow positive at best by 2018, while 2019 would turn negative as capacity payments roll off and current energy forwards remain unsupportive. Implicitly this suggests FCF of ~$250 Mn in 2018. This is roughly ~$100 Mn above our latest MtM model. Teaming Up in PA?While we have viewed a positive regulatory outcome in Ohio as a more likely scenario, management pointed out that Nuclear in PA is 56% of total generation and the major players there (FE, EXC, TLN) are currently in talks to address shortfalls in the state – though nothing formal has been submitted as of yet. The key here remains the viability of legacy coal assets in the state – if FE is able to work with EXC and TLN to get a bill through the PA legislature, the question is would the focus land primarily on the nukes or would there also be latitude to address issues on the coal side as well? Ultimately, we think the company would likely target 1) re-regulation 2) selling the assets, or 3) de-activation. However, selling the assets without a legislative or regulatory resolution to support continued operations would be challenging for assets like Sammis and extremely difficult for the Nuclear Assets. We remain more sober on prospects in PA for action given the wide range of interests between coal, nuclear, and gas. Further, without cohesion on a path to deal with assets among players it’s unclear what any proposal would be at this point. Overall, the state has been amongst the most committed to competitive power markets, and as such appears a heavy lift. To this point, rejoining the RGGI carbon trading program as Gov. Wolfe has discussed would appear substantially insufficient to address any real cash deficits given the very low trading price. Maturity profile a further focus as segment risks liquidity With the segment having both $131 Mn in 2017 maturities, and a further $550 Mn in 2018 maturity, we see risks pertaining to the subsidiaries' ability to sustain adequate liquidity. We further note with arbitration continuing on a long-standing coal delivery matter with the rail companies, we estimate the ~$500 Mn in NPV value as also due in the May 2017 timeline according to timeline disclosed. We note this deal was tied to PRB rail contracts for Ohio lake-shore plants which had presumed low sulfur PRB would be sufficient to meet tougher MATS standards. • Mgmt believes it is likely able to refinance 2017 maturities with (secured) First Mortgage Bonds. • Mgmt. does not intend to use corporate revolver to fund 2018 maturities • Nuclear business would have further ~$800 Mn obligation in ~2023 to fund the Beaver Valley 2 steam generator replacement. Under current economics this would appear an unpalatable investment. Mgmt notes there is potential for a further delay in the timeline for this replacement. What does Utility growth look like? We see ~$1 Bn of transmission spend as largely consistent with the company's current near-year plans, emphasizing its current $500 Mn/yr equity plan could well be extended into future years in order to ensure a stable balance sheet. We expect details for near-year balance sheet funding to be a key part of the 2016 guidance. Generation Asset PortfolioWe include a brief latest synopsis of key assets within the portfolio. FirstEnergy Solutions (FES) • Sammis and Mansfield: Latest commentary focuses on challenges in plant valuation given the ongoing sale-leaseback on Unit 1 of Mansfield adding complexity to any eventual review of the asset. Given this added complexity we see ~$200/kW as a maximum value, with a downside bias. • West Lorain gas peaker: The question is what this asset is this peaker worth; given recent upward prints on gas generation deals, we see a clear positive bias to valuations. • Overall, the FES subsidiary would appear to have less than ~$1 Bn in value, with the key uncertainty pertaining to the value of the nuclear assets, to which we ascribe little particularly given future capex requirements on Beaver Valley (two unit plant in PA). | | | | | | | Forecast returns | Forecast price appreciation+11.7% | Forecast dividend yield4.6% | Forecast stock return+16.3% | Market return assumption5.8% | Forecast excess return+10.5% | | Valuation Method and Risk Statement Risks to FirstEnergy (FE) investment thesis include but are not limited to: 1) adverse regulatory/legislative/legal outcomes; 2) declines in customer usage and growth; 3) unfavorable weather; 4) weak wholesale power prices; 5) economic downturn in its regulated service territories; 6) inability to access the capital markets on attractive terms; 7) nuclear risks and other natural disasters; 8) disruption of trading activity in power markets; 9) unfavorable changes in commodity costs; 10) inability to achieve regulated capital expenditure targets and/or higher than expected unregulated capital expenditure needs; and 11) other unforeseen risks.
