OREANDA-NEWS. Fitch Ratings has assigned an 'A' rating to Arizona Public Service Company's (APS, Issuer Default Rating: 'A-'/Stable Outlook) issuance of $250 million of senior unsecured notes, due 2026. The senior unsecured notes rank pari passu with existing senior unsecured debt. Proceeds will be used to refinance a like amount of recently matured long-term debt.

APS' Stable Outlook reflects the utility's relatively predictable cash flows and a constructive regulatory environment in Arizona. Fitch anticipates a balanced outcome in APS's recently filed 2016 general rate case (GRC) and expects the Arizona Corporation Commission (ACC) to address rate design regarding energy efficiency (EE) and distributed generation (DG) in a credit-supportive manner as rooftop solar continues to expand in Arizona. Adverse outcomes in pending or future rate design and/or GRC proceedings, signaling deterioration in the current credit supportive regulatory environment, could lead to negative credit rating actions.

KEY RATING DRIVERS

Strong Credit Metrics: APS' credit metrics are expected to remain strong. Fitch estimates EBITDAR coverage of approximately 6x through 2018, on average. Debt/EBITDAR is expected to weaken modestly due to high capex but remains better than 3.5x through 2018.

2016 GRC: On June 1 APS filed its 2016 GRC supporting a $166 million (6%) rate increase based on a 10.5% return on equity (ROE) for rates effective July 1, 2017. APS' GRC filing seeks to expand its partial revenue decoupling mechanism and requests authorization to defer over $900 million of future costs related to installation of emission controls at the Four Corners coal plant and the modernization project at the Ocotillo natural gas-fired generating plant. Fitch expects a decision in the second quarter of 2017 and has modeled in a 10% authorized return on equity (ROE) for APS, approximating recent industry averages.

AZ Regulatory Compact: The regulatory compact in Arizona has become 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 believes ACC 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 is credit supportive. APS' earned ROE for the LTM ended June 30, 2016 was approximately 9.4%, below its authorized ROE of 10%.

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 approximated 1.4% for the six months ending June 30th, a modest increase compared to the average 1.3% annual customer growth logged over the four years ended 2015, and a marked improvement over the prior three-year period when customer growth averaged 0.6%.

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 variation, increased 0.6% for the six months ended June 30th as compared with the prior-year period. This reflects the effects of improving economic conditions and customer growth partially offset by EE, demand response and DG. 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 (NM) remains a contentious, highly politicized issue in Arizona and is a secular source of concern from a credit perspective. 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 and aligning time of use rates with peak system demand to better reflect fixed costs in rates. APS' 2016 GRC filing includes a three-part rate design proposal comprised of a fixed charge, a demand charge and a volumetric component for residential customers. Fitch believes adoption of a more balanced rate design that addresses the current cost shifting issues associated with NM along with expansion of partial revenue decoupling for EE and DG would be positive for APS.

The ACC has opened 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 a decision later this year with the findings to be considered in 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

Large Capex Program: APS is targeting rate base growth of 6%-7% through 2018, driven by average annual utility 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 riders and depreciation cash flow, providing timely cost recovery.

Negative FCF: Due to its large capex program, Fitch expects APS to be moderately FCF negative through 2018, funding the majority of forecasted capex internally. APS' external capital needs are expected to be primarily funded with debt and Fitch anticipates a modest equity infusion from its parent Pinnacle West Capital Corp. (PNW, Issuer Default Rating [IDR]A-/Stable Outlook) into APS in 2017 to help maintain the utility's balanced capital structure.

KEY ASSUMPTIONS

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

--A 10% authorized ROE;

--Positive retail sales growth averaging 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

Positive Rating Action: Sustained debt /EBITDAR leverage metrics under 3.3x, better than expected outcomes in future GRCs and a balanced outcome in pending rate design proceedings to address DG could result in future upgrade.

Negative Rating Action: Deterioration in the regulatory compact in Arizona, an adverse outcome in APS' 2016 GRC, sustained debt/EBITDAR leverage metrics over 3.6x and/or a sharp acceleration in competition from DG and/or other emerging technologies could trigger downgrades.

LIQUIDITY

APS liquidity is sufficient with $967 million of available liquidity under its credit facilities as of June 30, 2016, including $31 million of unrestricted cash and cash equivalents. APS maintains liquidity through two $500 million unsecured credit facilities that mature in May 2021 and September 2020, respectively. These facilities support APS's $500 million commercial paper program and APS can upsize the facilities to $700 million each with consent of the lenders. There were no direct borrowings against these facilities as of June 30, 2016. The credit facilities are subject to a maximum debt/capitalization covenant of 65% and as of June 30, 2016 APS was in compliance with a debt/capitalization ratio of 46%. APS' long-term debt maturities are manageable, with $726 million scheduled to mature through 2019 as follows: $44 million in 2016; none in 2017; $82 million in 2018; and $600 million in 2019. Fitch expects APS to refinance these maturities on a timely basis.