Valuation is based on sum-of-the-parts analysis. Required Disclosures This report has been prepared by UBS Securities LLC, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS. For information on the ways in which UBS manages conflicts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance is not a reliable indicator of future results. Additional information will be made available upon request. UBS Securities Co. Limited is licensed to conduct securities investment consultancy businesses by the China Securities Regulatory Commission. UBS acts or may act as principal in the debt securities (or in related derivatives) that may be the subject of this report. This recommendation was finalized on: 10 October 2016 02:13 PM GMT. Analyst Certification: Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers and were prepared in an independent manner, including with respect to UBS, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. UBS Investment Research: Global Equity Rating Definitions 12-Month Rating | Definition | Coverage | IB Services | Buy | FSR is > 6% above the MRA. | 45% | 28% | Neutral | FSR is between -6% and 6% of the MRA. | 39% | 25% | Sell | FSR is > 6% below the MRA. | 15% | 17% | Short-Term Rating | Definition | Coverage | IB Services | Buy | Stock price expected to rise within three months from the time the rating was assigned because of a specific catalyst or event. | <1% | <1% | Sell | Stock price expected to fall within three months from the time the rating was assigned because of a specific catalyst or event. | <1% | <1% |
Source: UBS. Rating allocations are as of 30 September 2016. 1:Percentage of companies under coverage globally within the 12-month rating category. 2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months. 3:Percentage of companies under coverage globally within the Short-Term rating category. 4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months. KEY DEFINITIONS: Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stock's price target and/or rating are subject to possible change in the near term, usually in response to an event that may affect the investment case or valuation. Short-Term Ratings reflect the expected near-term (up to three months) performance of the stock and do not reflect any change in the fundamental view or investment case. Equity Price Targets have an investment horizon of 12 months. EXCEPTIONS AND SPECIAL CASES: UK and European Investment Fund ratings and definitions are: Buy: Positive on factors such as structure, management, performance record, discount; Neutral: Neutral on factors such as structure, management, performance record, discount; Sell: Negative on factors such as structure, management, performance record, discount. Core Banding Exceptions (CBE): Exceptions to the standard +/-6% bands may be granted by the Investment Review Committee (IRC). Factors considered by the IRC include the stock's volatility and the credit spread of the respective company's debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating. When such exceptions apply, they will be identified in the Company Disclosures table in the relevant research piece. Research analysts contributing to this report who are employed by any non-US affiliate of UBS Securities LLC are not registered/qualified as research analysts with FINRA. Such analysts may not be associated persons of UBS Securities LLC and therefore are not subject to the FINRA restrictions on communications with a subject company, public appearances, and trading securities held by a research analyst account. The name of each affiliate and analyst employed by that affiliate contributing to this report, if any, follows. UBS Securities LLC: Julien Dumoulin-Smith; Jerimiah Booream, CFA. Company Disclosures Company Name | Reuters | 12-month rating | Short-term rating | Price | Price date | FirstEnergy Corp. | FE.N | Neutral | N/A | US$31.32 | 07 Oct 2016 |
Source: UBS. All prices as of local market close. Ratings in this table are the most current published ratings prior to this report. They may be more recent than the stock pricing date 7.Within the past 12 months, UBS Securities LLC and/or its affiliates have received compensation for products and services other than investment banking services from this company/entity. 16.UBS Securities LLC makes a market in the securities and/or ADRs of this company. Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report. For a complete set of disclosure statements associated with the companies discussed in this report, including information on valuation and risk, please contact UBS Securities LLC, 1285 Avenue of Americas, New York, NY 10019, USA, Attention: Investment Research. FirstEnergy Corp. (US$) 
Source: UBS; as of 07 Oct 2016 |
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